The most common type of IRS audit is the underreporter exam. This is where the IRS compares your tax return to the tax documents submitted to the IRS and it appears that something was not reported on your tax return or misreported on your tax return.
What are information returns and what is reported to the IRS?
Any person engaged in a trade or business, including a corporation, partnership, individual, estate, and trust, who makes reportable transactions during a calendar year must file information returns to report those transactions to the IRS. A copy of these information returns must also be send to the party of this transaction. Below is a list of the most common types of information returns filed with the IRS.
| Transactions | Forms |
| Mortgage Interest (including points) | 1098, Mortgage Interest |
| Information about the acquisition or abandonment of property that is security for a debt for which you are the lender | 1099-A, Acquisition or Abandonment of Secured |
| Sales or redemptions of securities, futures transactions, commodities, and barter exchange transactions | 1099-B, Proceeds From Broker and Barter Exchange |
| Cancellation of Debt | 1099-C, Cancellation of Debt |
| Distributions, such as dividends, capital gain distributions, or nontaxable distributions, that were paid on stock and liquidation distributions | 1099-DIV, Dividends and Distributions |
| Interest income | 1099-INT, Interest Income |
| Payment card transactions | 1099-K, Payment Card and Third Party Network Transactions |
| Third-party network transactions | 1099-K, Payment Card and Third Party Network Transactions |
| Services performed by someone who is not your employee (Box 1) | 1099-NEC, Nonemployee Compensation |
| Cash payments for fish (or other aquatic life) you purchase from anyone engaged in the business of catching fish (Box 1) | |
| Payments to an attorney (Box 1) | |
| Rents | 1099-MISC, Miscellaneous Information |
| (Box 1) | |
| Prizes and awards | |
| (Box 3) | |
| Other income payments | |
| (Box 3) | |
| Cash paid from a notional principal contract to an individual, partnership, or estate | |
| (Box 3) | |
| Medical and health care payments | |
| (Box 6) | |
| Crop insurance proceeds | |
| (Box 9) | |
| Fish purchased for resale (Box 11) | |
| Section 409A deferrals (Box 12) | |
| Royalties | 1099-MISC, Miscellaneous Information |
| (Box 2) | |
| Payments of any fishing boat proceeds | 1099-MISC, Miscellaneous Information |
| (Box 5) | |
| Excess golden parachute payments (Box 13) | |
| Nonqualified deferred compensation (Box 14) | |
| Substitute payments in lieu of dividends or interest (Box 8) | 1099-MISC, Miscellaneous Information |
| Gross proceeds paid to an attorney | 1099-MISC, Miscellaneous Income |
| (Box 10) | |
| Example: In a settlement agreement. | |
| Gross proceeds from the sale or exchange of real estate | 1099-S, Proceeds from Real Estate Transactions |
| Timber royalties | 1099-S, Proceeds from Real Estate |
What is the IRS AUR and what do they do?
The IRS receives these information returns from third parties, such as employers and financial institutions. Using an automated system, the Automated Underreporter (AUR) function compares the information reported by third parties to the information reported on your return to identify potential discrepancies. These functions are in some of the IRS’s larger service centers, most commonly Odgen Utah for Minnesota taxpayers.
When a potential discrepancy is identified, a tax examiner further reviews the return, comparing the information reported to the IRS by employers, banks, businesses, and other payers on income returns(Forms W-2, 1098, 1099, etc.) to the income, credits, and deductions you report on your income tax return. If a discrepancy exists, a Notice CP2000 is issued. The CP2000 isn’t a bill, it’s a proposal to adjust your income, payments, credits, and/or deductions. The adjustment may result in additional tax owed or a refund of taxes paid.
Detecting and Preventing Underreporter Exams
There are ways to detect and prevent these types of audits in the first place. To prevent these types of audit, you should review your wage and income transcripts after filing. These transcripts are typically finalized November of the year after the tax year. Review these for any tax forms you might have left off of your tax return.
Next there are ways to detect if an underreporter exam has been opened. Looking at your account transcripts, there will be a code and transaction marked as “Review of unreported income.” When you see this code on your account transcripts, you should review your return and compare that to your wage and income transcripts to see what might have been left off.
