IRS Letter - You Owe SE Tax!

The IRS appears to have a new program running this Summer (2009) where they are sending notices to anyone that has miscellaneous income reported on their tax return that is not subject to self-employment tax.

We've seen several notices recently that propose to assess self-employment  (Social Security and Medicare) tax on income arbitrarily. I think this program was ill-conceived but unfortunately it's measure of success will be how much money the government collects from it and not whether it served the proper purpose of collecting the correct amount of tax truly owed by the citizens.

IRS Letter Example #1

In one case the taxpayer had received a 1099-MISC from a Fortune 500 Company for payments he received as a result of a legal action. He properly claimed the income and did not deduct any expenses against the income. The IRS sent a letter to the taxpayer and proposed an adjustment to his tax return that would have caused him to owe approximately $3,000 unless he could prove that it should not be subject to self-employment tax.

My first thought was, if the IRS wants to question whether this taxpayers' income was reported on the correct 1099 form, why not contact the issuer of the document? The company would have issued a Form 1099-NEC (NEC=non-employee compensation, or box 7 on the MISC, there's probably several million of these forms issued each year) if the taxpayer had performed services for the company. The issuer of the 1099 would be in a better position to answer any questions about the 1099.

There may be 300,000 recipients of 1099-MISC's and only 1,000 issuers (may be 10 or 20 times this number, but the ratio is still there). To contact the issuers and insure that they know when to issue a 1099-MISC (or box 3) versus a 1099-NEC (box 7) would be a lot less work, more productive and the 1,000 companies should be in a better position to deal with the issues and expense involved.

Instead, the IRS takes a "shotgun" approach. They send out 300,000 notices to recipients of 1099-MISC's instead of 1,000 letters to the issuers of the 1099's. Many of the recipients of the IRS letters will simply pay up instead of fighting it because; they are afraid of the IRS, they are uneducated when it comes to the tax law and because it may be less expensive to pay rather than fight. This is a gross injustice to the taxpaying public.

I also have to think that the IRS fully understands that the little taxpayer with $26,000 of income that prepared his own return is not as well equipped to deal with them as the Fortune 500 Company with billions in revenues and well educated CPA's and attorneys on staff.

IRS Letter Example #2

The taxpayer did not receive a 1099, but reported $30,000 of miscellaneous income not subject to self-employment tax and claimed no deduction for expenses related to the income. The monies were received by the taxpayer as a result of her acting as Conservator for an incapacitated relative. She provided care for this individual in her home.

The Answer to the Self-Employment Tax Issue

The Internal Revenue Code clearly states that "an individual must carry on a trade or business, either as an individual or as a member of a partnership or limited liability company treated as a partnership, to have net earnings from self-employment".

In addition, the code states, "thus, a person whose activities do not rise to the level of a trade or business for purposes of deducting trade or business expenses is not engaged in a trade or business for purposes of the self-employment tax".

In both cases referenced here the taxpayers received income that was NOT from a trade or business. The key to defending these cases rested with the fact that in order for income to be subject to self-employment tax, the income must be derived from a trade or business. Whether a particular activity is a trade or business is a question of fact. An activity is generally considered a trade or business if it is engaged in regularly and for profit. Whether the taxpayer holds him or herself out to the public as providing goods or services is also a factor.

Clearly in both cases the taxpayers were not involved in a trade or business and did not hold themselves out to the public as providing goods or services.

What Should I Do If I Receive a Letter From The IRS?

If you receive a letter from the IRS that proposes adjustments or changes to your tax return, you really should consult an EA, CPA or attorney, unless you fully understand the technical aspects of the issues. Quite often we see IRS letters that simply require a written response explaining the facts in order to resolve the matter. The IRS will send a follow up letter accepting the explanation and withdrawing their proposed adjustment.

Most people don't realize that more times than not, the IRS letter is computer generated (a human being has not reviewed the issues prior to the computer spitting out a letter to the taxpayer). I believe the IRS spent $9 Billion Dollars on their computer systems in the last ten years, and as good as the system is (and it is good), it's not always correct.

More About IRS Letters

If you have an IRS letter, look in the upper right corner for the letter or notice designation. If it reads "CP-2000" then you know you have a computer-generated IRS letter that will either propose an adjustment, question an item on the return or ask why the computer did not find an item on the return. In the case of the latter, the item the computer is looking for (because it was reported to them by a third party) may actually already be on the tax return. The computer didn't find a specific number on a specific line!

For example, a third party may have turned in a 1099 on you for $7,000. On your tax return you may have reported $8,900 on the income line because you had an additional $1,900 of income from other sources that did not turn in 1099's on you. It's a simple matter to write a letter and explain that the $7,000 is included in the $8,900 reported on line so and so.

