Income verification and proposed changes to your tax return: Forms CP2501 and CP2000

The IRS sends you a Form CP2501 when information on your income tax returns doesn’t match information it has received about you from a third party on either a Form W-2 (wages and tips), Form 1098 (mortgage interest), or Form 1099 of any variety (which covers most other types of income). Don’t believe that just because the notice comes from the IRS that it’s necessarily correct.

Income verification notices ask you to explain differences between the income and deductions you claim on your return and the income and deductions reported to the IRS by banks, your employer, and brokerage firms. The IRS assumes that the information it collects from these third parties is correct and that you’ve made a mistake on your return.

Often, the IRS doesn’t bother sending an income verification notice; it simply assumes that the information about you in its computer system is correct and sends Form CP2000, “Notice of Proposed Adjustment for Underpayment/Overpayment.” This form cuts right to the chase; it assumes the information that the government received regarding your income and that doesn’t appear on your return is correct, no questions asked. The IRS bills you for penalties, interest, and additional tax. (You also get this notice when you ignore an income verification request.) CP2000 proposes changes but includes a response form where you can explain why the notice is incorrect.

One of the quickest ways to become separated from your money is to ignore one of these nice little notices. If the notice you receive is wrong or unclear, you need to notify the IRS, as I explain in the earlier section “Understanding the Basics You’ll Find on an IRS Notice.”

Request for your tax return: Forms CP515 and CP518

Form CP515, “Request for Your Tax Return,” and Form CP518, “You Didn’t Respond Regarding Your Tax Return,” are reserved as the non-filers’ first notice and then final notice of overdue returns. These notices go to million people each year, asking why they didn’t file a tax return.

The fact that the IRS expects you to file a return doesn’t mean that you’re actually required to. For example, you should verify whether your income falls below certain limits, which means you don’t need to file a return. Still, if the IRS comes calling, looking for that return, you need to be able to answer.

Here are some of the reasons the IRS may be looking for a return from you when you don’t feel you need to file one:

• The income that the IRS says you didn’t report is exempt from tax (for example, the interest received on municipal bonds).
• The income that the IRS says you failed to report isn’t yours. For example, you opened a bank account for your child or a relative, and you inadvertently gave the bank your own Social Security number.
• The IRS counted the income twice. Perhaps you reported interest income on the wrong schedule. Or your broker reported your total dividends to the IRS as having been paid by the broker, while you reported those dividends on your return according to the names of the corporations that paid them.
• You reported income in the wrong year. Maybe someone paid you at the end of the year, but you didn’t receive this income until the beginning of the next year — and you reported it in that year.
• You made a payment to the IRS for which you weren’t given credit.

If you think that the IRS’s conclusions about your return are wrong, see the section “Correcting IRS Errors” later in this chapter.

Backup withholding notice

As a trade-off for repeal of the short-lived mandatory withholding on interest and dividends, Congress enacted a system of backup withholding if you fail to furnish a payer of taxable income with your Social Security number. The IRS also notifies the payer that backup withholding should be started if you fail to report interest and dividend income on your tax return.

If the IRS determines that backup withholding is required, the payer is informed to withhold tax at the rate of 24 percent (it was 28 percent prior to tax cuts which began in 2018). What type of income most often gets hit for this type of withholding? The IRS usually targets interest and dividends, payments of more than $600 per year to independent contractors, sales of stocks and bonds, and royalties.

Backup withholding usually applies only to interest and dividend income. Other payments, however, are subject to withholding if you fail to provide the payer with your Social Security number. The IRS doesn’t notify you that you’re subject to backup withholding — it instead notifies the payer, who is required by law to notify you.

By notifying your local taxpayer advocate — the IRS problem-solving official that I discuss in detail later in this chapter — you can stop backup withholding under certain circumstances:

• You didn’t underreport your income.
• You did underreport, but you paid the tax, interest, and penalties on the unreported income.
• The backup withholding will cause you undue hardship, and the underreporting probably won’t happen again.

