Winning Your Audit Part 3: IRS Automated Adjustment

This is part 3 of 6 of our in-depth guide to winning your audit.

When the IRS Increases Your Tax Bill Without an Audit

The IRS increasingly relies on computer-generated tax bills that are technically not audits. This means your tax return still could be examined in the future.

The IRS is authorized to make changes to your tax account without a formal audit in some cases. (Internal Revenue Code § 6213(g)(2).) The IRS has programs (described below) that often exceed Congressional intent of the law, which was to let the IRS correct minor taxpayer errors. Instead, the IRS effectively performs one-sided mail audits. Many poor souls pay up without question.

• Correction notices. The IRS says there is a math error or a similar obvious problem with your tax return. For instance, you claimed four dependents but only listed the names of three on your return. The IRS corrects your return—and bills you.
• Penalty assessment notices. Typically, a penalty notice and bill will be sent if you didn’t meet a filing or payment deadline. The IRS may be wrong for any number of reasons, or it might be right but you may have a reason to have the penalty abated, or canceled. See Penalties & Interest for more information.
• Interest assessment notices. If you did not pay a tax bill on time, you will always be charged interest. Sometimes, the IRS computation of interest is incorrect; occasionally, you can get it waived even if it is correct. Again, see Penalties & Interest.
• Underreporter program notices. The IRS initiates an underreporter case when its computer finds a discrepancy between two data sources. Usually, the two sources are your tax return and information reported to the IRS on a 1099 or W-2 form. You will get either a CP-2501 notice—a letter asking you to explain (CP means computer paragraph)—or a CP-2000 notice proposing additional tax, penalties, and interest. In either case, you’ll be given 30 days to respond. According to the IRS, the most common underreporter issues are:
  • IRA distributions rolled over but not properly reported (Form 1099R)
  • income reported on the return that does not match IRS data on a Form 1099 or Form K-1
  • mortgage interest deductions that don’t match the financial institution’s report to the IRS (Form 1098), and
  • wages and/or tax withholding that doesn’t match W-2 forms.

Underreporting notices are the most common of the four programs.

Dealing With IRS Automated Adjustment Notices

The most common automated adjustment notice is the CP-2000 (see sample below). Look at the top right-hand corner of the first page of the notice for the code. The problem with CP-2000 notices is that many are totally or partly wrong. Money Magazine estimates that at least 25% are in error. A common IRS mistake is failing to see that the income was reported elsewhere on the form than where the computer looked. For instance, one year I reported earnings in a money market fund as interest instead of dividends, and the IRS computer spit out a CP-2000 notice stating that I did not report $450 of income and billed me for additional tax, and penalties and interest.

If so many of these notices are wrong, why does the IRS keep sending them? The Money Magazine article reported that most people who were billed for $589 or less simply paid it. The magazine estimates that IRS collects seven billion dollars a year it is not entitled to.

Can you fight an automated adjustment notice? Absolutely. If you receive one of these notices, just follow these steps:

Step 1. Call the IRS. Call the number on the notice (or 800-829-1040) to start. Ask for a full explanation even if you suspect the IRS may be right, but you aren’t sure. Ask for an abatement if you believe the IRS is, or probably is, wrong—abatement is the IRS word for canceling a bill. Tell the IRS person why the notice is wrong or that your records are different from the IRS’s and promise to send the proof. You probably won’t settle this during the telephone call, but you want the fact that you are disputing the notice entered into the IRS computer.

Step 2. Contest in writing. Don’t rely on a telephone call to straighten out an IRS problem. The tax code provides that if you don’t object to an automated adjustment notice within 60 days, it becomes final.

There is no preprinted IRS form to contest automated tax notices. Send a typewritten letter to the IRS office that sent the notice. Use the format in the sample letter below. Make the letter brief and to the point. IRS people have short attention spans and won’t struggle through long-winded explanations or unclear handwriting. Staple a copy, not the original, of the IRS notice to the front of your letter. Mail it certified, return receipt requested. Use the IRS bar-coded return envelope that was included with your notice to speed up processing.

When writing the IRS, always make several photocopies of whatever you send. If the IRS misplaces your correspondence, you can send it again—and again, if necessary.

Step 3. Go to tax court. If you fail to respond to a CP-2000 notice, or if you do respond but the IRS ignores or disagrees with your explanation, the IRS will issue a Notice of Deficiency. You will know when it comes because these notices—also called 90-Day Letters—are sent by certified mail and labeled Notice of Deficiency. If you get one, your only recourse is to file a petition in U.S. Tax Court within 90 days after the date of the letter. This is not a difficult thing to do, but does cost $60. See Chapter 5 for instructions.

Letter to Dispute an IRS Tax Adjustment

Be Patient If You Don’t Hear From the IRS Immediately

Don’t be surprised if you keep getting bills in spite of your letters contesting an automated adjustment notice. It takes a month or more to get your response into the system to stop the computerized cycle. Simply respond to later IRS notices with a photocopy of your earlier letter. Never ignore IRS letters, and never send originals. If notices ignoring your letters keep coming after 90 days, call the Taxpayer Advocate Service at 800-829-4059. Tell the taxpayer advocate that the IRS has not answered your letters and ask for help.

Consider calling a tax professional for advice, although it is seldom cost-effective to hire one for this type of problem. Many tax professionals will talk to you on the phone free of charge. If the erroneous IRS bill is a biggie, consult with a tax professional first or have them contact the IRS on your behalf.

Even if the IRS eventually proves to be correct, by sending letters, requesting help from the taxpayer advocate, or filing a petition in tax court you will have greatly delayed the final tax bill. This gives you extra time to get the payment together or to figure out another way to deal with the tax bill (see When You Owe the IRS for alternatives in dealing with a tax debt).

Your Rights During an Audit

IRS Publication 1, Your Rights as a Taxpayer, should be included with your audit notice. (A copy is in the Taxpayer Bill of Rights.) It very clearly explains the Taxpayer Bill of Rights. The most important audit rights are to:

• Be treated fairly by IRS personnel. If you find someone who is not professional, prompt, and courteous, you have a right to speak to a supervisor.
• Have a representative handle your audit. He must be qualified to practice before the IRS and have your written power of attorney. With a few exceptions, the IRS can’t force you to appear or even contact you if you send a representative in your place.
• Sound record the audit, although this isn’t recommended. Taping an audit would most likely only cause the auditor to be unfriendly and work harder.
• Not have to submit to repeat audits. If you were audited within the last two years, and the IRS made fewer or no tax adjustments, you can’t be audited for the same items again. The IRS can, however, examine different items in your return. If you believe you’re being re-audited for the same items, complain to the IRS appointment clerk or auditor. The no-repeat audit policy does not apply to examinations of business-related items on an individual’s return.
• Have proposed adjustments explained. Audit reports are vague, so you are entitled to get a detailed explanation if you ask for it. You can do this by phone or in person. If the auditor refuses, talk to her manager.
• Not be forced to incriminate yourself. You always have this Constitutionally guaranteed right when dealing with the government, even the IRS. For example, if you earn your living by robbing banks, the IRS can’t demand that you give details, as long as you report the income. You cannot, however, lie to the IRS about the source of your income. In this case, you should state on your tax return or during an audit that you are claiming the Fifth Amendment—but see a tax or criminal attorney before doing so.
• Appeal your audit.