If your IRS Letter reads "CP:503, 504 or 505, these are Collections Notices. Each IRS letter in this category sounds worse (more threatening) than the previous in sequence. These are computer generated standard form letters. These IRS letters will reference ACS which stands for Automated Collection Service and you generally have about 30 days before they start looking for bank accounts to levy (freeze) or wages to place a garnishment on.

This article was written by:

Gregory J. Cook, EA, CPA
Accredited Tax Advisor
www.cookco.us

Feel free to copy or reproduce this article as long as you keep the author's name and link to his website as stated.

My Research into Why the IRS is sending these letters to taxpayers

 After researching this I concluded that taxpayers are likely to get the IRS letter related to self-employment taxes if they reported any income on line 21 of the Form 1040. The reason the IRS is sending these letters dates back to September, 2000 when the Treasury Inspector General for Tax Administration (TIGTA as it's known by its IRS acronym), issued the following report:

The Internal Revenue Service (IRS) could assess and collect significant amounts of unreported self-employment taxes each year before tax refunds are issued to taxpayers. We estimate that over a 2-year period, taxpayers did not report $156 million in self-employment taxes; over 61 percent of these taxpayers received $51 million in tax refunds that could have been offset against the unreported self-employment taxes.

The self-employment tax is a Social Security and Medicare tax on the income of individuals who work for themselves. Funding of Social Security and its long-term viability have received considerable political attention in recent years. Author: They are laying out the reason (justification) for this program in that second sentence.

The General Accounting Office recently reported that non-wage income has grown significantly since 1970 as a portion of total individual income. The number of tax returns that included self-employment income increased 138 percent from 1970 to 1990. Self-employment income was the largest portion of non-wage income included in the IRS’ inventory of tax debts at the end of Fiscal Year 1993. Author Comment: So based on these facts, TIGTA concluded that taxpayers must have income that should be subject to self-employment tax, on which they are not paying SE tax. This person or persons should be fired, unfortunately they probably got a promotion and pay raise (read on, it gets better).

In a 1998 report, Compliance with Self-Employment Tax Requirements (Reference Number 083502, dated May 19, 1998), the Treasury Inspector General for Tax Administration (formerly IRS Internal Audit) recommended that the IRS take steps to improve its process of administering self-employment tax requirements. The objective of this audit was to determine whether the IRS had taken effective corrective actions in response to that report to improve the identification and collection of unreported self-employment taxes.

The IRS has taken some actions to address unreported self-employment taxes. Changes were implemented to the computer screening criteria used to identify tax returns with unreported self-employment taxes. The IRS also developed an educational letter which was sent to taxpayers filing these tax returns, requesting the taxpayers to review their tax returns and amend the returns by submitting Self-Employment Tax (Schedule SE) if they deemed it necessary. This letter was sent well after the tax returns had been processed.

Despite these efforts, significant amounts of self-employment taxes remain unassessed and uncollected each year. The IRS needs to take steps to further improve the identification and collection of these taxes. The ongoing "stand up" of the IRS’ new Small Business/Self-Employed (SB/SE) Division presents an excellent opportunity to address these issues.

In our prior report, we recommended that the IRS identify taxpayers owing self-employment taxes when returns are processed and work those cases immediately in Correspondence Examination. The IRS has not implemented those recommendations. Author Comment: They still haven't, because in the two cases I worked recently, the first was on a 2005 tax return (The IRS sent the letter just before the statute of limitations was about to expire) and the second was on a 2007 tax return.

Identifying unreported self-employment taxes as tax returns are processed and assessing self-employment taxes on those cases with available tax refunds would help the IRS:

• Comply with the desires of the United States (U.S.) Congress for the IRS to promptly inform taxpayers of their obligations with respect to tax deficiencies.
• Minimize the burden to some taxpayers of paying self-employment taxes.
• Minimize the cost of collecting the taxes.

By assessing unreported self-employment taxes before refunds are issued, the IRS could immediately collect self-employment taxes of $21 million each year owed by 78,000 taxpayers with self-employment income of $2,000 or more. Author Comment: I highly suspect the accuracy of these estimates, but I do believe they could send threatening, scary letters and get people to pay them $269 rather than fight! ($21,000,000 divided by 78,000 people = $269) Actually what they are suggesting, is for the IRS to just go ahead and deduct $269 from these peoples refunds (that's even better).