If you get hit with backup withholding, file all your returns for delinquent years, start reporting all your income, or pay what you owe. If you do this, the IRS automatically stops backup withholding on January 1 if everything is in order by the preceding October 15.

Federal tax lien notice: Form 668(F)

A statutory lien automatically goes into effect when you neglect or refuse to pay the tax the IRS demands. This type of lien attaches to all property that you own. A statutory lien is sometimes referred to as a secret lien because its validity doesn’t depend on its being filed as a matter of public record. Statutory simply means that, under the law, the IRS has the right to do it. The IRS doesn’t have to prove that you failed to pay what you owe before it files a lien. Guilty unless proven innocent!

Because a statutory lien places the rights of only the IRS ahead of yours, the IRS usually files Form 668(F), “Notice of Lien,” so that it places itself first in line before your other creditors. A federal tax lien covers all of a taxpayer’s property, including real estate, cars, bank accounts, and personal property. These liens are filed in accordance with state law, usually with the county clerk, town hall, or court where the taxpayer lives.

You should be aware that credit agencies routinely pick up liens that have been filed against you. After a credit agency has this information, your credit is marked as lousy. Even if paid, a lien stays on your credit history for 7 years. If you’re unable to pay the taxes you owe, the unpaid lien remains on your credit report for up to 15 years!

Although the law requires that the IRS release a lien within 30 days after you pay it, the IRS doesn’t always comply. Upon paying the tax, you can obtain a release of the lien by either contacting the revenue officer who filed the lien or following the procedure in IRS Publication 1450, “Certificate of Release of Federal Tax Lien.”

Always keep copies of any correspondence you have with the IRS. If you have phone conversations with the IRS, be sure to get the name and ID number of each IRS employee you speak with. Also, ask the IRS employee whether the conversation will be logged in, so if you have to call again, there will be a record of the earlier conversation.

Paying interest on additional tax

The IRS must send a notice of additional tax due within 36 months of the date when you file your return. If it doesn’t send a notice before the 36 months are up, it can’t charge interest after this 36-month period. Nor can the IRS resume charging interest until 21 days after it gets around to sending a notice.

This provision doesn’t cover all notices, so here’s what you should know about this 36-month rule:

• Your return has to be filed on time; otherwise, you’re not entitled to this suspension of interest.
• The rule doesn’t cover a failure to file or to pay penalties.
• Additional tax due as a result of an audit isn’t covered.

Receiving a delinquent tax return notice

You should treat a delinquent tax return notice as seriously as it sounds. If your tax return is delinquent, the IRS will always contact you by mail and will never demand payment over the phone (see the sidebar, “Beware of IRS phone scams”). Note that the IRS has the right to issue a summons commanding you to appear with your tax records and explain why you didn’t file a tax return. Any taxpayer who receives a delinquent tax return notice should consider seeking the services of a qualified tax advisor.

Failure to file a required tax return is a criminal violation of the Internal Revenue Code and can result in jail time. Usually, the IRS isn’t terribly interested in prosecuting the small fry who don’t owe a huge amount of tax and saves its prosecutorial dollars for the big fish who owe the farm. These cases make big headlines, serving as lessons for people who wonder what would happen if, just once, they “forgot” to file.

If you file late returns — even in response to an IRS inquiry — and don’t owe a substantial amount of tax (what’s considered substantial is known only to the IRS), the IRS probably will accept the return and assess a penalty for late payment and possibly fraud instead of trying to send you to prison (although the IRS does have that option).

If you don’t reply to a delinquent tax return notice, the IRS can take one of the following steps:

• Refer the case to its criminal investigation unit
• Issue a summons to appear
• Refer you to the audit division
• Prepare a “substitute” return

If the IRS decides to prepare a substitute return for you, it uses the information that it has on you in its master file, using the married-filing-separately or filing-as-single tax table, the standard deduction, and one exemption. Having the IRS prepare your return is the quickest way to become separated from your money. Although no fee is involved, you’re likely to pay more tax. Remember, the IRS isn’t interested in saving you money.

