5th ANNUAL TAX RETURN TEST TAX PAYERS, START WORRYING! Not a single tax preparer we tested this year turned in an error-free return. Is your pro any better? Judge for yourself.

(MONEY Magazine) – MAYBE IT WAS INEVITABLE: EVERY YEAR SINCE 1987, MONEY has asked 50 professional tax preparers to complete the federal income tax return of a hypothetical family. And every year fewer pros have aced it. In 1988, there were only 10 error-free returns in our survey; in 1989, two; in 1990, one. And this year -- we shudder to say -- no one managed a pristine performance, even though the contestants were perhaps the most experienced group ever to take the test. The unavoidable conclusion: ''Many preparers aren't keeping up with the tax law, or they lack adequate review processes in their practices,'' says Douglas Mueller, the St. Louis C.P.A. who was chiefly responsible for designing the test. He suspects that plain carelessness was a factor in several of the fumbles. What insights can you draw from this abysmal record? Principally, this one: if you use a tax pro and don't routinely check his or her work, you could be in for audit shock one of these years. Here are highlights of the test results: -- As in past years, no two preparers came up with the same bottom line. Although the test authors determined that the lowest legal tax was $26,619, the contestants came up with figures ranging from $16,219 to $46,564, a variation of 187%. Thus the hypothetical test family could have unwittingly underpaid their income tax by more than $10,000 -- or overpaid it by nearly $20,000. -- Many returns were littered with mistakes, even on such basic matters as dependency exemptions, charitable deductions and the child-care credit. The failings were especially dismaying because for the first time in the history of the test, MONEY required that contestants have at least five years of experience in preparing tax returns. -- The pros worked from eight to 70 hours and charged our model family from as little as $520 to a stiff $4,500 for their services. The average hourly fee, however, was $78, compared with $80 last year. Individual taxpayers can learn several lessons from the contestants' mediocre showings on the MONEY test. For starters, you -- not your tax preparer -- are the first line of defense against errors on your return. So check all your documents, such as W-2 and 1099 forms, against your year-end pay stub and other records. If you don't understand a figure, ask for an explanation from whoever sent you the document. If you're not satisfied with the answer, alert your accountant, and make sure he or she gets to the bottom of it before preparing your return. Choose a preparer who understands your knottiest tax situations -- or who can get help from a colleague who specializes in problems like yours. Also mention to your pro any major changes in your finances during the year, even if you aren't sure whether they affect your taxes. Tell him or her to call you with any questions. And before you sign your completed return, get an explanation for any line you don't understand. Finally, if your taxes are complicated, make your tax return just one part of a regular exchange of information between you and your tax pro during the year. That way you can reduce the chances of erroneous assumptions or faulty quick fixes at filing time. Your aim: a correct tax return, not to mention sound sleep after April 15. This year's test was designed by a team headed by Douglas Mueller, tax partner at Mueller Prost Purk & Willbrand in St. Louis, who was the sole A+ preparer on last year's exam. His assistants in drafting this year's test were two colleagues at his firm, Lilly Godfrey, a C.P.A., and David Walther, a tax attorney and C.P.A. Their model return was reviewed for accuracy by Scott Ehrenpreis, a tax consultant at the accounting firm of Becker & Co. in New York City, who found the test both fair and challenging. ''None of the issues was overly complicated, but each tested the pros' ability to recognize and research the tax angles,'' says Ehrenpreis. The test focused on the 1991 finances of the fictional Butler family -- husband Mark, 46, a recently unemployed sales manager for a computer firm; wife Janet, 42, a self-employed massage therapist; and their children, Jonathan, 20, a full-time college student who lives away from home; James, 12; and Jennifer, 6. In addition to the couple's salary and self-employment income of $117,250, Mark received $4,000 as part of a severance package and a $6,345 cash payout from his 401(k) retirement account when he was laid off from his job at the end of October. He also inherited $73,000 from his father. The couple's investments include stock of Mark's former employer, mutual funds, a publicly traded limited partnership and a real estate limited partnership. This year's contestants included 35 C.P.A.s, six enrolled agents (a designation earned by tax pros who have worked at the IRS for at least five years or who have passed a rigorous two-day IRS exam), and seven untitled practitioners whose careers involve preparing returns. The final number of test takers totaled 48; two preparers dropped out at the last minute. As in past years, the Big Six accounting firms declined our invitation to