The IRS made processing errors on tax returns and related documents, which caused its computers to erroneously identify some taxpayers as owing self-employment taxes. An estimated 30,000 taxpayers were erroneously identified in this way and sent self-employment tax education letters. These taxpayers had either: (1) claimed religious exemptions from self-employment tax requirements, (2) reported "Other Income" on the U.S. Individual Income Tax Return (Form 1040) line 21, or (3) indicated they were statutory employees by checking the appropriate box on Profit or Loss From Business (Schedule C).

The logic of the IRS’ computer program to identify and prioritize tax returns with unreported self-employment taxes is flawed. (NOTE: Author strongly agrees) As a result, tax returns with significantly varying amounts of unreported self-employment taxes can receive the same priority in the IRS’ compliance program. This can lead to the ineffective use of scarce Examination function resources.

The educational letters sent to taxpayers appearing to owe self-employment taxes should be more specific and assertive, provide an explanation of the importance of the self-employment tax, and explain to taxpayers what will happen if they do not respond. If taxpayers are not convinced of the importance of taking action in response to an IRS letter, many will not respond. Author comment: The IRS really took this part of the recommendation to heart. Their new approach is to send an IRS letter that reads, "you owe xxxx dollars, if you do not pay within xx days we may take collection action, which might include contacting third parties about you, freezing your bank account, contacting your employer to garnish your wages, ...".

Future plans are to send letters to all taxpayers with self-employment income of $2,000 or more that did not report self-employment taxes. During the implementation of the Self-Employment Tax National Strategy, letters were sent to all taxpayers with self-employment income of $1,000 or more. Letters to taxpayers with less than $2,000 resulted in gross self-employment tax revenue of approximately $3.3 million (Why do they only report the results of the very small cases? See author comments below about this project titled Self-Employment Tax National Strategy). Although these cases individually may not warrant follow-up by the IRS, they do warrant letters informing taxpayers of their self-employment tax obligation. Author: What they mean by this statement is, we know we're picking on the little guy and it's not a lot of money individually. Don't actually assign case workers to this in order to really determine if they owe it or not (that costs too much), try to limit your spending to one or two of the scary letters that cost about $1 each to generate and send.

The IRS should identify unreported self-employment taxes during returns processing and assess these taxes before refunds are issued to taxpayers. To make this process more effective, the IRS should improve the accuracy of the information used to determine if taxpayers are liable for self-employment taxes. This information relates to applications for exemptions from self-employment taxes, income reported on line 21 of Form 1040, and the statutory employee indicator on Schedule C. In addition, the IRS should revise the formula for prioritizing self-employment tax cases and should improve the educational letters sent to taxpayers potentially owing self-employment taxes. Author Comment: What they mean by "improve the letter" is make it more threatening and scary, and what they mean by "respond" is send a check. When you send someone a payment stub with a dollar amount on it and a return envelope for the payment, it is clear what response you are seeking. Remember what they said above about "be more assertive...", "tell them what will happen if they don't respond (send a check)"..."taxpayers may not respond (send a check) if they aren't convinced of the importance of taking action".

Management’s Response: In January 2001, the IRS will begin identifying, via computer, taxpayers with potential unreported self-employment taxes as the returns are processed. A project to hold refunds of a limited number of taxpayers who owe self-employment taxes will be tested. If the project is successful and if resources are available, the project will be expanded to all SB/SE Correspondence Examination sites by 2003. The IRS will forward copies of forms indicating taxpayers are exempt from self-employment taxes to the area responsible for processing that information to ensure that the applicable records are updated. The IRS will revise instructions for Form 1040, line 21 and will revise returns processing instructions to improve the accuracy of data indicating that taxpayers are statutory employees and not liable for self-employment taxes. The IRS will also revise the scoring formula used to identify and prioritize tax returns with potential unpaid self-employment taxes and will make changes to letters sent to taxpayers potentially owing self-employment taxes. Author: We will test the waters with computer generated IRS letters not people, because those scary letters only cost a $1. And oh yes, we will make the letters more threatening than they were in the past. Although these actions will not improve the over-all correctness, fairness or service we provide, if it brings in dollars, we will expand the project in the future.

Office of Audit Comment: While we agree that sending different letters to taxpayers based on the amount of self-employment tax they owed would result in different treatment of taxpayers, in our opinion, the differing treatment is consistent with the way the IRS currently administers taxes. The IRS takes different actions when processing tax returns or when taking enforced collection actions based on the amount of tax involved. Author: We admit that we treat the guy who owes us $200 different from the guy that owes $20,000. We can't go to the expense of having an IRS employee actually look at a $200 case and take the time to determine if it's right or wrong (that would cost more than we collect). We don't think there's anything wrong with this approach and we will continue to operate in this fashion. The more money the taxpayer owes us, the more likely he can afford a representative to fight us or simply, the more willing he may be to defend himself. END OF TIGTA REPORT

AUTHOR COMMENTS: Now you may say, "that report was issued nine years ago"! My response, "The wheels of big government do turn slow". Trust me, this report started the ball rolling and as long as the IRS collects additional revenues from sending out these letters, they will continue to do so (like a snowball rolling downhill).