Why not beat the IRS to the punch? The IRS has an official policy of usually not prosecuting anyone who files a return prior to being contacted and who makes arrangements to pay what’s owed. Penalties and interest, however, are assessed. This procedure is called a voluntary disclosure.

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Surviving the four types of audits

Four types of audits exist: correspondence audits, office audits, field audits, and random statistical audits, more commonly referred to as the audits from hell. With all four types of audits, maintaining good records is the key to survival. If you haven’t already taken out the trash and lost all your evidence, you can refer to Chapter 6 for help filing and organizing the documents you may need.

Prepping for an audit

Preparing for an audit is sort of like preparing for a test in school: The IRS informs you which sections of your tax return it wants to examine so that you know what to “study.” The first decision you face when you get an audit notice is whether to handle it yourself or to turn to a tax advisor to represent you. Hiring representation costs money but saves you time, stress, and possibly money. (Note: You may of course still attend the audit if you hire a tax advisor to represent you. Ask the advisor his/her opinion as to whether you should attend the audit or not.)

If you normally prepare your own return and are comfortable with your understanding of the areas being audited, represent yourself. If the IRS is merely asking you to substantiate deductions, you’ll probably do all right on your own. What constitutes substantiation may at times involve a somewhat complicated interpretation of the law and its accompanying regulations. If the amount of tax money in question is small compared to the fee you’d pay a tax advisor to represent you, self-representation is probably the answer. However, if you’re likely to turn into a babbling, intimidated fool and you’re unsure of how to present your situation, hire a tax advisor to represent you.

The IRS permits three types of individuals to represent taxpayers: enrolled agents (EAs), certified public accountants (CPAs), and attorneys. All three are bound by IRS rules of practice. EAs become enrolled to practice before the IRS by passing a two-day written examination administered by the IRS in which their knowledge of the tax code is tested. Alternatively, they must have at least five years of experience as an IRS tax auditor. CPAs and attorneys are also permitted to represent taxpayers before the IRS. Many states have continuing education requirements for CPAs and attorneys. The IRS requires that EAs also meet continuing education requirements.

Probably the best way to find a qualified tax professional is to ask relatives or friends for a recommendation of someone whose level of service and performance they’re more than satisfied with. To figure out which of these tax practitioners may be best suited to help you in an audit, see Chapter 13.

Changing your mind regarding representation partway through an audit is okay. At any time during the examination, such as when you feel a dizzy sensation and before you throw up in the examiner’s lap, the Taxpayer Bill of Rights allows you to request that the audit be suspended until you have time to consult with an EA, a CPA, or an attorney. After you make this request, the IRS agent must stop asking questions or requesting documents until you’re properly represented. (You can see the Taxpayer Bill of Rights at www.irs.gov/taxpayer-bill-of-rights.)

But if you decide to handle the audit yourself, get your act together sooner rather than later. Don’t wait until the night before to start gathering receipts and other documentation. You may discover, for example, that you can’t find certain documents.

You need to document and be ready to speak with the auditor about the areas the audit notice says are being investigated. Organize the various documents and receipts in folders. Being organized for the items requested in the audit letter is critical both to establish credibility and to avoid prolonging the exam. Don’t show up, dump shopping bags full of receipts and paperwork on the auditor’s desk, and say, “Here ya go… .”

Don’t bring documentation for parts of your return that aren’t being audited, either. Besides creating more work for yourself, you’re required to discuss only those areas mentioned in the audit letter.

Whatever you do, don’t ignore your audit request letter. The IRS is the ultimate bill-collection agency. And if you end up owing more money (the unhappy result of most audits), the sooner you pay, the less interest and penalties you’ll owe.

