The most frequent reason taxpayers are contacted by the IRS is because they have overlooked some item reported to both them and to the IRS by third parties such as banks, brokers and pension payers. In 2008 the IRS and its computers generated 3.5 million letters to taxpayers proposing they pay an additional $6.4 billion in tax because some "information document" couldn't be reconciled with what they'd listed on their 1040s.
This year there are some special traps. But with a little extra effort, you can avoid receiving one of those annoying letters. (Even when they're wrong, straightening things out with the IRS
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can be time consuming.)
Watch out for bank consolidation.
With all the changes and consolidations of banks and brokers this past year, it's more important than ever to be sure you match all the accounts you reported to the IRS in prior years with the 1099s you've received this year.
Be on the watch for online financial institutions (such as ING (NYSE:ING) Direct and E*Trade Financial (Nasdaq:ETFC)) that provide your annual tax information electronically only - if at some point you've agreed to go paperless. If that's the case, you'll need to log on to your account and generate your own Form 1099 information documents.
Industry turmoil could also create problems with the 1098s issued by mortgage servicers. These forms should report the deductible home mortgage interest you paid as well as any real estate taxes paid through the mortgage company. If the company collecting your monthly mortgage payments has changed, you'd be well advised to match your own records against the totals from the multiple 1098s you might (or might not) receive. If you refinanced this past year, be on the alert; often, the initial lender sells the loan shortly after funding it, and your tax paperwork may be disrupted. (For tips on how to get prepared, see Last-Minute Tax Tips.)
It's a messy year for 1099-Rs.
Another information document that is causing more confusion this filing season than previously is Form 1099-R, which covers distributions from individual retirement accounts, pensions, annuities, retirement and profit-sharing plans. New IRS instructions for the 2009 form state: Generally box 2a should be left blank when reporting distributions from traditional or SEP IRAs…Box 2b, "Taxable amount not determined" should be checked.
Unfortunately, many people receiving this form are making the erroneous assumption that if the box is left blank it is an indication that the gross amount included in Box 1 is not taxable this year. This is especially confusing for those who received the same form last year with both the gross income and taxable income boxes containing entries.
In addition to the IRS' instruction changes, there are special situations where mistakes by the issuer of the 1099-R or by the taxpayer are more likely. Those include cases where funds are rolled over from one IRA to another or from an employer retirement plan to an IRA. Since the taxpayer "knows" the rollover or distribution is not taxable, the need to report the transaction is easy to overlook. But if you don't want to receive one of those troublesome IRS letters, report the gross distribution on line 15a of your 1040, but don't include it in the taxable amount shown on 15b. Write the word "rollover" on 15b.
It's not just taxpayers who make errors, however. If you've received a Form 1099-R, watch for the code in Box 7. The IRS provides explanations for codes "1" through "9" and "A" through "U". Code "1" stands for "Early Distribution, no known exception." The most frequent mistake I see issuers make is putting a code "1," when the taxpayer simply did an indirect roll-over of funds to another IRA account. In this case, you must fill out Form 5329, and on line 2 of the form enter code "12" to let the IRS know it is an error and no 10% penalty for early withdrawal applies.
A few additional 1099-R traps were created by special tax provisions in effect for 2009. Congress decided that for 2009 those who are 70.5 or older could skip taking the usual "required minimum distributions," from their IRAs. The IRS then allowed seniors who had already been sent RMDs to roll them back into their IRAs. If you got a 1099-R for a distribution you rolled back, the same rule applies. Don't ignore it. Report the gross distribution and then report that none of it is taxable.
Another problem affects older taxpayers who took advantage of a temporary provision which allowed them to donate money directly from their IRAs to a charity, without including the distribution in their income. There is no special code on Form 1099-R to indicate the money was sent to a charity, so it is up to the taxpayers to make sure they indicate on their Form 1040 that a "QCD" (qualified charitable donation) has been made from IRA funds. Do this by showing the total distributions in box 15a of Form 1040 and the amount less the QCD in box 15b. The IRS instructions indicate you must write QCD next to line 15b if this applies. I've yet to feel confident that the IRS can see such writing when the return is transmitted electronically, so if you made a QCD, file your return on paper.
Stock options and grants are a trip point.
Do you participate in an employee stock purchase plan or receive nonqualified stock options or restricted stock grants? Then pay attention. The value of the stock on date of exercise or vesting is included in your wages and reported to the IRS and to you on your W-2. But for you to benefit from the stock participation, the securities were sold through a brokerage that will report the gross proceeds to IRS on a 1099-B, Proceeds from Broker and Barter Exchange Transactions.
Thus your proceeds from the stock have been reported twice - once on your W-2 and once on a 1099-B. Don't ignore the 1099-B. You must report the stock sale on Schedule D to acknowledge the information reported to the IRS on the 1099-B. To avoid being doubly taxed, when completing your Schedule D, you add the stock value reported on you W-2 to the cost (or basis) of the shares at exercise or vesting.
Based on our experience with numerous companies offering stock-based compensation and using a variety of national brokerages as transfer agents, I have another warning: Do not assume the information you have received from the brokerage is complete or correct!Take the time to be sure you are reporting all transactions, using the correct stock basis, and reconciling both the W-2 and the 1099-B.