The IRS likes to talk about the "Tax Gap", the term they use to describe the amount of taxes that go uncollected each year because our tax system relies somewhat on "voluntary reporting". They never talk about what I like to refer to as "IRS Donations", the money that people send the government in the form of taxes that they really don't owe.

If the IRS collected $3,300,000 by sending letters to taxpayers that had more than $1,000 but less than $2,000 in miscellaneous income reported on their tax returns, I conclude the following: Average Dollar Amount of Miscellaneous Income = $1,500 (may not be the mean, but I'm using it) x .9235 x .153 = $211.94 in Self-Employment Tax, plus $52.99 in interest and penalties = $264.93 Average Collected from each Taxpayer. $3,300,000 divided by $264.93 = 12,456 Affected Taxpayers.

I further conclude that it was less expensive to these 12,456 people to just send the government a check for $264.93 than fight it! Some people will fight, just as a matter of principle, but the majority won't. It's the same reason that frivolous lawsuits are settled all the time, economics and aggravation factor. Would you rather quietly write a check for $264.93 from the comfort of your home or office, or hire an attorney, CPA or Enrolled Agent and pay them more money, spend hours of your time, incur additional out-of-pocket expense and possibly suffer public humiliation and embarrassment?

The one thing this report failed to tell us was, how many letters were sent. I would be willing to bet that many of those people that received the IRS letters had won a prize or award, i.e., from a radio station, charity give away, etc. and did not really owe the money.

I even speculate that many taxpayers had reported an item as miscellaneous income that they really weren't required to report, therefore, they didn't even owe income tax to begin with, much less self-employment tax. The really sad part of this story is this. The IRS did not dedicate the resources to have a human being follow up with these taxpayers to ascertain if they really owed the $264.93. If a taxpayer got an IRS letter and sent in a check to the IRS, the IRS cashed the check and in most cases didn't even send any computer generated thank you note or acknowledgement!

In conclusion, the IRS should become simply IR. Drop the word "Service" from their name because it just don't apply. If they want to keep the word "Service" in the name, then dedicate the resources to be fair to the citizens when you undertake a project like this and don't measure the success of such a project by how much it cost versus how much money you collect. The true measure of success should be whether they collect the correct amount of tax.

Of course, "doing the right thing" often costs more. Training IRS personnel to know when self-employment should be collected and not requires, well, training (time and money). Assigning those personnel to look at each of these 12,456 cases is more expensive than just letting the computer spew letters and forget about it.

I will tell you with confidence, why the IRS conducted this program with their computer instead of people; 1) they would not have collected $3.3 million if they did it the right way, 2) it would have cost the government more money than they would have collected if they did it fair (man hours, telephone, follow-up postage, etc) and 3) Finally and Most Importantly, they choose the "easy way" to conduct their tests (it's less costly) then use the bogus results of their test to further pursue an incorrect conclusion in the future.

Just because the computer generated a certain number of threatening, scary letters and the government collected $3.3 million dollars, they conclude taxpayers are under-reporting and underpaying self-employment tax. Want to make this system really fair? Make the IRS pay for the taxpayers representation and associated expense when the IRS loses a case. If they had to weigh that possible expense in these testing programs they would not undertake such frivolous projects.

This program won't get much if any national attention. Why? Because it affects too few people. After all, what are 12,456 casualties? In the two cases that brought this to my attention, the first taxpayer had prepared his own return. My firm actually prepared the return in case #2, one letter out of approximately 3,000 returns we prepared that year.

I have to make one final statement about the "implementation of the SET National Strategy program". The federal government could send a threatening, scary IRS letter to taxpayers informing them of a "problem with line 77 of their Form 1040" (the Form 1040 only has 76 lines), give the taxpayer the option of fighting or paying less than $300 for this problem to go away, and guess what? That's right, the IRS will collect millions of dollars, which will prove that there in fact was a problem with line 77 of the 1040 and that their new program entitled "Line 77 Slot Machine Jackpot" was a huge success and should be expanded to include Line 78 next year!

This article was written by:

Gregory J. Cook, EA, CPA
Accredited Tax Advisor
www.cookco.us

Feel free to copy or reproduce this article as long as you keep the author's name and link to his website as stated.

If you enjoyed this article, you might like to read about Computerization of the IRS and How it Affects Taxpayers.