Less than two years ago, the Taxpayer Advocate’s office informed me that the Commonwealth of Massachusetts was going to begin examining returns that apply for the earned income credit (EIC). Interestingly, we were told that this is an IRS initiative.  However, with the lack of manpower with respect to this seemingly (on an individual basis) small issue, they defer to Massachusetts to conduct the examination.  As such, if a taxpayer loses the EIC at the Massachusetts level, the eventual loss of the EIC will be much greater at the Federal level.  In essence, the Commonwealth is doing audits of EIC tax returns for the indirect benefit of the Internal Revenue Service.

As an aside, we have one of the toughest Departments of Revenue in the country.  Hands down, and we have an earlier post with respect to CFO magazine’s view of the Commonwealth.  But conversely, we have probably the best Taxpayer Advocate in Dennis Buckley.  I tip my hat to Dennis, I consider him a friend, and he is the Commonwealth’s best advocate for fairness.

Now back to the EIC.  We have seen this a few times.  On one case, we responded to the information request, and never heard from the examiner again.  No closure, no letter, no answer to our request for an appeal if we couldn’t agree or anything of the sort.  Not bad work if you can get it, but I would prefer a case be closed with proper protocol.

But just days after e-filing a 2010 return for a client, they were notified of a Mass DOR audit.  This was a Schedule C taxpayer that also qualified for the EIC.  We immediately had the client keep their Federal refund in the bank, just in case.  We quite recently closed that case successfully, preserving 75% of the original EIC in the process (which means we preserved about the same percentage of the Federal EIC).  However, we just learned from Boston Tax Institute that they are now aware of a case for 2011.  That case was also a Schedule C taxpayer that qualified for the EIC.  We attempted to reach out to this local practitioner in order to share notes because there are traps for the unwary, but to no avail, tax season being what it is I guess…

It’s a simple audit, but with an interesting strategy.  The Commonwealth will intensely focus on Schedule C expenses, attempting to ascertain what can be deemed to be personal in nature, if anything.  The more expenses are disallowed, the EIC diminshes accordingly.   And in turn, that benefits the IRS as well.  Schedule C’s are the juiciest of the juicy for changes.

What we did learn, and it developed into a good defense strategy, was that the Commonwealth wasn’t giving adequate time to handle this type examination.  We were surprised, and contested this issue throughout the audit, as it was very difficult to comply with the document request in their timeframe.  Finally, after the third go around for more documents, we simply told the examiner to write up the case and we will go to the Appellate Division.  We wanted to raise our concern about the “rush” nature of this audit, in addition to the facts.

We learned in doing so that the case gets pulled out of the audit function, and is now at the Appeals level.  That effectively ended the “intrusive side” of the examination, and from that point forward, we dealt with Appeals and addressed whatever questions they had.  Using a mutually agreed to formula for the personal portion of two line items, we settled the case favorably.

So be aware.  It would appear that a Schedule C activity with an Earned Income Credit will be selected for examination by the Commonwealth of Massachusetts.  And don’t give up any of the EIC if you can, because Uncle Sam is waiting behind the door!