Question

After consulting with a tax adviser, a taxpayer believes that the odds of her state income tax return being audited are 80%. If audited, she believes that the odds of the state taxing authorities detecting and disallowing a certain deduction claim are 80%. If the state authorities disallow this deduction claim, she objectively believes that there is a 30% chance that a state tax court will overturn the state taxing authority's decision and allow this deduction.

1. What is the probability that she in fact will ultimately get the benefit of this deduction on her tax return?
2. May she claim this deduction, without making special disclosures?

Answer 1

a.         There are three Success outcome paths in calculating the expected value outcome. First, if her tax return is not audited, 20% of the time the taxpayer will get the benefit of this deduction, or equivalently, a Success outcome.

Second, if her tax return is audited (with an 80% chance), the odds are 20% that her deduction claim will not be disallowed. This path therefore has a joint probability, or Success expected value, of 80% times 20%, or 16%.

Finally, the joint probability that her tax return will be audited, the deduction will be disallowed, and she nonetheless will receive the benefit of the deduction from a state court on appeal is 80% x 80% x 30%, or a 19% Success outcome. Thus, if she does claim the deduction, the sum of these various decision pathways leads to the conclusion that she ultimately will get her deduction benefit with a probability of 20% + 16% + 19%, or a total of 55% of the time.  

b.         No. The threshold standard is the substantial authority standard, which requires a 40% or great chance if success if a tax position is detected and challenged on the merits. The relevant probability factor in this case is 30% because reporting standards’ odds of success are conditional probabilities that are based on the assumption that the taxing authority has in fact discovered and challenged a taxpayer’s claim. That is, the reporting standard odds are based on the odds of a position being sustained if detected and challenged by the taxing authority.