Winning your audit

Two people with identical situations can walk into an audit and come out with very different results. The loser can end up owing more in taxes and having the audit expanded to include other parts of the return. Here’s how to be a winner:

• Treat the auditor as a human being. Although this seems like obvious advice, your anger and resentment at being audited won’t win you any points. The examiner is just doing her job and knows you’re busy and don’t want to be at an audit. Ranting and raving in front of her is likely to make her search extra hard for places where your return may be dicey. Treating the examiner with respect and courtesy makes the audit a much easier experience for everyone concerned.
• Stick to the knitting. You’re there to discuss only the sections of your tax return in question. Don’t volunteer other information unless you want the examiner to look at those areas as well.
• Discuss and don’t argue. If the auditor wants to disallow a deduction or otherwise increase the tax you owe and you don’t agree, state once why you don’t agree. Don’t get into a knockdown, drag-out confrontation. The auditor may not want to lose face and will only feel inclined to find additional tax money — that’s her job. Keep in mind that you can plead your case with several layers of people above your auditor during an appeals process. If that course fails and you still feel wronged, you can take your case to Tax Court.
• Don’t be intimidated. Just because IRS auditors have the authority of the government behind them, that doesn’t make them right or all-knowing. The audit is only round one. If you disagree with the results, you have the right to appeal.
• Go to Tax Court. If you receive a Statutory Notice of Deficiency (this notice comes after you’ve exhausted all your appeals within the IRS or if you don’t respond to a notice that the IRS wants to audit your return), you have 90 days to appeal your case to the U.S. Tax Court. If you don’t appeal, the IRS can enforce collection on the 91st day. A good tax advisor can help you at Tax Court; see Chapter 13 for details on finding one.

Understanding the statute of limitations on audits

The IRS must make any assessment of tax, penalties, or interest within three years from the due date for filing a tax return. If the IRS grants you an extension of the filing deadline, the statute of limitations is extended to include the extension period. If the due date falls on a legal holiday or a Saturday or Sunday, the due date is postponed to the next business day.

If you omit from your return more than 25 percent of the income that you’re required to report, the statute of limitations extends to six years. No statute of limitations runs on a false or fraudulent return. Thus, if you filed a false or fraudulent return, there’s no time limit on when the government can assess additional tax. The same goes for not filing a return; there’s no time limit.

Keeping your correspondence short and sweet

There’s elegance in simplicity when corresponding with the IRS. Keep to the point. Letters should be no longer than one page. A clearly written and concise half page should get even quicker results. Note that the tax examiner reviewing your inquiry could have little experience in the area you’re writing about. Such people are, however, extremely conscientious in performing their duties. You stand a better chance of achieving the results you want by making their jobs as easy as possible. Don’t succumb to the temptation to go into a narrative on how unfair the tax system is or how you’re paying more than your fair share. Save that stuff for your representative in Congress or pals you chat with about politics.

Your letter to the IRS should contain the following items — and nothing more:

• Vital facts: name, mailing address, Social Security number on the tax return, and the year of the disputed tax return.
• The control number from the notice, type of tax, and a copy of the notice you received.
• The type of mistake the IRS made.
• The action you want the IRS to take.
• Copies of the documents necessary to prove your case — canceled checks, corrected Form 1099s, mailing receipts, and so on — but never the originals.

Address your letter to the Adjustments/Correspondence (A/C) branch at the service center that issued the notice. You should note the type of request you’re making at the extreme top of the letter — “Request to Adjust Form [form number].” Use the bar-coded envelope that was sent with the notice to mail your letter.

Include a simple thank-you and the telephone number where you can be reached in case the clerk at the IRS service center has any questions. Telephone contact between you and an IRS employee can take weeks off the adjustments/correspondence process.

Always keep copies of any documents you send to the IRS. It’s also a good idea to keep a log of all of your interactions with the IRS, such as received original notice on this date, called IRS on this date, sent written response on this date, and so on. Note that the IRS has been affected by the recent congressional action (or inaction) and is taking longer to process responses. If you send correspondence and receive no response, you can call to see whether the IRS received it. Consider sending documents via certified mail so you know when the IRS receives them.

Sending a simple response to a balance due notice

If you receive a balance due notice for a tax that you’ve already paid, it’s time to dig out the proof you kept that shows when and how much you paid. With proof in hand, it’s a simple matter to write on the front of the notice:

“This balance has been paid. Enclosed is a copy of proof of payment of taxes that you have failed to credit to my account. Please remove all penalties and interest charges that were assessed.”

