An IRS Letter Is Not the End of the World -- Unless You Ignore It
For tax payers, few things can cause a spike in in your blood pressure faster than receiving a letter from the Internal Revenue Service (IRS). But before you go into a doom spiral imagining all of the worst-case scenarios, it is important to take a step back and understand what an IRS notice actually means.
Yes, the IRS has the authority to assess taxes, impose penalties, and even in extreme cases, seize assets. More often than not, it is a routine matter that can be resolved without much trouble as long as it is handled properly.
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The absolute worst thing you can do when you receive a letter from the IRS is to bury your head in the sand and hope it goes away. Unlike an unwanted wedding invitation, an IRS letter does not simply disappear if you ignore it long enough.
In fact, the IRS typically provides a response deadline, and failing to respond to the notice within the given timeframe often escalates the issue. Therefore, even in an instance where you believe the IRS has made an obvious mistake, it is imperative that you respond in writing and in a timely manner to avoid additional penalties, interest, assumptions, or possibly admission of guilt.
It is also a mistake to assume that every IRS notice is 100% accurate and to simply pay whatever amount they claim you owe just to make the problem go away. While the IRS has sophisticated systems for catching discrepancies, those systems are not infallible. Human errors, misclassified income, misfiled payments, or even a missing tax form (that was later corrected) can all result in incorrect notices.
Before cutting a check, it is wise to share the notice with your tax preparer or accountant and ask for their opinion. A professional can review the IRS’s calculations, compare them with your original return, and determine whether the assessment is accurate. In many cases, a simple clarification or additional documentation can resolve the issue without you having to pay anything extra.
Additionally, if your preparer is an Enrolled Agent (EA) or Certified Public Accountant (CPA), they are also authorized to represent you in front of the IRS in a more formal hearing. People in these positions have likely experienced this same situation in the past or have a deep understanding of how to conduct research on your specific issue to offer you the best course of action. In any event, acting too quickly to "just get it over with" can cost you unnecessary money.
Sometimes, a mismatch between what you reported on your tax return and what a third party—such as your employer or your brokerage firm—reported to the IRS can trigger a notice. For instance, if you are a person who receives Restricted Stock Units (RSUs) or some other form of equity compensation from your employer and you sold some of those shares, it is very likely that the company managing your stock plan reported that sale as entirely a capital gain on the 1099 form they sent to the IRS.
Even if you took the proper steps to reconcile this transaction using Form 8949 and Schedule D, there is a chance that IRS computers may have misread one of your supplemental documents and issued a discrepancy letter indicating, in error, that more taxes are owed.
If you have proper documentation showing those shares were sold on the day they vested—and that no additional gain was actually realized—you can clear up the issue without having to pay extra. This is why keeping accurate records is invaluable. And while the general rule of thumb is to maintain tax records for at least three years, it is prudent to keep records of up to seven previous tax filings.
One of the more frustrating aspects of dealing with the IRS is receiving a notice about a tax return filed two or three years ago—long after you have forgotten about what occurred. However, there is a reason for this delay in communication. The IRS generally has three years from the date you file a return to audit or adjust it, known as the statute of limitations. And in cases where they suspect an intentional underreporting of income, this period can broaden to six years.
It is also important to note that the agency is notoriously underfunded, understaffed, and still relies heavily on paper correspondence sent through the U.S. Postal Service. This means that most IRS issues take weeks or even months to sort out, rather than days. But this slow pace can actually work to your advantage, as it gives you time to gather documents, consult a tax professional (if necessary), and craft a detailed and thoughtful response.
If you receive an IRS letter, the first step is to carefully read it and determine what the IRS is asking for. Some notices are simple requests for additional information, while others propose changes to your return or demand payment. The best course of action will depend on the nature of the notice. In any instance, having detailed, organized records can mean the difference between a quick resolution and a prolonged dispute that drains your time and resources.
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Malcolm Ethridge, CFP® is the Managing Partner at Capital Area Planning Group, based in Washington, D.C. He is also the Managing Partner of Capital Area Tax Consultants.
Malcolm’s areas of expertise include retirement planning, investment portfolio development, tax planning, insurance, equity compensation and other executive benefits.
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Disclosures:
The information provided is for educational and informational purposes only, does not constitute investment advice, and should not be relied upon as such. Be sure to consult with your legal advisors before taking any action that could have tax and legal consequences.
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