When you review your return and wage and income transcripts and notice that something was not reported, you should amend your return immediately. If you amend your return you will save yourself the accuracy penalty for leaving off income. The two most common accuracy related penalties are the “substantial understatement” penalty and the “negligence or disregard of the rules or regulations” penalty. These penalties are calculated as a flat 20 percent of the net understatement of tax.
More on these penalties and possible abatement and ways to avoid assessment will come later. But even if the IRS has issued the review code on your transcripts, if you get an amended return in before the IRS sends out their first letter to you, you can save yourself the 20% accuracy penalty.
Receiving the CP2000 Notice from the IRS
Once you receive the CP2000 notice it is too late to amend your tax return. The CP2000 provides a proposed tax amount due and the IRS’s supporting calculations. The front page in big bold letters the IRS will state the proposed amount due. The rest of the first and second page will provide instructions of what to do if you agree or disagree. Starting on the third page and the next few pages are the important pages of the CP2000.
These pages let you know their calculations and what was left off of their return. This would indicate who issued you the tax form, what form they issued you, and for how much. This could be anything from a 1099-S for a sale of a home, 1099-B for stock trading, 1099-C for cancelation of debt, or any other tax documents you might have forgotten to include.
The IRS often does not have all the correct information to make the assessments. However, they are just making the assessments based on the information that they have available and that is in their best interest. For example, in stock trades, they will not have information on your basis in the stock. Without the basis in the stock the IRS would over assess you tax on the total amount of the stock sale and not just your gain.
Take Care of the Problem as Early As Possible
If you submit a response to the first CP2000, the IRS may make some adjustments based on the information that you provided them. The changes would show up in a new CP2000 letter and so on while you keep responding with new information. However, if the IRS is done making changes or you do not respond to a CP2000, they will then issue a CP3219A. This is the Statutory Notice of Deficiency and provides you the right to challenge the proposed assessment in United States Tax Court. From the date on this letter, you have 90 days to petition Tax Court with your disputes or the IRS will assess the proposed tax against you.
If you wait until this point to retain an attorney, it would be a major mistake. This mistake could end up costing you thousands of additional fees for an attorney when it could have been resolved on the first letter with the IRS. Now the attorney needs to prepare a Tax Court petition and potentially take the case in front of the Tax Court.
How can a tax attorney wrap up the audit in just one letter?
An experienced tax attorney has seen plenty of CP2000. Because these are triggered by unreported tax forms, there are just so many issues for those unreported forms. An experienced tax attorney will know the mistakes that the IRS makes with each one of those forms, the exclusions a taxpayer can qualify for to reduce or eliminate the income, and know the documents needed to end the audit as quick as possible.
A tax attorney can help you remove or avoid an accuracy penalty even if you forgot to include income on your tax return.
As mentioned above, there are two different kinds of accuracy penalties the IRS assesses on top of the underreported tax. Internal Revenue Code (IRC) §§ 6662(b)(1) and (2) authorize the IRS to impose a penalty if a taxpayer’s negligence or disregard of rules or regulations caused an underpayment of tax, or if an underpayment exceeded a computational threshold called a substantial understatement, respectively
The first way to defeat these taxes is to show that no tax was understated. However, even if you did understate tax and left off income from your tax return, there are ways to avoid being assessed the penalties. First, the penalties need to be understood to understand how to avoid them.
Penalty for substantial understatement
You understate your tax if the tax shown on your return is less than the correct tax. The understatement is substantial if it is more than the larger of 10 percent of the correct tax or $5,000 for individuals. For corporations, the understatement is considered substantial if the tax shown on your return exceeds the lesser of 10 percent (or if greater, $10,000) or $10,000,000.
You may avoid the substantial understatement penalty if you have substantial authority for your tax treatment of the item or through adequate disclosure. To avoid the substantial understatement penalty by adequate disclosure, you must properly disclose the position on the tax return and there must at least be a reasonable basis for the position.
To properly disclose the position, complete and attach IRS Form 8275 to your tax return and disclose all relevant facts. A reasonable basis is one that has approximately 10 percent or greater chance of success if challenged. This means that the position must be more than just arguable. There must be some authority supporting the position.
