Monday, August 30, 2010

How to Stop the IRS Machine

Taxpayers all over the country are receiving letters from the IRS with unsettling news. According to Forbes, the IRS has been sending out bills to taxpayers because of discrepancies between their 2008 tax return and income totals reported by employers and other sources. However, before you reach for your checkbook, be sure to take a careful look at the notice. Many of the letters are reportedly incorrect and/or misleading. reports:

It's document matching time at the Internal Revenue Service. Millions of taxpayers are opening their mailboxes to find a boldly stated notice shouting "Summary of Proposed Changes" identifying an increase to their 2008 taxes, penalties, interest and a whooping Proposed Balance Due. These notices are often more than 10 pages long, and not until you've gotten to page five do you find out what the IRS alleges created the problem: discrepancies between the amounts reported to them by others and what you included in your return. This is the meat of the letter (known as a CP-2000 notice) and often where you will find what led to the notice "mis-match."

Do not reach for your check book in defeat. Do not immediately scream obscenities about your tax preparer. These letters are often wrong. They are directed at getting your attention. They are machine-generated, generally unseen or untouched by human eyes or hands until the taxpayer responds to the notice. Until a response is received and logged in by IRS personnel, the machine will control the process. Uninterrupted, this automation will lead the IRS to be legally entitled to collection of the balance being proposed. Here are a few examples illustrating the variety of issues on notices I've seen recently:

Shock and Awe Proposed Balance Due: $54,871; Actual Balance Due: Zero

The IRS computers concluded the taxpayer had an IRA distribution of $198,981, but showed a taxable IRA distribution of just $40,000 on the return. The real story is this: The taxpayer converted a pre-tax IRA worth $198,981 to a Roth IRA early in 2008, and he correctly reported this as an IRA distribution on his 2008 return. The stock market dropped dramatically toward the end of 2008. Not willing to pay taxes on an amount well in excess of the account value in early 2009, he properly "re-characterized" (returned to his traditional IRA before filing) all but $40,000 of the converted amount, reporting that amount as taxable on the return. He correctly disclosed this and included Form 8606 on his return. It was all explained, but the IRS machines had not checked for those entries. (For 10 Reasons To Convert To A Roth IRA, click here.)

Shock and Awe Proposed Balance Due: $524; Actual Balance Due: Zero

The taxpayer authorized $2,000 of her 2008 IRA distribution to be donated to her local church. Her tax return correctly indicated a $21,690 distribution with $19,691 taxable. As the IRS instructions dictated, the code "QCD" (for qualified charitable distribution) was indicated on the return. But the IRS' "automated underreporter" systems apparently did not notice the code.

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