So Your Client Just Received a Letter from the IRS: When to Start Worrying
Matthew A. Morris, Esq., LL.M
Jon Barooshian, Esq., LL.M.
Clients often start to panic when they receive a letter from the IRS. Most people assume that a letter from the IRS is only the first step in an arduous and time-consuming audit process, ultimately resulting in a significant tax bill. The truth is, however, that most IRS letters are simply (a) invitations to communicate regarding one or more inconsistencies in a previously-filed return or (b) requests to file a past-due income tax or information form. It is also possible that the IRS has sent a notice to your client due to identity theft concerns (i.e. if the client moved to a new address or spelled his or her name differently on the most recently filed return) or some type of administrative error in the IRS’s computer system.
Then again, other letters from the IRS do signify that your client’s return has been selected for examination or that the IRS has already made adjustments to a previously-filed return on the basis of information received from third parties. It is in these cases that clients and their representatives must be especially cautious regarding both the form and content of their responses.
The following is a description of the most common IRS notices and letters, listed in rough chronological order (which also corresponds with the increasing severity of the communications):
- CP 59 Notice: The purpose of this notice is to inform your client that the IRS has no record of a tax return on file for a particular tax year. This notice is simply designed to encourage the taxpayer to file his or her return. There is a section on this notice that enables the taxpayer to explain why he or she is filing late, but that section should only be completed and returned to the IRS after consultation with qualified tax counsel. The penalties for failure to timely file a return and timely pay the income tax due according to that return can be significant (up to 50 percent of the tax due), so it is in the taxpayer’s best interest to consult with you or—if the client has significant exposure to additional tax and civil penalties—a qualified tax attorney before preparing and submitting the explanation section.
- CP 63 Notice: This notice is similar to a CP 59 notice (discussed above). The only significant difference is that a CP 63 notice informs your client that the IRS is holding his or her income tax refund—usually for a more recent tax year—until the past-due return has been filed.
- CP 2000 Notice: The purpose of this notice is to inform your client that the income and/or payment information that the IRS received from third parties (e.g. employers, financial institutions) does not match the information reported in a previously-filed return. You should review these notices carefully with your client to make sure that he or she understands which items of income and/or expense are being adjusted. You should also cross-reference the CP 2000 notice against a copy of the income tax return as filed to make sure that the reviewed item has actually been omitted. If the missing income or expense item is relatively small (i.e. $500 or less) and the taxpayer agrees with the IRS that the item should have been reported on the original return, then the taxpayer should sign, date, and return the CP 2000 notice and agree to the proposed changes. But if the missing income or expense item is relatively large (i.e. over $500) and you and your client are not sure that the item should have been reported on the original return, then your client should not agree with the proposed changes and should contact you (or a tax attorney depending on the amount of the proposed adjustment) to discuss the appropriate response.
- CP 2566 Notice: The purpose of this notice is to inform your client that the IRS has prepared a return for the taxpayer based on information reported to the IRS from third parties. The IRS refers to this as a “substitute for return” (“SFR”). An SFR is almost always bad news for your client. The SFR typically lists the taxpayer’s filing status as “single” (which may or may not be the case—taxpayers typically owe less filing as “head of household” or “married, filing jointly”) and limits the taxpayer to the standard deduction (as the IRS has no way of knowing whether the taxpayer is entitled to itemize his or her deductions for the unfiled tax year). Instead of accepting the SFR or objecting to specific line items of the SFR, you should work with your client to gather the information necessary to complete the past-due income tax return for that particular year. Regardless of the fact that the IRS has already filed the SFR, the past-due return will still be considered an original rather than an amended return. There is a response form on the CP 2566 Notice, but your client should only complete that response form with assistance from you or another qualified tax professional; once the response form is completed, you should send that form and the original past-due income tax return to the address listed on the notice.
- CP 05A Notice: The purpose of this notice is to inform your client that his or her return has been selected for examination (i.e. audit) and that the IRS needs additional documentation as part of this examination. The CP 05A is typically more significant than a CP 2000 notice because the latter is just meant to inform the taxpayer that there is a discrepancy between information reported on the return and a particular item of income or expense that was reported to the IRS by third parties. A CP 05A or similar notice is much more open-ended and typically suggests that the IRS has reason to believe that the taxpayer did not accurately report one or more items of income and/or expense on the originally-filed return. For example, if a self-employed taxpayer who owns a sole proprietorship receives a CP 05A Notice, this typically means that the IRS is questioning the accuracy of the income or expenses claimed on Form 1040, Schedule C. The taxpayer usually should not represent himself or herself in the examination—either you or a qualified tax attorney (depending on the amount involved and your comfort level and experience with IRS audits) should represent the taxpayer throughout the audit process.
