How To Avoid IRS Letters
Aside from notices for unpaid taxes, most other IRS notices are due to the omitting of or incorrectly reporting information on the tax return. The following are the most common omissions/errors:
1. FAILURE TO REPORT INCOME
The IRS receives 1099s from payors that report various types of income. If the IRS cannot locate the amounts on the return, a notice will be generated proposing an increase to income and tax.
The most common omissions are interest, dividends, and stock sales. With regard to stock sales, the IRS receives the gross proceeds from security sales from brokerages and traces the total to the return. If the total on the return is less than the total reported by the brokerage, the IRS will propose taxing the difference. They do not have the amount paid for the securities so they assume it is zero. It is not sufficient to tell your accountant “I lost $10,000 in the stock market” The detail of the securities sold must be provided so the gross proceeds can be reported. Otherwise a notice will be generated.
Form 1099 Misc is used to report nonemployee compensation. If you are self employed, you should keep a record of all income received. If you receive 1099s, make sure the total of the 1099s is not greater than the amount you actually received. One reason this can occur is if you receive a commission and split it with another individual. The payor may send you a 1099 for the entire amount and this must be reported on the tax return. You would issue a 1099 to the individual that you split the commission with and take a deduction for that amount on your tax return.
Another situation is when you are issued a 1099R. This could be for distributions from an pension, annuity or a retirement plan. It is possible that some or all of the money received is not taxable. However, the tax return must report the gross amount even though it is partially or fully nontaxable. Not reporting the gross amount will cause a notice to be generated by the IRS.
Individuals with health savings accounts are provided 1099s for the amount distributed from the accounts each year. The distributions are not taxable if used for qualified medical expenses. However, the total amount received must be reported on the return even if not taxable.
If you are a shareholder in an S corporation or are a partner in a partnership or a member of an LLC, you will receive Form K-1 which provides you the information to report on your tax return. If the information is omitted, the IRS will send a letter adjusting the income and tax on the return.
So, the moral of the story is to never discard any tax related forms and provide all such forms to your accountant. Never assume that they are not needed just because the amounts reported are not taxable.
2. Misreporting of mortgage interest
The IRS matches the mortgage interest from form 1098 to the individual’s tax return. They use the social security number on the form to do this. However, if you pay mortgage interest and do not receive a 1098 (eg interest paid to an individual), the interest must be reported on certain lines of the tax return that are different from the lines used to report interest reported on 1098 forms.
You could receive 1098 form in the name and social security number of the person who sold you real estate. This would occur in the case of a “wrap-around mortgage” where you purchase the property from someone who you are indebted to who does not pay off the underlying mortgage. Even though you could be paying the bank directly, you would actually be liable to the individual who sold you the property not the bank. Again this must be reported on certain lines of the tax return or the IRS will try to disallow the deduction.
Another example would be the case where you own property jointly with another individual. While your name appears on the 1098 form, the form may have the social security number of the other individual.
Your accountant needs to know when these situations exist so the mortgage interest deductions can be reported correctly on the tax return. This will avoid the IRS sending a notice proposing to disallow the mortgage interest deduction.
3. MISREPORTING TAX PAYMENTS
The IRS and state will send notices if their records of payments do not agree with what is reported on the tax return. An error in the date a tax payment is made can generate a notice because it affects the computation of interest and penalties. It is important to provide your tax preparer the exact amounts, dates, and for which tax year tax payments are made.
4. CLAIMING DEPENDENCY EXEMPTION WHERE THE DEPENDENT HAS CLAIMED IT
A child can be anxious to receive a tax refund and file the tax return erroneously claiming the dependency exemption where the parents are entitled to the exemption. The exemption cannot be claimed on more than one return. If you are entitled to claim your child as a dependent, inform your child not to claim the dependency exemption. Otherwise, the IRS will disallow the exemption on your return.
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