compete. But two storefront chains, H&R Block and General Business Services, were represented by one preparer each. Of the total number, nine contestants asked to participate; the remainder signed up at MONEY's invitation. & While there were no perfect scores, a dozen returns were exemplary. Because of the tax code's ambiguity, the target tax of $26,619 was not the only acceptable answer. For example, this year's winner, William A. Fritz Jr. of Fairfax, Va., concluded that the Butlers owed $26,878. Fritz's return was marred by only three outright errors. He incorrectly deducted a $1,000 capital loss on a stock sale because he didn't realize that the transaction's timing resulted in a wash sale and hence no deductible loss. He overlooked a deductible $450 loss from a limited partnership. And lastly, he understated income by $333 by wrongly assuming that Mark was eligible for favorable tax treatment on an inherited annuity. ''I should have asked more specific questions to pin down these issues,'' says Fritz. Without these mistakes, the tax due on Fritz's return would have been $27,092. His $473 variation from the target tax resulted from decisions he made that were more conservative than those on the model return but were nevertheless justified. For example, Fritz understated Janet Butler's home-office deduction by claiming only 10% of the house's expenses for her office. By contrast, just one preparer among the dozen top performers, Len Hutner of Washington, D.C., deducted 14.28% of such expenses, as did the model return. Hutner's reasoning: Although the home office took up a tenth of the house's square footage, it was also one of seven rooms. Therefore, he wrote off a seventh -- 14.28% -- of the house's expenses against the home office. As you would expect, the tests with extreme high or low results were plagued with goofs. It's important to note, however, that such a score didn't necessarily mean that a preparer made the most mistakes. For instance, only one major blunder accounted for most of the distortions on the return with the highest tax due, submitted by Gary Progar of Milford, Del., and the lowest tax, by Katharine Owens of St. Louis Park, Minn. Progar, who overshot the mark by $19,945, botched a key figure in the devilishly complicated alternative minimum tax computation, boosting the hypothetical family's tax by $14,400. ''In reviewing the return, I think a client would have caught my mistake and set me straight,'' says Progar. Owens' $10,400 shortfall resulted largely from taking a $30,000 loss from a partnership that the Butlers had already written off. That screamer alone understated the family's tax by $7,200. Following are the issues that flummoxed the pros most often: -- Dependency exemptions. In 1991, the Butlers paid $9,000 in medical expenses for Janet's elderly mother, Mary Reed, and gave their son Jonathan $13,700 ($12,000 of it from Mark's inheritance). As a result, six contestants listed Mary as a dependent, and eight claimed the same status for Jonathan. The pros were wrong in both cases. Mary collected $11,160 in Social Security, rents and babysitting fees in 1991; adults cannot be treated as dependents on someone else's return if their gross income tops $2,150. Jonathan provides almost all of his own support through a campus job and pays his college bills with loans. Since the Butlers could take an exemption for him as a full-time student under age 24 if they provided more than half of his support, eight preparers maintained that the $12,000 gift should be regarded as intended for living expenses. But the test clearly stated that Jonathan had invested the money, thus shattering any possible pretense that it was used for his support. -- Mark's W-2. We asked the preparers to recompute this familiar form from the facts we provided. Our reason: to measure a preparer's skill in scanning W-2s for mistakes. Alas, only 10 preparers hit the correct W-2 income of $83,850. Among their blunders: 29 accountants stumbled in determining the lowest possible taxable portion of Mark's reimbursed business expenses. Under the per diem arrangement he had with his employer, the IRS requires that reimbursements above a certain cap be included in the taxable income listed on his W-2. The complicating factor: the IRS lets the employer choose between two methods of computing the cap. Nineteen accountants correctly used the so- called high/low method, which is pegged to the cost of living in the specific areas where a taxpayer travels for business purposes. That approach resulted in a low $1,400 of taxable reimbursement for Mark. Thirteen preparers followed a method involving IRS tables that average high- and low-cost areas, which resulted in a taxable reimbursement of $1,760. (If the reimbursement caps apply to you, then either you or your accountant should check to make sure that your employer is using the method that will be most advantageous to you.) Five contestants mistakenly excluded from taxable income a $4,000 cash payment Mark took in lieu of outplacement services when he was laid off; tax understatement: $960. Had he taken the services instead, they too would have been taxable. The value of outplacement services is tax-free only when you don't have a choice between cash and