- Letter 525 (30-Day Letter): The purpose of this letter is to inform your client that an IRS auditor has examined a previously-filed return and proposes adjustments to the originally-reported tax liability. This letter should not come as a surprise—your client should only receive this letter after being notified that his or her return has been selected for examination and assigned to an auditor (see discussion of CP 05A Notice, above). This is often referred to as the “30-Day Letter” because it gives the taxpayer 30 days to respond to the proposed adjustments. Your client should never try to respond to a 30-Day Letter without first consulting with you or another qualified tax professional.
- Letter 531 (90-Day Letter): The purpose of this letter is to inform your client that he or she has 90 days to file a petition with the U.S. Tax Court to challenge the proposed assessment of additional tax liability. If your client does not file a petition to the U.S. Tax Court within 90 days, then the IRS will assess the tax and commence with collections activities. You and your client should never try to respond to a 90-Day Letter or file a petition to the U.S. Tax Court without first consulting with a qualified tax attorney.
- Form 668(Y) – Notice of Federal Tax Lien (“NFTL”): A client typically receives an NFTL after attempts by the IRS to collect outstanding taxes, penalties, and interest have been ignored marking the IRS’s intention to begin more aggressive collection proceedings. Form 668(Y) is a document that memorializes the IRS’s lien which gets filed in a public forum—such as the local registry of deeds or U.S. District Court—to put the taxpayer’s current and potential future creditors on notice of the outstanding obligation. Credit reporting bureaus such as Equifax, Transunion and Experian also pick up this information and that can result in a devastating impact on the taxpayer’s credit score. A copy of the Form 668(Y) sent to the targeted taxpayer should be accompanied by a document describing the taxpayer’s rights to challenge the NFTL in a proceeding before an IRS administrative hearing that, if timely filed, will also give the taxpayer a right to appeal the administrative decision to the U.S. Tax Court.
- CP504 – Notice of Intent to Levy: This notice informs your client that the IRS intends to issue a levy against his or her state tax refund because there is a balance due for one or more tax years. The CP504 also informs the taxpayer that the IRS will begin searching for other assets on which to issue a levy and that the IRS may also file an NFTL if it has not already done so. If you and your client believe that no tax is owed for that particular year or the Notice of Intent to Levy is invalid for some other reason, then you should immediately seek assistance from a tax attorney who understands IRS procedures and taxpayers’ rights.
- CP504B – Notice of Intent to Seize (Levy) Your Property or Rights to Property: This notice informs your client that the IRS intends to issue a levy against certain property or rights to property because there is a balance due for one or more tax years. This notice also explains that the IRS will continue to search for assets that it can seize and that it may also file a NFTL if the IRS has not already done so. This notice also explains the denial or revocation of a U.S. Passport. The CP504B also comes with a notice to the taxpayer’s rights to a hearing prior to seizure.
- The IRS Summons: Section 7602 of the Internal Revenue Code authorizes the IRS to issue a summons to (1) a person liable for tax, (2) an officer or employee of such person, (3) a person with possession, custody, or care of the business books of a person liable for tax, and (4) any other person the IRS deems necessary. The statute allows the IRS to use this power (a) to determine if a return is correct; (b) to make a return where there is none; (c) to determine tax liability; (d) to collect taxes; and (e) to inquire into any offense connected with the administration or enforcement of the internal revenue laws. In short, the IRS has the authority to summon any person with information that is helpful to a tax investigation and direct that person to testify or produce written evidence. When the IRS issues a summons, your client can comply, refuse, ignore it, or go to court and attempt to quash it by showing he or she has legitimate legal reasons not to disclose the information. If your client ignores or refuses to comply with the summons, the Justice Department can get a court order to enforce it. If your client still refuses to comply with the summons after receiving a court order, then he or she could face sanctions for criminal or civil contempt.
Regardless of how your client chooses to respond to the above notices, the prudent thing to do is consult with you and—depending on the client’s exposure to additional tax, civil penalties, or criminal penalties—a qualified tax attorney who can help the client to figure out the best course of action. The last thing any client should do after receiving a summons or any other letter from the IRS is to ignore it. Once a particular taxpayer is on the IRS’s radar, the IRS will continue to escalate assessment and collection activities until the taxpayer successfully challenges the assessment, pays the tax in full, or negotiates an alternative to an immediate lump sum payment such as an installment agreement or offer in compromise.
As with any professional engagement, there has to be a clear line of communication between the client and the tax professional in order to properly respond to an IRS notice. Both the client and the tax professional have to understand the scope of the IRS’s examination, the potential magnitude of any corresponding tax adjustment, the client’s exposure to additional taxes and penalties (both civil and criminal), and the client’s objectives and expectations regarding the examination process. It is only after everyone has a complete understanding of these issues that the tax professional will be able to formulate a strategic and targeted response to the IRS notice.
Matthew A. Morris and Jon Barooshian are tax attorneys at Bowditch & Dewey LLP in Framingham whose practice areas include federal and state tax controversy, audit defense, and collection defense. Attorney Barooshian’s practice areas also include criminal tax defense.
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