Taxpayers commonly receive letters, sometimes known as “correspondence examinations” or “letter audits” but also referred to as “CP 2000 notices,” from the IRS demanding additional tax.
For this reason, I want to talk briefly about why taxpayers receive these threatening letters and also about how taxpayers can and should respond to such a letter.
Why You Received CP 2000 Notice from IRS
Okay, so here’s the deal. The IRS’s computers compare your tax return and its income items and deductions to informational returns the IRS receives from outside parties like banks, mortgage companies, investment brokers, employers, and so on.
Not surprisingly, the IRS can match much of the information on your tax return with information shown on these third-party sources. For example, the IRS can easily compare the wages you report on your tax return to the wages employers have reported as paid to you.
Whenever a mismatch appears, the IRS looks at the mismatch to determine whether you the taxpayer have under-paid income or related taxes. When that’s the case, the IRS recalculates your taxable income and your income tax liability and then sends you the CP 2000 notice asking you to pay the additional tax.
Why You Shouldn’t Over-react to an IRS Letter
Let me share a couple of interesting points about this process: First, the IRS does not typically send you a notice if you over-reported your income or under reported your deductions. In other words, the IRS correspondence examination process looks for situations where you have potentially underpaid your taxes and not for situations where you’ve potentially or even obviously overpaid your taxes. (I regularly see examples of this.)
A second thing to keep in mind is that when the IRS does do a recalculation of your tax liability based on one of these mismatches in income or deduction, the IRS assumes the absolute worst.
For example, suppose that just by accident you forget to include income from the sale of some stock you purchased years ago. Suppose, for sake of illustration, that you bought some stock five years ago for $25,000 and that you sold it just last year for $5,000. What the IRS does if you forget to report the $5,000 of income is assume that the $5,000 represents pure profit—in other words the IRS assumes that you must have gotten the stock for free. (Clearly this is absurd.) And then the IRS assumes that this income should be taxed at the highest possible rate—which would mean the income should be taxed as short-term capital gain and not as long-term capital gain.
So here’s the upshot of all this: If you do receive a CP 2000 notice from the IRS, don’t freak out about the numbers that the letter provides. Almost surely, the tax payment demanded overstates in a kind of “worst case scenario” way the tax you owe. It’s common, in fact, for the IRS to demand money when, in fact, you are actually owed a tax refund.
Responding to IRS CP2000 Correspondence
If you receive a correspondence examination letter, you must respond in a timely fashion—usually within 30 days. Note, though, that you often can call the IRS and ask for more time if you’ve got a good reason (such as being on vacation when you received the letter).
To respond to the IRS letter, you need to first figure out whether the changes that the Internal Revenue Service suggests are correct. As I’ve already noted, commonly, the IRS’s proposed changes are not correct. The changes usually rely on incomplete data. Further, the changes usually assume the worst.
Accordingly, you’ll first need to carefully research the changes in income and deductions suggested by the Internal Revenue Service. You need to understand exactly what information they say should have been on your tax return or should not have been on your tax return. Once you understand this, you should be able to rather easily figure out whether the IRS is correct.
If the IRS is correct, you should write a check to pay the demanded amount due as soon as you can. You also need to check the box on the correspondence examination letter that indicates you agree with the IRS’s proposed changes.
A minor tax tip: If you’re somebody who’s filed your tax returns on time and paid your taxes, you can often write a nice letter to the Internal Revenue Service asking them to waive the penalty on the underpayment. Such a letter often, though not always, results in the penalty being abated. (The interest on the underpayment won’t be abated, however.)
If the IRS is incorrect—and I think this is the case more commonly than anybody wants to admit—you need to write a letter to the IRS explaining in detail why the IRS’s proposed changes are incorrect. You should absolutely include any documentation that supports your accounting position. Here are some examples:
Home mortgage deduction challenged or disallowed:
If the IRS challenges a home mortgage deduction or disallows such a deduction, explain why you can claim the deduction. If the mortgage company sent you a 1098 mortgage interest expense form, be sure to include that with your letter. If for some reason the 1098 form reports the mortgage interest has been paid by some other person’s Social Security Number (such as your ex-spouse) be sure to address that issue in your letter. It would not be a terrible idea to include copies of the checks you may have written to pay the mortgage interest you’re claiming.