the service. -- Mutual fund redemption. The Butlers pocketed $70,000 when they sold 500 mutual fund shares in December. The preparers had to select the best way to compute the gain. One of four permitted methods, called specific identification, was off limits because the Butlers had not stated which shares they were redeeming at the time of the sale. Six pros used specific ID anyway, which undershot the Butlers' gain by $5,530 and their tax by $1,327. Of the three remaining methods -- double-category averaging, single-category averaging and first-in, first-out -- 35 preparers correctly opted for single- category averaging, the method that yielded the lowest allowable gain of $14,558 and a tax of $3,494. Another seven pros used the first-in, first-out method for a gain of $18,915 and a tax of $4,540. -- The inheritance. After splitting his father's bequest with his two sisters, Mark had a legacy that included $2,000 from a retirement annuity that his father had never tapped. Some 31 pros overlooked the fact that $1,667 of the $2,000 annuity was nontaxable because of a special exclusion in the tax code for those inheriting undistributed pensions. The oversight cost the Butlers an additional $400 in tax. -- Medical expenses. Many preparers were confused over the tax treatment of the Butlers' hefty medical payments for Janet's mother Mary Reed and their son Jonathan. The correct answer: the Butlers could deduct $9,000 of medical bills they paid for Mary Reed's hospital stay, because the amount represented more than half of her total support for the year. But the Butlers could not write off $2,000 they spent on a knee operation for Jonathan because the amount is less than half of his living expenses. The 13 pros who missed the deduction for Mary Reed's medical costs increased the Butlers' bottom line by $749. The 14 preparers who claimed Jonathan's expenses understated the couple's tax by $480. -- Interest expenses. The Butlers refinanced their home in 1991 with a $145,000 mortgage. They used $127,800 to pay off their old mortgage, $14,000 to equip Janet's home office and $3,200 on home improvements. The preparers had to determine how much interest and points could be written off in 1991 and where on the return to allocate those sums. As the tax test authors had suspected, the answers were all over the board. ''Interest expense has been one of the most complicated areas of tax preparation ever since tax reform in 1986,'' says Doug Mueller. ''Overnight, we went from one type of interest to at least five, each governed by its own set of quirks. Even worse, the IRS constantly reinterprets its own rules through new regulations, court cases, notices and letter rulings.'' So much for tax simplification. As a consequence, the preparers came up with 32 different deduction amounts. The Mueller tax team calculated $3,704 in points and $13,087 in interest. Seventeen preparers took a similar approach to Mueller's; he allocated $13,498 in interest and points as itemized deductions on Schedule A and $3,293 to Janet's Schedule C; of the last amount, $1,054 was attributed to the purchase of business equipment and $2,239 to her home office. Twenty-six other preparers were less assertive, taking the write-offs as an itemized deduction on Schedule A and as a home-office deduction but shying away from claiming any amount against Janet's business purchases. This choice proved costly because the Butlers were subject to the alternative minimum tax (AMT), which forces taxpayers with excessive tax breaks to pay tax on their income at a flat 24% rate. In computing the Butlers' AMT, some of the itemized interest write-off on Schedule A had to be canceled, but not the business-expense deductions on Schedule C. -- Alternative minimum tax. Under normal circumstances, a family like the Butlers would not run afoul of the AMT because their deductions and other tax breaks are usually in line with their income. But in 1991, Mark unleashed the AMT by exercising incentive stock options (ISOs) that his former employer had granted him nearly 10 years earlier. Here's the AMT angle: When you exercise ISOs, you owe no tax on the so-called bargain element, which is the difference between the option price and the stock's current market value. You owe tax only on your profit when you actually sell the stock. But in the year that you exercise the options, the bargain element is added to your income in computing your AMT. In Mark's case, the figure came to a hefty $40,000 -- enough to trigger the AMT. Fourteen of the participants overlooked the bargain element, however, and therefore they mistakenly concluded that the Butlers had no AMT liability. The resulting tax shortfall: a $3,175 whopper.

CHART: NOT AVAILABLE CREDIT: NO CREDIT CAPTION: 48 WAYS TO FLUNK A TAX TEST The target tax of $26,619 (high lighted in red) eluded all 48 contes tants in ) this year's test. Yet even an error-ridden return -- as many of these proved to be -- would have cost the hypothetical family a bun dle in tax preparation fees: the av erage bill worked out to $78 an hour. For comparison's sake, the tax experts who designed the test for MONEY estimated that a perfect return should have taken 28 hours to complete with a fee of $2,500, for an hourly rate of $89.