“Gasp!” That might be your first reaction to seeing an envelope with an eagle on the upper left corner and the dreaded words next to it: Internal Revenue Service. But fear is not an emotion that should flow through your body. Why not? Well, if you’ve accurately recorded what properly belongs on your tax return, you have nothing to fear from the IRS if they contact you about an audit.
Documentation is your friend and it can prove invaluable in any examination. So what exactly is an audit? An audit (or more frequently called “examination”) is simply a means for the IRS to discover what may be missing or irregular on a return. The IRS usually has three years from the due date to verify the accuracy of your return. However, if certain situations are present it can be longer. The IRS relies heavily on what is known as third-party reporting. This is basically the verification process to ensure you’ve reported everything you should be reporting on your return. The concept of third-party reporting is simple. The IRS receives a form from the party that paid you. You report that amount on your return. It matches what has been reported. Case closed.
For example, your employer simultaneously provides you with a W-2 in late January and sends a copy to the IRS. When you report your W-2 on your tax return, the IRS is expecting to see the same numbers that your employer reported to them. What ends up generating a letter from the IRS is in areas on your tax return where they don’t have the luxury of third-party reporting. In the case of performing artists, this would be on a Schedule C (self-employment income) or on Form 2106-Unreimbursed Employee Business Expenses (suspended until the end of 2025 under the Tax Cuts and Jobs Act of 2017). It could also involve proving you made a contribution to your retirement program.
The formula that the IRS uses to determine just who will get that letter examining your return is a closely guarded secret, much like the recipe for the coating on the wings at Kentucky Fried Chicken. We know they have 11 herbs and spices, but just how it gets put together is anyone’s guess. If you receive a letter, generally speaking, it will be one of two types. One is called a CP2000 (see upper right corner of the letter) and is the most common. The other type of letter is a little bit more in-depth and is asking for actual documentation to back up what you reported, such as receipts for deductions.
In a CP2000, the IRS informs you that what you reported on your tax return either didn’t match what was reported to them or was left off the return completely. This letter is computer generated and requires a response from you or they will assume it is correct and assess the additional tax. It can be a really innocent mistake on your part. But, beware. The IRS is frequently incorrect in their understanding of your particular situation. One of the most common things people can leave off their return or make an error deals with reporting the proceeds from stock or mutual fund sales on Form 1099-B. This can usually be cleared up with a written explanation and faxed to the IRS Service Center.
The IRS would much rather you just agree to the assessment of additional tax, but don’t be so quick to agree if you think there is a discrepancy. This is where most people fear that something awful will happen if they dispute the amount and so just give in and pay the bill when it may be incorrect.
In the second type of IRS correspondence, which is also computer-generated, you’ve been selected because, based on that “secret recipe,” the IRS wants to see proof that you are legitimately entitled to a deduction you have claimed. This is much more in-depth. Space does not allow for the way this type of letter should be responded to, but professional help is definitely recommended if you should receive a letter requesting copies of receipts or other documentation.
There is actually a third type of letter, which could open your entire return for examination, but this is rarer than the first two types of letters. Remember, the IRS will never send you an email or make a phone call to you regarding an audit. They might, however, show up at your house. If that is the case, ask to see a badge and definitely call a professional.
In most cases, the IRS makes responding to their letters fairly straightforward, but the ease with which the IRS facilitates your agreement or disagreement with their initial findings can also create pitfalls. The biggest issues you have to think about are: Is the letter correct? Do I owe the money? Is it worth the hassle? Should I get professional assistance to respond?
All of these are serious questions to consider. Perhaps a quick phone call with your tax preparer can help to determine the appropriate response. (If you prepared your return yourself, that option is not applicable.) As previously mentioned, the CP2000 (mismatch) letter can often be handled quite easily if the letter is correct. Just agree and they’ll tell you how to pay the bill. If the letter is incorrect, more time involvement, as well as money for a professional to respond, may be necessary. The type of letter asking for documentation is more complex and can expand into other areas of your return if not carefully responded to. Therefore, don’t go it alone and make sure you’re properly represented by a competent and experienced tax professional.
If you discover that you actually do, in fact, owe them additional money after a letter is received from the IRS, you have options. It’s usually best to pay the amount owed in full if it is legitimate. But, if the sum is sizable and you don’t have the funds readily available, the IRS is willing to take payments (penalties and interest may accrue until the balance is paid in full). A call to them asking for your payment options would be worthwhile or a chat with an experienced tax professional would be helpful if you don’t have two hours to wait on hold.
Often, the IRS will automatically share the results of your examination with the state you live in, so it’s usually best to file an amended return with your state as well before they send you correspondence. This will limit the penalties and interest that they can impose on you. They’ll catch up at some point and their statute of limitations is frequently longer than the IRS has.
All in all, a letter from your friends at the IRS doesn’t have to be all that scary. You just need to know how to navigate the roadmap at the IRS, how to determine what type of examination it is, and how to make sure you pay the least amount possible, especially if it’s zero.
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