Third Party Reporting: What the IRS Already Knows Before You File Taxes
Are you in shock about a tax notice that you received from the IRS? Do you wonder where tax notices come from? Many of them originate from the IRS’s Automated Underreporter (AUR) program. Using a taxpayer’s tax identification number (such as a social security number or employer identification number), the IRS compares a taxpayer’s filed return (or lack of a filed return) with the information that the IRS has obtained from third-party reporting such as Forms W-2, Forms 1099, Forms 1098, and other information that the IRS has received. Of significant importance is the fact that the IRS (or its computer system) expects to see this information reported on the appropriate taxpayer’s return, on the appropriate line(s) of the return, and in the appropriate amount(s). If the information does not appear on the appropriate taxpayer’s return, on the appropriate line(s), and in the correct amount(s), you may receive an AUR notice from the IRS.
Important to note is that an AUR notice is not an assessment of tax, but it will become one if you choose to ignore it. If you receive an AUR notice, such as a CP2501 or a CP2000, what you will want to do is read the notice carefully, determine what the IRS is claiming was not reported, and compare that to the return that you filed. It is possible that the IRS is wrong and that you do not owe what the notice is alleging that you owe. This happens more often than one might think! In fact, quite frequently, the information was actually reported on the tax return and the IRS is just looking for substantiation for why the transaction did not result in taxable income. Another common occurrence is that the income may not have been reported on the taxpayer’s return because the taxpayer knew that the transaction did not result in taxable income and therefore the taxpayer (or his CPA) omitted it from the return. Once the evidence is provided that the transaction was not taxable, the case may be closed with no changes.
Here are some examples of information that the IRS knows before you file your tax return based on third-party reporting, which taxpayers often forget to report on their self-prepared returns (or information that they forget to give to their CPA at tax time) which result in AUR notices from the IRS. They are listed in no particular order and this is not an all-inclusive list.
The IRS Knows the Work You Did, For Whom, and How Much You Got Paid
Taxpayers oftentimes forget to report W-2 wages earned and 1099 non-employee compensation income on their taxes. You may have worked a second job for a couple of weeks, decided to quit, and forgot all about it at tax time. Or maybe you taught that one-night course at the community college and forgot all about it once you received your funds. Sometimes the problem is compounded by the fact that you have moved, and the payer mailed the W-2 or 1099 to your old address. The IRS expects to see the sum total of your earnings from every job you worked on the “wages” line of your tax return and expects to see any non-employee compensation that is issued in your social security number on a Schedule C, which is a “Profit and Loss from Business” form.
Oftentimes taxpayers report non-employee compensation on the wrong line of the tax return, such as the “other income” line, for example, rather than Schedule C because the one-night course at the community college doesn’t quite seem like profit from a business in their view. The problem with reporting this income on the “other income” line is two-fold: 1) the IRS expects to see the income on Schedule C, and if it’s not there, as far as they are concerned the income is unreported and 2) you are responsible for paying self-employment taxes for services performed outside of W-2 employment, and the other income line will not calculate self-employment tax unless you explicitly instruct the software you are using to do that.
When the IRS sends you the AUR notice for the unreported non-employee compensation, they will show the proposed income at its full amount, with no regard for any expenses or deductions you may have which would offset this income. This is a very good reason why hiring a taxpayer representative (Attorney, CPA, or EA) can oftentimes result in not paying the full amount of what is assessed on an AUR notice. The representative will ask you about these offsets which could decrease what you may owe.
The IRS Knows About Your Cancelled/Forgiven Debt
Another common situation that gives rise to an AUR notice is canceled debt in the form of credit cards, mortgage foreclosure, auto repossession, or other situations in which you receive a benefit from not paying a loan in full (FYI- I am not referring to Paycheck Protection Program loan forgiveness here). When proceeds from a loan are disbursed to a taxpayer, generally it is not a taxable transaction due to the taxpayer’s obligation to repay. But if the taxpayer is no longer obligated to repay, the taxpayer received something of value with regard to this debt cancellation, and it is viewed as income from the IRS’s perspective.
