As promised 10 days ago, this is the first of 37 issues in our new posts, The Ultimate US Tax Guide, where I will share with you 37 key tax insights that US taxpayers like us need to understand, to help us take care of our US taxes with more confidence and clarity. In this post, we´re going to discuss the IRS silence and notices.
One of the main reasons I decided to start this series is because, over a dozen plus years working with US immigrants and expats on their tax issues; speaking to social groups and organizations of Americans living overseas; and with US expats in general; I became aware that there are many misconceptions and incorrect assumptions that many US taxpayers operate from, which can sometimes get them in trouble.
I have met US taxpayers who have been, inadvertently, doing things incorrectly for years, without hearing a peep from the IRS, so they reasonably assume that they have been doing things the right way. When they haven’t.
Some of these taxpayers have been using retail tax preparation software and filing their tax returns electronically. Once their electronic file is submitted, they get a confirmation that reads something along these lines:
“Your tax return has been accepted by the IRS. Your confirmation number is XXXXXXX”
And they go: “Yay, I filed a correct tax return with the IRS! 2019 US taxes, check!
But that’s not what the message above means. It just means that the electronic file was formatted correctly for the IRS to be able process it. The IRS has made no judgement, yet, or ever, as you will learn next, regarding the accuracy or completeness of that tax return.
So here is the first tax principle I want to share with you:
IRS silence doesn’t mean agreement
Just because the IRS has accepted your electronic file or because you have filed tax returns for years and haven’t heard from the IRS about them, it doesn’t necessarily mean that you have been doing things correctly.
Unfortunately, or fortunately, depending on your perspective, the IRS doesn’t review every individual tax return.
When the IRS selects a tax return for audit, this is typically referred to as an IRS examination. The IRS uses four major methodologies to select a tax return for examination:
- Computer screening: something in your tax return is not in line with the standard norms for similar tax returns, a statistical anomaly, and the IRS pulls it aside to ask you questions about it
- Related examinations: a related party, such as a business that is under examination, has a transaction with you, and this brings you under the IRS’ attention
- IRS campaigns: the IRS decides to focus on a particular issue, and if your tax return includes the issue in question with the fact pattern they are interested in exploring, they pull your tax return aside for examination. At the moment, for example, the IRS is conducting a foreign earned income exclusion and also a foreign grantor trust reporting campaign.
- Random selection: in this self-explanatory methodology, the IRS selects a small sample of tax returns randomly every year for examination.
If your tax return is selected for examination, the IRS will first notify you by mail. The examination will most likely be conducted by correspondence, i.e., also by mail. More than 80% of IRS examinations are correspondence examinations, and the remaining ones are (or used to be, before COVID-19) field examinations conducted at your home, place of business or tax advisor’s office.
The rate of IRS examinations has declined significantly over the past decade. In 2019, for example, only 0.45% of individual tax returns were examined. In 2010, the rate of examination was 1.11%, almost two and a half times higher.
No wonder there is a sense of complacency!
On average, only 1 of every 222 tax returns filed is examined, based on 2019 rates. The average taxpayer can expect to go through multiple lifetimes without hearing from the IRS. In 2010, the rate of examination was 1 for every 90 tax returns filed, and back in 1996, it was 1 for every 60.
Some of you may think, but……wait a minute! I get IRS letters ALL THE TIME! What is going on?
While the trend of IRS examinations has been in steady decline for decades, what has changed dramatically in the opposite direction is the rate of IRS automated correspondence.
Every year, the IRS sends about 220 million automated notices. 220 million letters that are computer generated automatically and mailed to taxpayers.
In 2018, the IRS received around 149 million tax returns. And it sent out 220 million letters. That’s 1.5 letters per tax return on average.
So some of you may never ever hear from the IRS, and some of you may hear from the IRS, painfully, several times a year.
What is the difference?
I’m only half kidding. The most common difference between someone who never gets an IRS letter and someone is who always getting IRS letters, is whether the IRS has third party documentation that contradicts an item of income, an asset, a credit or a payment reported in that tax return.
For example, if you expect to owe more than $1,000 in US taxes, you are required to pay estimated taxes. If you pay $500 in estimated taxes but you claim on your tax return that you paid $600, you will get a notice from the IRS about the $100 difference. Sometimes your estimated tax payment is assigned to the wrong tax year, or even the wrong taxpayer, and you get erroneous IRS notices. Those are the most fun, said no one ever!
On a different example, if you live abroad, qualify for the foreign earned income exclusion, are able to exclude all your income and never owe any US tax, you do not run the risk of receiving an IRS notice due to an estimated tax discrepancy. This is a problem you will never have. You may, though, be selected for a foreign earned income exclusion campaign examination! Do not worry, the rate of examinations is very low, even for IRS campaigns.
In a nutshell, some people have items in their tax return that third parties also have to report to the IRS: interest from a US bank account where the bank sends you a copy of the 1099-INT and it sends another copy to the IRS; dividends from a US brokerage account reported on a 1099-DIV; US self-employment income reported on form 1099-MISC; a foreign bank account reported to the IRS by your foreign bank under FATCA; a K-1 for your beneficial interest in a US partnership or trust; etc. All these items can result in automated IRS letters if the amounts on your tax return do not match the amounts on the forms received by the IRS from the third party.
What are some of the most common IRS automated notices?
CP2000: automated underreporter notice, typically because an amount you reported on your tax return is lower than the amount reported by a third party.
CP2501: another type of automated underreporter notice, but because you forgot to report an item of income altogether.
CP12: this is one type of notice that usually makes people happy: you thought you owed money to the IRS but it turns out you owe less, or are entitled to a refund! Usually this happens when you forget to include an estimated payment or tax withholding, or you overreport, instead of underreport income.
You may also receive notices because you made a mathematical or calculation error on your tax return and the tax balance is incorrect as a result, because the IRS disagrees on your tax balance, because you claim a tax credit you were not entitled to, etc.
This brings us to the second tax principle of the week:
IRS notices do not necessarily mean you filed your taxes incorrectly
You may receive an IRS notice in error, because the third party reported the income wrongly, or because the third party failed to report the income to the IRS altogether, or because the IRS assigned you income that belongs to someone else or applied your payment to the wrong tax year or taxpayer! Anything is possible.
If you receive an IRS notice, don’t ignore it, but also, do not panic. It may have been sent to you in error. Review the notice carefully and act accordingly. If you are not sure what to do, call the number on the notice. Be patient. Wait times can be long. But do not pay whatever balance the IRS claims you owe without making sure first that you agree that you owe it. If necessary, consult a tax professional.
So, what did we learn today?
Principle #1: IRS silence does not automatically equal IRS agreement. You may have just gotten lucky!
Principle #2: IRS noise (letters) does not automatically equal tax trouble. You may have just gotten unlucky!
As we discuss the remaining 35 tax principles, we will focus on helping you understand when you should be paying a little more attention to your taxes, and when you can worry a little bit less about them, until you get the balance just right.
If you have any questions or any suggestions for tax principles you would like to learn about or think we should share with everyone, please send us a note to let us know. We welcome everyone’s suggestions.
Until next week. Much love,