A Letter From the IRS? Uh-Oh. But Don't Panic!

NEW YORK (TheStreet) -- You filed your 2011 federal and state income tax returns on time and received, and probably already spent, your refunds. Then yesterday you got a notice in the mail from the IRS, or your state tax agency, telling you there was an error on the return and you owe additional tax, penalty and interest!

In 2011, the IRS received over 1.8 billion 1099s, 1098s, W-2s, and other such returns reporting income and deductions for tax year 2010. The information on these returns was matched against 141 million 2010 individual income tax returns. The Service found almost 20 million "alleged" discrepancies and issued a CP-2000 notice to 4.7 million taxpayers explaining what they thought was wrong and asking for payment of additional tax.

There are 2 basic rules when you receive correspondence from the IRS or a state tax authority:

1. Never ignore the notice. The problem will not just go away. The only things that might go away are your wages or your home!

On the other hand...

2. Never automatically pay the amount requested on an IRS or state tax notice. It has been my experience from 40+ years as a professional tax preparer that at least 2/3 of all federal and state tax notices are incorrect.

If you get a notice in the mail carefully check the return that is being questioned. If it was prepared by a tax professional send a copy of the notice to your preparer immediately. If you prepared the return yourself, and you do not understand the notice, you should consult a tax professional.

So far this year I have received quite a few IRS and state notices from clients requesting additional tax on 2011 returns. In almost all instances a letter from me, with photocopies of appropriate documentation, resulted in the IRS or state agency agreeing that the return was correct as originally filed and that no additional tax was due.

In recent years I have seen IRS and state notices where:

The tax liability on qualified dividends, either under the "regular" tax or the Alternative Minimum Tax, was calculated treating the dividends as "ordinary" income instead of using the applicable lower 15% or 0% tax rate

A state tax refund was treated as fully taxable, even though the taxpayer did not receive a "tax benefit" from deducting state income tax on the prior year return

An IRA or pension distribution was treated as fully taxable when all or part of the distribution represented a tax-free return of contributions or was rolled over

Credit was not given for all tax withholding reported on W-2s or 1099s, or for all dependents reported on the return

In some cases, the taxpayer or preparer made a clerical error or omission on the original return, but it is more likely that the notice was issued because there was some problem in the IRS or state processing software.

I have been told that the IRS software sometimes reads numbers incorrectly by missing a decimal point. In one situation a taxpayer received a CP-2000 claiming he did not report $88,000 when the actual 1099-MISC reported $880.00.

When responding to the IRS, or the state, do not expect a prompt reply. The first letter you receive from the IRS will acknowledge receipt of your, or your tax preparer's, response, tell you they need more time to review the situation, and promise to get back to you in 45 days. And 45 days later they will write to tell you that they still need more time, and will get back to you in another 45 days.

More on taxes:

Yes, it's deductible, but...

Can I deduct my gym membership?

--By Robert D. Flach

Robert Flach has more than 40 years of experience as a tax professional and also blogs as The Wandering Tax Pro.

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