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Don't delay if you've under-reported income to IRS

Staff Reports

Stamford Advocate

Last week, a reader received a letter from the Internal Revenue Service telling him that he owed an additional $3,000 for his 2006 taxes, plus interest, due to under-reported income.

If you are in this situation, don't panic - but don't sit back, either - or your tax bill will be even higher due to interest and possible penalties.

John (not his real name) owed the additional tax because he under-reported the income on his 2006 return by $11,000. (The IRS matches the figures you report on your tax return with tax reports the IRS receives from payers, such as your employer, bank, brokerage firm and Social Security.)

The IRS letter (Notice CP2000) that John received included specifics: He did not report $11,000 of income ($1,000 of Social Security income and $10,000 of dividend income).

When a taxpayer receives such a notice, he should dig out his 2006 tax records and do some checking and soul searching.

John found that he had made a few mistakes. He located the Form 1099s that he received from his broker in 2006 and saw that he forgot to report his dividends. Likewise, the SSA-1099 he received from Social Security confirmed that he reported $1,000 less of his Social Security income than he should have.

What should he do now?

The last page of the letter (Notice CP2000) is essential reading. "Changes to Your Return" compares John's 2006 tax return to a corrected version which the IRS created based on the figures supplied to the IRS by payers.

John will need to fill out and sign the CP2000 agreeing with the IRS' correction.

As to paying the taxes and interest, John has three options:

* He can pay the full amount due ($3,000 plus interest of $200) when he mails in his Notice CP2000. The timing is important, since interest continues to be calculated from the due date of the 2006 return (April 17, 2007) for as long as the tax remains unpaid.

* If he can't pay the full amount, he can make a partial payment - but interest will continue to accrue at a rate of about 8 percent per year, according to tax attorney Allan Pearlman of New York City.

* If he can't pay anything at all, John might consider a monthly payment plan by filling out an Installment Agreement Request (IRS Form 9465), giving John up to 60 months to pay the tax owed. However, interest and penalties will accrue during the entire period. We'll discuss installment agreement in a future column.

Luckily for John, he did not "substantially understate" his income, for which a very heavy accuracy-related penalty is assessed. According to Mildred Carter, analyst at CCH, a substantial understatement is the greater of $5,000 or 10 percent of the tax required to be paid. CCH, a Wolters Kluwer business, is a provider of tax information and software solutions.

This penalty is 20 percent of the underpayment, according to Ted Lanzaro, a Shelton certified public accountant.

Taxpayers may worry if they get an under-payment notice, it increases their chance of audit. "Not necessarily," said Dianne Besunder, spokeswoman for the IRS.

"It's not that uncommon to get a CP2000 notice for forgotten bank interest, for example," she said. "Taxpayers who a CP2000 notice should act quickly to reduce interest and penalties."
- Julie Jason

Additional comment about this article and the part which is credited to Allan R. Pearlman:

If a taxpayer makes a partial payment, the rest is still owed. Also, not only does interest add on to the tax due, but penalty charges for not paying the tax due are imposed as well, at a rate of a ½ percent a month up to 25% of the tax owed.

This means that not only is the taxpayer charged roughly 8% interest, but also another 6% per year in non-payment penalties for a total of about 14%.

While these numbers might be edging us into eyes-glaze-over-in-boredom territory, the thing to take away here is when unpaid tax is due and payment is late, interest and penalties pile on, and added together, they pile on at a rate much higher than 8%.

Also, in a situation where there's tax that's really owed and the taxpayer can't pay it all off at once, many times the best answer is to enter into a payment plan with the IRS where the debt is paid off monthly, over time. When a taxpayer enters into a formal payment plan, the nonpayment penalty is reduced a little bit, making the piling on a little bit less painful.


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