Let's pretend that you've just received a letter from the Internal Revenue Service.
Relax. Most letters from the IRS involve minor issues. It's possible that you made an arithmetic error on your return and the IRS actually owes you money. Alternatively, if the error was made in your favor, you might owe the IRS some money and interest. The current interest rate is 4% on an annualized basis. So if you owe $100 for one month, the interest is only 33 cents ($100 times 0.04, divided by 12). If you owed $1,000, the total interest would only be $3.30.
The biggest reason that people receive letters from the IRS is human error. Each year, more than 1 million letters are sent to people because they failed to sign their returns. Or maybe they made a mathematical error. Or even better: The IRS made the mistake. For example, in 1998, the IRS sent out apologies to 20,000 taxpayers for mistakes it made in handling their accounts.
Math errors rarely result in audits
Sometimes, the IRS errors are ridiculous. A few years ago, Kenneth Steen of Chattanooga, Tenn., expected a refund of $513. Instead, he received a letter from the IRS demanding payment of more than $300 million. An IRS official later confirmed that about 3,000 people around the nation got similar erroneous notices.
According to the General Accounting Office, about half of the 10 million notices the IRS issues each year are because the information is "incorrect, unresponsive or incomplete."
If it's a math mistake, these errors rarely lead to a full audit. Check the numbers. Sometimes, the IRS misreads one of your numbers or the number is keyed incorrectly into the IRS computer. If it's wrong, send a letter with a printout of your calculations.
Mismatched interest and dividend reporting is the No. 2 cause for a letter from the IRS. Payers of interest and dividends are required to report those payments both to you and to the IRS on a Form 1099. If the amounts reported don't match the amounts on your return, you will get another letter from the IRS.
There are lots of errors here. Sometimes, the IRS will enter the Form 1099 information into its computer and erroneously keystroke the income amount or the Social Security number of the recipient. If the income isn't yours, you should get a letter from the bank or other payer and forward that letter to the IRS. If the amount is incorrect, send a copy of the Form 1099 mailed to you by the payer.
Sometimes, you may get a letter saying the income isn't reported even when it really is. I have a client who got a letter from the IRS demanding additional taxes for nine items of income that allegedly were not reported. In fact, seven were correctly reported on Schedule B on the return and the other two were accounts in the names of my client's children. I sent a copy of the Schedule B, with the items numbered and circled, and the issue was resolved.
Never represent yourself
What if it's the big one, the tax audit? An audit is merely a process where the IRS asks you to substantiate the numbers on your tax return. For example, if you claimed a charitable deduction of $750, the IRS would want to see canceled checks and receipts totaling $750. If you show up with $800 in substantiation, you get a refund; if your substantiation is less than $750, you owe money.
Once you know what the IRS wants, call your tax professional. Never represent yourself at your own audit. You may know what to say, but you don't know what not to say. If the audit is simple -- to prove your charity and interest deductions, for example -- you can do it yourself by mailing in copies of your substantiation. Otherwise, for all in-person audits, I strongly suggest professional representation. In either case, if you have the records, you needn't worry.
Actually, if you are audited one year with a refund or no change, it decreases your odds of being audited in subsequent years. In fact, if you are audited on the same items two years in a row with no additional taxes due, the IRS manual specifically recommends that they not audit you on the same items for the third year.
Almost all of the letters received from the IRS are computer-generated. This means that if an input error was made, it's now your problem. But in almost all cases, a well-drafted letter with appropriate substantiation will win the day.