If you paid by check, you need to send a copy, front and back, of the canceled check. For credit card payments, a copy of your credit card bill, with the payment to the IRS and the date and amount highlighted, should suffice. If you transferred the funds directly from your bank account through an electronic funds transfer, send a highlighted copy of your bank statement that shows the amount taken from your account and the date. And if you’re enrolled in the Electronic Federal Tax Payment System (EFTPS), include a copy of the electronic funds transfer (EFT) acknowledgment number you received as a receipt.

Getting attention when the IRS ignores you with the help of a taxpayer advocate

At times, it seems that a black hole ravages every IRS service center, devouring loads of taxpayer correspondence. Naturally, the IRS won’t respond right away in these cases. If you don’t get a response, the IRS has a special office that handles these problems: the office of your local taxpayer advocate.

More expenses than income (net operating losses)

Before the tax reform that took effect in 2018, an amended return was permitted whenever you incurred a net operating loss (NOL). You have an NOL if the amount of money you lost (in a business or profession) exceeds all your other income. In the past, you could carry back an NOL to offset your taxable income in the two previous years. Tax reform eliminated the NOL carryback provision. The new laws did however somewhat open up the carrying forward of NOLs, which are now allowed for an unlimited number of years, up from the previous limit of 20 years until it’s used up. One final detail: NOLs are limited to 80 percent of taxable income in any given tax year.

The tax benefit rule

Whenever you deduct an expense in one year and part or all of that expense is reimbursed in a subsequent year, you usually have to report the reimbursement as income. For example, suppose that you deducted $10,000 in medical expenses in 2018 and were reimbursed $3,000 by your insurance company in 2019. You have to report the $3,000 as income in 2019.

However, if the original deduction didn’t result in a tax savings, you don’t have to report the reimbursement. For example, if you receive a state tax refund for a year in which you claimed the standard deduction instead of itemizing your deductions, you don’t have to report the refund.

Declare all your income

When you prepare your return, you may be tempted to shave off a little of that consulting income you received. Who will miss it, right? The IRS, that’s who.

Thanks largely to computer cross-checking, the IRS has many ways of finding unreported income. Probably the most common cause of IRS correspondence audits is omitting interest, dividends, wages, pension, or other kinds of income that is reported to the IRS. Be particularly careful if you’re self-employed; anyone who pays you more than $600 in a year is required to file a Form 1099, which tells the IRS how much you received.

When you knowingly hide income, you face substantial penalties and, depending on the amount, criminal prosecution. That wouldn’t be a picnic, especially if you can’t afford to hire a good defense attorney.

Don’t itemize

People who itemize their deductions on Schedule A of Form 1040 (discussed in Chapter 9) are far more likely to be audited because they have more opportunity and temptation to cheat. By all means, if you can legally claim more total deductions by using Schedule A than you can with the standard deduction, then itemize. Just don’t try to artificially inflate your deductions.

On the other hand, if it’s basically a tossup between Schedule A and your standard deduction, taking the standard deduction is safer, easier, quicker, and the IRS can’t challenge it.

Earn less money

At first glance, earning less money may seem like an odd suggestion, but there really are costs associated with affluence. One of the costs of a high income — besides higher taxes — is a dramatic increase in the probability of being audited. If your income is more than $100,000, you have about a 1 in 20 chance each year of being audited. But your chance is less than 1 in 100 if your income is less than $50,000. You see, besides being subjected to lower income tax rates, earning less has additional advantages!

If you manage to pile up a lot of assets and don’t enjoy them in retirement, your estate tax return — your final tax return — is at great risk of being audited. Do you think a 1 in 20 or 1 in 100 chance is bad in the audit lottery? Uncle Sam audits about 1 in 7 estate tax returns. The IRS collects an average of more than $100,000 for each estate tax return it audits! So enjoy your money while you’re alive or pass it along to your heirs in the here and now. Otherwise, your heirs may have trouble getting it in the there and later!

