|Here’s what happens. The IRS Automated Underreporter Unit (AUR) matches income reported on individual tax returns with the income that is reported to the IRS from various third parties (e.g., employers, financial institutions, and banks) and recorded in its wage and income transcript file.|
If there is a difference, the IRS “flags” the tax return for further review and may issue a CP2000 Notice. The notice tells the taxpayer that there are proposed tax changes because of a mismatch between the income shown on their return and the income reported to the IRS. It is worth noting that the IRS system does not work in real-time but rather runs in a batch mode.
There are two kinds of individual tax AUR notices:
- A “hard” CP2000, which shows proposed changes and additional tax due
- A “soft” CP2501, which asks for clarification regarding missing income items
Both require a response, although the CP2501 requests it far more politely.
The business versions of the CP2000/CP2501 are the CP2030/CP2531. IRS Publication 5181 is a great reference on CP2000/CP2030 Notices.
These notices are a fact of life because our taxpayers do not always present us with all their income documents when we are preparing their tax returns. In fact, in recent years, the IRS AUR has sent out over 4 million CP2000 Notices.’
Typical reasons run the gamut and include:
- “I didn’t tell you about the inherited U.S. savings bonds I cashed in because my hairdresser told me they were tax-free:’
- “I didn’t tell you about my Roth IRA distribution because it is tax-free:’ (Roth distributions are fully taxable if they are not shown on the tax return. The taxpayer must prove basis to prove they are not taxable. However, they could be subject to a penalty)
- “I moved and didn’t get my 1099-R for my $50,000 early distribution:’
- “I exercised my non-qualified stock options (Code V in Box 12 of the W-2) and paid normal income tax on the gain. TurboTax did not prompt me to enter the sale on Schedule D:’
As we say in the trade, you can’t make this stuff up!
A return flagged for unreported income can still be subject to examination at a later date. When a taxpayer gets a CP2000 Notice, they often think they are being “audited?’ It is important
to help the taxpayer understand exactly what the notice means and what his or her response options are.
Possible CP2000/CP2501 responses include:
- No response, in which case the proposed tax will be assessed
- Respond and agree
- Respond and disagree
- Respond and disagree, providing compelling documentation as well as background information in an attempt to reduce or eliminate the penalties associated with any increased tax.
Taxpayers have 60 days from the date of notice to respond to the CP2000/CP2501. The notice actually says 30 days, but it provides for 60 days if the taxpayer is out of the country. Since the IRS doesn’t know whether or not someone is out of the country, 60 days has become the standard.
I have gotten involved in responding to CP2000 Notices after the Notice of Deficiency was issued (I have faxed a response to the AUR Group on the 30th day of the 90-day
NOD and received a No Change on the 85th day). If no response is received after a late “hail Mary” fax, the taxpayer can still file a pro se petition to the Tax Court and continue to work on resolution while the case makes its way through docketing and appeals.
IRS Wage and Income Transcript Database Development
The IRS wage and income transcript database begins to populate after the tax year is over. For example, 2015 wage and income data were added to this database throughout calendar year 2016. In early 2017, the database will be complete, and the IRS will run its return-matching program against the database. The 12 months required for the database to be developed is the reason for the substantial delay between filing a return and getting a notice.
When the IRS runs its matching program, it flags returns showing a mismatch with Transcript Code 922, Unreported Income. This should occur in February and March 2017 for the 2015 tax year.
2015 PATH Act Changes
In an effort to reduce tax identity theft, the new deadline for filing W-2s and 1099-MISC with Box 7 NEC (non-employee compensation) has been moved up to January 31. This will allow the IRS to verify that the income reported on 2016 returns “matches” the income reported to the IRS prior to sending out refunds with refundable credits.
It is not clear how this new W-2 program will affect the AUR matching program and its associated CP2000 Notices. Stay tuned.
Strategies for Preventing
The way to prevent a CP2000 Notice is to report all income properly. Since our clients exercise some judgement on the tax documents they present to us, we can’t depend on the information we receive from them to be complete. Here are a few strategies we can use to at least reduce the frequency of CP2000 Notices.
