The IRS and Congress have long struggled with the estimated $300 billion tax gap and have acknowledged the need to find ways to identify people who are avoiding tax or not calculating their income and deductions correctly. The IRS recently started a “soft notice” initiative and has sent notices to taxpayers to spur voluntary compliance.
A recent article outlines the significant increase in the use of correspondence audits and the amount of taxes generated by their use (Placid, Cecil, and Pacini, “IRS Enforcement Activities: Past, Present, and Future,” 39 The Tax Adviser 448 (July 2008)). It also shows that from 2003 to 2007, correspondence audits accounted for close to 80% of all audits.
IRS Commissioner Douglas Shulman stated on July 18, 2008, that “I also believe we cannot audit our way to full compliance. We need to drive greater innovation into our enforcement endeavors. We need to supplement our efforts with new tools, such as more information reporting, soft notices and self-correction options for taxpayers” (remarks before Tax Analysts Conference on the IRS Restructuring and Reform Act of 1998).
The automated underreporter program, which affects 4–5 million taxpayers annually, starts with third-party information returns filed with the IRS by employers, banks, and brokers. The Service matches the amounts reported on the individual and the information returns and creates an inventory of the resulting mismatches. IRS technicians select cases from this available inventory and review them. Notices CP2000, We Are Proposing Changes to Your Tax Return, are then issued to taxpayers for discrepancies that remain unresolved. The CP2000 notice makes changes to the original return whether the taxpayer agrees or not. If the IRS is incorrect, it is up to the taxpayer to prove it is right.
Nearly 3.5 million CP2000 notices were issued in the government’s 2007 fiscal year, with $5 billion in tax revenue generated. The Service has recommended taking the following actions to avoid the automated underreporter program:
- Do not group income amounts together;
- Include an explanation when payer data is incorrect;
- Avoid netting;
- Report income on the correct line of the tax return;
- Identify reporting from joint accounts;
- Provide an explanation when the amount differs from the payer information;
- Include copies of revised schedules; and
- Maintain detailed records.
The AICPA Practice and Procedures Committee has received numerous comments from members about CP2000 notices and has met with the IRS Wage and Investment Division commissioner to review these issues. Committee members have indicated several concerns:
- The time allowed for replying to the notice is not sufficient;
- There is no specific individual to contact about the notice;
- The document request is unrealistic and inapplicable to the matter being questioned; and
- There are many unnecessary pro se Tax Court petitions filed as a result of the process.
The Wage and Investment Division has indicated that it will look into the procedures that are in effect. The committee continues to communicate its concerns at regular meetings with IRS personnel.
As part of the continuing process to reduce the tax gap, the Service has developed an alternative process to address the “unselected mismatches.” This is Notice CP2057, which the IRS is calling a “soft notice.” The Service has developed the soft notice approach to reduce the tax gap through voluntary compliance. Initial efforts with the soft notice indicate that a significant number of individuals filed an amended return and did not repeat underreporting in subsequent years.
The 2008 soft notice initiative will include a subsample of each of the major income categories for tax year 2007 cases. CP2057 notices will be mailed to affected taxpayers, informing them that there appears to be a discrepancy with the income types listed, but will not provide them with any type of tax calculations. The notice instructs taxpayers to double check parts of their return. It also tells them to file a Form 1040X, Amended U.S. Individual Income Tax Return, if there is an underreported amount, or to correct the information documents reported to the IRS in error. Taxpayers who receive a soft notice and repeat their behavior will be identified in the following tax year.
The IRS indicates that it will mail approximately 31,000 CP2057 notices to taxpayers for tax year 2007 returns. For tax years 2003 and 2004, 2,505 soft notices were sent to all types of taxpayers. The results showed that 25% filed Form 1040X, 78% showed corrected behavior in a subsequent year, and 13% made phone calls to the IRS. If the initiative’s results show limited underreporting in the subsequent year and taxpayers correct underreported income, the Service may expand the use of the notice. The IRS will also continue to issue CP2000 notices.
By using the CP2000, the Service has seen significant results in generating compliance and revenue. Because of this success, and the relatively low cost of sending out automated notices, practitioners should expect to see the IRS continue to experiment with their use.
John Miller is a faculty instructor at Metropolitan Community College in Omaha, NE. Gerard Schreiber is a partner in Schreiber & Schreiber CPAs in Metairie, LA, and is a member of the AICPA Tax Division’s IRS Practice and Procedures Committee. For further information about this column, contact Mr. Miller at firstname.lastname@example.org.