The IRS will receive a Form 1099-C “Cancellation of Debt” or a Form 1099-A “Acquisition or Abandonment of Secured Property” which informs them of this potential tax benefit that you received, and they will be looking for you to report this cancellation of indebtedness as income on your tax return. But did you know that if you are either bankrupt or insolvent that cancellation of indebtedness is not taxable? Providing adequate proof of such bankruptcy or insolvency in your case can potentially alleviate your responsibility of paying tax on the entire forgiveness amount. Hiring a taxpayer representative to assist you with a concise and targeted response can get a case like this resolved efficiently and effectively.
The IRS Knows That You Sold Your House
Selling a home can be one of the most financially rewarding transactions that a taxpayer can have in the course of his or her lifetime. If you buy at the right time for the right price and sell at an optimal time and price, this can result in a very good return on your investment. But if you sell a house worth more than $250,000, the IRS is going to know about it, due to the Form 1099-S that the payer is required to file.
It is oftentimes surprising to me how familiar many taxpayers are with the Section 121 exclusion. They may not know that the exclusion results from Internal Revenue Code Section 121, but taxpayers generally seem to know that if they sell their house that “the gain isn’t taxable”. Well, that is not quite true, as Section 121 has very specific requirements that must be met for potentially up to $250,000 ($500,000 for married filing jointly) of the gain on the sale of a “principal residence” (which is a term of art) to be excluded from income. The taxpayer’s partially mistaken belief that selling their house is not taxable oftentimes results in many taxpayers completely excluding the transaction from their tax return, meaning that they do not report the transaction at all. Though the transaction may be fully excludable under Section 121 if all requirements are met, it is quite likely that the taxpayer may have missed a requirement or did not report the “depreciation recapture” portion of the sale as income, so a quick AUR notice by the IRS may result in an easy and large recovery for the IRS.
It may be that once all the documentation is gathered that the amount the IRS is proposing as income is too high, and that is oftentimes the case. But it is extremely important to put a quality response together, and that is where you can oftentimes utilize the assistance of a taxpayer representative.
The IRS Knows About Your Investment Income
One simple item of income that taxpayers oftentimes forget to report is bank interest. If a bank pays interest of $10 or more in a tax year, the payer bank is required to report it to you (and to the IRS) on a Form 1099-INT. So often, taxpayers forget to report this $10 on their taxes. The IRS may seemingly let it go and not waste its time sending you an AUR notice, due to the low collection potential. But oftentimes, this unreported bank interest is a throw-in during an audit or an AUR notice issued for something bigger, and the taxpayer’s failure to systematically report the bank interest year after year may indicate “dishonesty” from the IRS’s perspective. It can impact your ability to get penalties waived, it can increase your likelihood of being assessed accuracy-related penalties, and it can result in wasted time, money, and effort in responding to an issue that would have a tax effect of $3 or less on your return.
Interest is not the only investment income that the IRS knows about. They receive information on stock sales, dividends received, rents received, royalties from creative works and/or oil and gas investments, Forms K-1 issued to you, and increasingly cryptocurrency sold. Taxpayers are obligated to track and report these transactions and maintain the associated records for at least as long as the assessment statute of limitations remains open. Failure to do so may result in an AUR notice being received two years later and your documents to defend yourself are gone, lost, or take a significant amount of effort and/or money to recreate.
When the IRS sends you a notice about unreported investment income, they usually do not include your cost basis or deductions. The IRS may only know about the gross proceeds you received for the rents, not your costs of utilities paid, property taxes, mortgage interest, etc. so they are looking for only the income and not necessarily the amount that should actually be taxable once your deductions and costs are factored in. I assisted a client with a notice a few years ago on a tax return that I had prepared for him, in which the client forgot to give me one of the 1099’s from his investment accounts. The IRS sent him an AUR notice proposing thousands of dollars of tax on potentially unreported income from proceeds on the sale of stock. However, once we gathered the documents surrounding the cost basis for his sales, the taxpayer actually had a capital loss and was due a refund! So this is yet another example of why the IRS’s word is not the gospel on these AUR notices. Upon assessing the facts, gathering the information, and most importantly contacting an authorized representative, you can oftentimes have a situation that is not nearly as scary or shocking as what the IRS is proposing.
If you have received an AUR tax notice about unreported income, you may want to consult with an authorized representative as soon as possible, since the clock is ticking on your due process rights. AUR notices become assessments of tax, penalties, and interest, if ignored.
If you would like to discuss an AUR notice that you have received, please contact me using the form below and I will be happy to assist you with determining how much you really owe, or whether you owe anything at all!