Don’t cheat

It may have taken the IRS a while to wise up, but now the government is methodically figuring out the different ways that people cheat. The next step for the IRS — after it figures out how people cheat — is to come up with ways to catch the cheaters. Cheaters beware!

The IRS also offers rewards for informants. If you’re brazen enough to cheat and the IRS doesn’t catch you, you may not be home-free yet. Someone else may turn you in. So be honest — not only because it’s the right thing to do but also because you’ll probably sleep better at night knowing that you aren’t breaking the law.

Tax protesters, take note. The IRS may flag returns that are accompanied by protest notes. Threats are bad, too — even if they’re meant in fun (humor isn’t rife at the IRS). The commandment to follow is: Thou shalt not draw attention to thyself.

The protest issue is interesting. During congressional hearings, tax protesters stand up and tell members of Congress that the income tax is unconstitutional. They say they have proof. (If I can get my hands on the proof, I’ll include it in the next edition of this book.) In the meantime, pay your taxes and resist the temptation to send along a cranky letter with your tax returns and payments. To read the IRS’s “The Truth About Frivolous Tax Arguments,” point your web browser to www.irs.gov/pub/irs-utl/friv_tax.pdf for 60-plus action-packed pages, including legal citations.

Don’t cut corners if you’re self-employed

People who are self-employed have more opportunities to make mistakes on their taxes — or to creatively take deductions — than company-payroll wage earners. As a business owner, you’re responsible for self-reporting not only your income but also your expenses. You have to be even more honest when dealing with the tax authorities because the likelihood of being audited is higher than average.

Don’t disguise employees as independent contractors. Remember the old barb: You can’t put a sign around the neck of a cow that says, “This is a horse.” You don’t have a horse — you have a cow with a sign around its neck. Just because you call someone an independent contractor doesn’t mean that person isn’t your employee. If you aren’t sure about the relationship, consult a tax advisor.

Other audit triggers for small businesses cited by tax advisors include:

• Cash businesses
• Businesses with relatively high expenses
• Relatively high charitable and medical deductions
• 100 percent business use of vehicle

Nothing is wrong with being self-employed, but resist the temptation to cheat, because you’re far more likely to be scrutinized and caught as a self-employed worker.

Double-check your return for accuracy

Review your own return before you send it in. If the IRS finds mistakes through its increasingly sophisticated computer-checking equipment, you’re more likely to be audited. The IRS figures that if it finds obvious errors, some not-so-obvious ones lurk beneath the surface.

Have you included all your income? Think about the different accounts you had during the tax year. Do you have interest and dividend statements for all your accounts? Finding these statements is easier if you keep your financial records in one place. Check your W-2s and 1099s against your tax form to make sure that you wrote the numbers down correctly.

Don’t forget to check your math. Have you added, subtracted, multiplied, and divided correctly? Are your Social Security number and address correct on the return? Did you sign and date your return?

Such infractions won’t, on their own, trigger an audit. In some cases, the IRS simply writes you a letter requesting your signature or the additional tax you owe (if the math mistake isn’t too fishy or too big). In some rare instances, the IRS even sends a refund if the mistake it uncovers is in the taxpayer’s favor. Regardless of how the IRS handles the mistake, it can be a headache for you to clear up, and, more important, it can cost you extra money.

Stay away from back-street refund mills

Although this advice doesn’t apply to the majority of tax-preparation firms, unfortunately, some firms out there fabricate deductions. Run away fast from tax preparers who tell you, after winking, that they have creative ways to reduce your tax bill, or those who base their fees on how many tax dollars they can save you. Also beware of any preparer who promises you a refund without first thoroughly reviewing your situation.

The IRS is actively going after fly-by-night preparers, who promise you the moon and the stars but may end up landing you in the muck. When the IRS audits a preparer, it looks at many (and sometimes all) of the returns the preparer has worked on and filed for taxpayers. If it finds problems in how that preparer runs his or her business, you can expect the IRS to also look more closely at all the returns that preparer prepared.

With any preparer you should review the return. Questionable preparers often overstate charitable, business, and medical deductions. A quick check will show whether these amounts agree with the information you provided to the preparer.