Penalty for negligence and disregard of the rules and regulations
“Negligence” includes (but is not limited to) any failure to:
- make a reasonable attempt to comply with the internal revenue laws
- exercise ordinary and reasonable care in preparation of a tax return or
- keep adequate books and records or to substantiate items properly
This penalty may be asserted if you carelessly, recklessly or intentionally disregard IRS rules and regulations – by taking a position on your return with little or no effort to determine whether the position is correct or knowingly taking a position that is incorrect. You will not have to pay a negligence penalty if there was a reasonable cause for a position you took and you acted in good faith.
Reasonable Cause
IRC 6664(c) provides a reasonable cause exception to the penalties under IRC 6662 and IRC 6663 where the taxpayer had reasonable cause and the taxpayer acted in good faith. A reasonable cause determination takes into account all of the pertinent facts and circumstances. Generally, the most important factor is the extent to which the taxpayer made an effort to determine the proper tax liability.
Taxpayers are required to maintain records sufficient to establish the amount of gross income, deductions, and credits claimed on a return. Taxpayers were most successful in establishing a defense for an asserted underpayment when they produced adequate records or proved they made a reasonable attempt to comply with the requirements of law.
While the Tax Court has been sympathetic to honest misunderstandings of a complex tax code, it will still impose an accuracy-related penalty on taxpayers not demonstrating a good faith effort to comply with the law. This may be demonstrated through discussions and opinions by tax professionals. Or this could be my having gathered and read many tax guidance and saving those that you used for your determination. The taxpayer’s education, sophistication, and business experience are relevant in determining whether his or her reliance on tax advice was reasonable. To prevail, a taxpayer must establish that:
- The adviser was a competent professional who had sufficient expertise to justify reliance;
- The taxpayer provided necessary and accurate information to the adviser; and
- The taxpayer actually relied in good faith on the adviser’s judgment.
The IRS has provided this table for Reasonable Cause Guidance:
| Circumstances that may indicate reasonable cause and good faith: | Circumstances that may not indicate reasonable cause and good faith: |
| Honest misunderstanding of fact or law that is reasonable given the experience, knowledge, sophistication and education of taxpayer. | Lack of significant business purpose. |
| An isolated computational or transcription error. | Reliance on advice of a tax advisor or appraiser who the taxpayer knows or should have known lacked sufficient expertise or lacked independence. |
| Reliance on erroneous information reported on Forms W-2, 1099, etc., provided that the taxpayer did not know or have reason to know that the information was incorrect. | Taxpayer agreed with the organizer or promoter of the tax shelter that the taxpayer would protect the confidentiality of the tax aspects of the structure of the tax shelter. |
| Reliance on advice of a tax advisor or appraiser who does not suffer from a conflict of interest or lack of expertise. | Claimed tax benefits are unreasonable in comparison to the taxpayer’s investment in the tax shelter. |
| Reliance on erroneous information (e.g. cost or adjusted basis of property, or amount of opening or closing inventory) inadvertently included in data furnished by a corporation with multiple divisions or in financial books and records prepared by those divisions, provided the corporation employs internal controls or procedures aimed at identifying such factual errors. | Nondisclosure of a reportable transaction. |
Conclusion
Taxpayers should be diligent to make sure that all income is included in their tax returns, during the time of filing and post filing. If anything is left off, the best thing to do is amend your tax return as soon as possible before the IRS AUR starts the underreporter audit process. Once the process has started, you should retain an experienced tax attorney as soon as possible to end it as soon as possible and for the best results. An experienced attorney can help you pay the least amount of tax, reduce or completely eliminate any penalties you might face. At Wildes at Law, we have lots of experience dealing with these kinds of audits and you will be in good hands when you engage with us and have us protect you and your rights as a taxpayer.
Resources
IRS AUR Internal Revenue Manual: https://www.irs.gov/irm/part4/irm_04-019-002r
Accuracy Penalty IRS Manual: https://www.irs.gov/irm/part20/irm_20-001-005
Taxpayer Advocate Guidance: https://www.taxpayeradvocate.irs.gov/get-help/issues-errors/underreported-income/
Tax Topic 652: https://www.irs.gov/taxtopics/tc652