Broker proceeds from sale of stock or bonds:
If you inadvertently forgot to report proceeds from the sale of stock, bonds or some other investment, prepare a schedule D form that shows the stocks or bonds you sold, the amount paid for the stocks or bonds, and the purchase and sale date. If you have trade confirmation notices from the broker, consider including photocopies of these items with your letter. Be sure to explain that you merely omitted stock sale transactions from schedule D inadvertently. By the way, this sort of mismatch triggers gobs of letter audits and is the easiest sort of problem to deal with.
Disallowed Personal Exemptions:
If you claim a dependent on your tax return that some other tax payer claims in his or her tax return, the IRS will disallow the dependent on the subsequent tax return. This is maybe obvious, but there are two common scenarios where this mix-up occurs. Dependent children often claim a deduction on their own tax return (even though they aren’t really independent) and that then means that the parent can’t claim the dependent. Ex-spouses sometimes claim children as dependents when they should not (according to the custody agreement). In these cases, you probably need to get the other taxpayer (your son, daughter, or ex-spouse) to amend the tax return that incorrectly claims the dependent. And then you’ll be able to claim the dependent. Alternatively, you can supply information to the IRS that proves you’re entitled to claim the dependent—and then let the IRS go after your child or ex-spouse.
Is this your CPA’s or Enrolled Agent’s fault?
You might think that a letter audit or correspondence examination is the fault of your tax return preparer. And that may be the case. But after doing thousands of tax returns and talking with dozens of fellow tax accountants, I think this situation is a bit murkier than that.
Commonly, taxpayers forget to supply all of the required source documents to the tax return preparer at tax time. Obviously, if your tax return preparer doesn’t know, for example, that you sold stock, he or she will not know to report that stock on your tax return.
Tip: If your tax return preparer supplies a tax organizer, you really should use that organizer to communicate clearly what your income and deductions are. Using an organizer will largely eliminate the sorts of problems that cause disagreements between taxpayers and their tax accountants.
Clients sometimes wonder whether the tax accountant should pay the tax, interest and penalties demanded by the IRS in a CP 2000 notice. Very clearly, the tax accountant shouldn’t have to pay the taxes that you owed anyway. If the tax return had originally been correctly prepared, the taxpayer would’ve had to pay the taxes then.
As far as the interest, here’s what I think (and I think what a court or economist would say): If you’ve had use of the federal government’s money for two years, probably you should view the interest as reasonable charge for having possession of those funds. You may have had the money sitting in a money market account or in an investment account earning income during that time period. Or the underpayment may have meant you carried a lower balance on some credit card. The other noteworthy thing about the IRS interest rate on underpaid tax is that the rate is usually pretty modest. Way less, for example, than the interest rate you would have to pay on any credit card balances you carry.
The penalty is trickier. Here’s what I think (and this is just my opinion). The fair way to treat a penalty is to look at who made the mistake that led to the understatement of income or the overstatement of the deduction. If you made the mistake (perhaps by omitting to provide information to the tax accountant), you should pay the penalty. If your accountant did, in my opinion, he or she should pay at least to the extent of any fees you paid. Finally, if you guys share the responsibility, maybe the fair approach is split the penalty.
Note, however, that if you’re paying some low-end, inexpensive tax return preparer $50 or $75 to do your return, I don’t think you can ask them to help with the penalty. At that price, you’ve probably only paid for data entry and postage. You need to be working with someone who’s providing a higher quality product if you want the preparer to back up the work product quality, at least in my opinion. Finally, remember again that if you’ve been a good taxpayer, the IRS will often waive or update penalty.