File an extension and verify income. Some of us work with troubled taxpayers (procrastinators) and have a Form 2848 or 8821 in place for each of our clients. We create a preliminary tax return prior to April 15 and ask our taxpayers to send in the preliminary balance with their extension.
In the August/September timeframe, we pull the IRS wage and income transcripts and verify that we have accounted for all the income reported to the IRS. Occasionally, I have seen new income documents hit the IRS transcripts as late as early October. Following this extension-and-verify-income procedure generally will reduce or eliminate CP2000 Notices.
Duplicate the IRS AUR procedure. A great strategy to check for an income-return mismatch is to duplicate the IRS AUR procedure. Late in the year, pull the wage and income transcripts from the previous year on each return we prepared and look for differences between reported income and the tax return.
This is a lot of work, but it can be simplified with the wage and income summary, a one-page summary of all the income items. Typically, you will have a Form 8821 or 2848 on each client, so you can easily pull transcripts via IRS e-Services using commercially available software.
Catch the error before the IRS does. Take advantage of the IRS matching process and do your own search for the Code 922 Unreported Income in the IRS account transcripts in the February to March 2017 timeframe. The IRS has done the heavy lifting; you just look at the results.
When you do so, you can verify the mismatch between the filed return and the IRS wage and income transcript; if there is an error or omission, you can amend the return months before the AUR CP2000 Notice is mailed to your client. This saves the embarrassment of your client receiving an IRS notice (they hate that) and avoids having to pay some interest and the ever-possible 20 percent penalty (accuracy-related or substantial understatement of tax).
Monitoring these transcripts has an interesting benefit. The IRS is flagging income that was left off the return—but if the omitted income results in a refund, it appears to be current IRS policy to not send a CP2000 Notice. I have seen two of these in the past several years and have filed amended returns for refunds (a W-2 with high withholding was omitted from the return).
The policy of many tax professionals is to cover penalties and interest if they make an error; detecting and correcting these errors early saves the cost of penalties and reduces the potential interest.
Understanding the IRS
Matching Program Process
If the IRS Matching Program detects unreported income, a Code 922 is placed in the account transcript with the corresponding date. Typically, the transcript will appear as:
When the IRS sends a notice to the taxpayer, the date is changed to match the date on the CP2000 Notice. Typically, the transcript will be updated to:
With each ensuing IRS letter, the date of the 922 code on the transcript will be updated to the date on the most recent letter. If no response is received, the final letter will be a CP3219A Notice of
Deficiency (commonly known as the 90-day letter). If no response is received after the CP3219A is issued, the tax determination is final, and the additional tax due is posted to the account transcript. If the taxpayer later wants to contest the assessed tax, they can submit an Audit Reconsideration request with supporting documentation to attempt to get the tax reduced to the correct amount.
In 2014, the AUR unit ran the matching program several times throughout the year. By observation, it appears that IRS budget cuts have reduced the number of matching runs. The IRS could increase the frequency of its computer-matching runs, since the majority of the data is available sooner.
If you are monitoring the account transcripts to check on AUR unreported income, it is prudent to pull the account transcripts every two weeks using commercially available software to continuously check on the status of each account. This strategy has the additional benefit of scanning for returns that have been flagged for examination (Code 420). The time between a return being flagged for exam and the actual exam letter has been observed to be as long as 18 months.
If a return is flagged for exam, you can review the return and, in some cases, offer an amended return to self-correct the issue that appeared to cause the exam flag. We have seen cases where the audit was short-circuited and the IRS accepted the changes on the amended return with no further correspondence.
In this time of budget constraints, we have also seen a timely filed 2012 return flagged for exam in late 2014 (Code 420), and seven months later saw a code 421 Exam Closed with no letters sent to the taxpayer and the Power of Attorney (POA). It appears that the audit would have to begin with less than 12 months remaining on the three-year audit statute—IRS policy is to have more than a year remaining on the statute before an exam is initiated. When an audit flag is detected on a prior year return, the current year return should be prepared with the expectation of an audit. All items should have documentation to back up every number on the current year return.
This all may sound like a lot of work, but it’s what we do. Enrolled agents are the go-to tax professionals when it comes to pulling and analyzing IRS transcripts to monitor and protect our clients.
EA Journal Vol. 35 No. 2 March/April 2017