It’s a moment many taxpayers dread.
A letter arrives from the IRS and it’s not a refund check. But don’t panic; many of these letters can be dealt with simply and painlessly.
Each year, the IRS sends millions of letters and notices to taxpayers to request payment of taxes, notify them of changes to their accounts, or request additional information. The notice you receive normally covers a very specific issue about your account or tax return. Each letter and notice offers specific instructions on what you are asked to do to satisfy the inquiry.
However, the letters also have to advise you of your rights and other information required by law. Thus, these letters can become overly lengthy and sometimes difficult to understand.
Here are dos and don’ts to follow if you receive correspondence from the IRS or state tax authority:
Do immediately get a copy of the correspondence to this office so it can be reviewed and timely responded to.
Don’t respond if the correspondence requests personal information. There has been substantial identification theft related to scam artists pretending to be the IRS or another authority, especially correspondence by e-mail. Let this office take a look before responding.
Don’t procrastinate or throw the letter in a drawer, hoping the issue will go away. Most of these letters are computer-generated and, after a certain period of time, another letter will automatically be generated. And, as you might expect, each succeeding letter will become more aggressive and less easily dealt with.
Don’t automatically pay an amount the correspondence is requesting unless you are positive you owe it. Quite often, you will not owe what is requested, and it will be difficult to get your payment back.
Most notices are computer-generated after comparing the income items reported on your return with those reported by the payers. For example, your employer sends you a W-2 every year and also sends a copy to the government so that your wages are on the IRS computer. Your bank sends the 1099-INT to the IRS showing how much interest you earned. Your brokerage firm reports your dividends with Form 1099-DIV and stock transactions with 1099-B forms. If you are self-employed, those who pay you $600 or more during the year are required to send you and the IRS a 1099-MISC, and if you have credit card transactions, the clearing house will issue a 1099-K. If you are retired and collecting a pension or drawing on your own IRA, a 1099-R will be sent to you. Lenders report how much interest you paid on your home loan during the year. If you are lucky enough to hit it big in Vegas, you will receive a 1099-G for your winnings. The list goes on and on, and if what you reported on your return doesn’t match what is on the IRS’s computer, you will receive a computer-generated notice. One big problem that has developed over the years is the IRS’s willingness to allow payers to use substitute forms that are unrecognizable as income-reporting documents. Many of the brokerage firms are now providing their substitutes in letter-size documents printed front and back on multiple sheets that almost take a financial expert to understand. This results in frequent errors.
There are times when you may receive an income item and it appears to be taxable to the IRS, when in fact it is not. Here are some frequently encountered situations:
Sold a security with no profit − Whenever you sell a security, the brokerage house will report the gross proceeds of sale to the IRS. In other words, the IRS has on their computer what you sold it for. For purchases made before 2011, they have no clue what you paid for it, which means you must report the sale on Form 8949 and Schedule D on your tax return. If you fail to report it, the IRS treats the entire sales price as a profit. Let’s say you sold 200 shares of stock, which originally cost you $5,050, for $5,000. You actually have a loss of $50. Unless you report the transaction and show that you paid $5,050 for the shares, the IRS is going to assume you had a $5,000 profit. This frequently occurs when taxpayers overlook a transaction or simply omit it because there was no profit. If this is what caused the notice, you will need to respond to the IRS to explain the mistake and provide verification of the stock’s original cost.
Rollovers − Another frequent error is when you rollover an IRA, 401(k), etc. from one plan to another or one trustee to another. If you don’t show on the tax return that the distribution was rolled over, the IRS assumes the entire amount to be taxable. If these funds are transferred between trustees, a 1009-R is not supposed to be issued, but sometimes they still are. It is better to make sure. On the other hand, if you take possession of the funds and then redeposit them into another IRA, a 1099-R will be issued, and the rollover must be accounted for on the return. If this is what caused the notice, you will need to provide verification of the rollover to the IRS with your response.
Shared accounts − Generally, banks and other financial institutions only have the capability of having one taxpayer ID as the primary owner on an account, even though it may be a joint account with others. These financial institutions will issue the 1099 or other reporting documents under the social security number (SSN) of the primary owner, and the total will be reported to the IRS under that SSN. This also will affect married or separated taxpayers who do not file jointly. The IRS expects to see the same amount that was reported on the 1099 on the return of the individual whose SSN was used on the 1099. When there’s a mismatch, the IRS will send out a notice of unreported income. When responding to the IRS notice, you will need to provide the names, addresses, and SSNs of the other owners and a statement to the fact that they each reported their appropriate share.
The foregoing are just a few of the more common examples of computer mismatches that can cause computer-generated notices. Even though the IRS feels the notices are readily understandable, experience has shown that taxpayers can become confused and that the experienced eye of a tax professional is usually required to decipher the notices. That is why we highly recommend that this office review any notice you receive prior to your taking any action or responding.
A Word of Caution – The IRS routinely provides state tax agencies with the results of the correspondence audits. Generally, if the IRS’s notice proves to be correct, the results of the correspondence audit will need to be dealt with on the state level through an amended state return, or you can wait to receive the state notice. However, if you wait for the state notice, additional interest and penalties may possibly accrue for the state return.