How to Address a Defective Allowance on Your Tax Return

A defective allowance on a tax return is any deduction, credit, or exemption that was claimed incorrectly. These errors are often unintentional, arising from simple misunderstandings or clerical mistakes rather than a deliberate effort to mislead tax authorities. Understanding the common causes of these defects, how the Internal Revenue Service (IRS) identifies them, and the correct way to respond to a notification is important for any taxpayer.

How Allowances Become Defective

One of the most frequent reasons for a defective allowance is a mismatch between the information a taxpayer reports and the data submitted to the IRS by third parties. Employers file Form W-2 detailing your wages, while banks and financial institutions file various Form 1099 documents to report interest, dividends, or miscellaneous income. If the income figures on your Form 1040 do not align with the amounts on these third-party information returns, it creates a discrepancy that flags your return for review.

Misinterpreting complex tax laws is another common source of error. For example, a taxpayer might claim a dependent without realizing that person fails to meet one of the specific tests for age, relationship, support, or residency. Similarly, a person might claim an education credit, such as the American Opportunity Tax Credit, for expenses that are not eligible, like room and board or transportation costs. These mistakes can easily lead to an improper reduction of tax liability.

Simple clerical or mathematical errors can render an allowance defective. Transposing numbers when entering data from a W-2, making a calculation mistake when determining the amount of a deduction, or even a data entry error while using tax preparation software can lead to an incorrect filing. While tax software helps prevent many calculation errors, it cannot catch mistakes made during the initial input of financial data from source documents.

IRS Identification and Notification

The IRS primarily identifies defective allowances through its Automated Underreporter (AUR) program. This automated system cross-references the income, deductions, and credits claimed on your tax return against the database of information returns filed by third parties. When the AUR system detects a mismatch, it flags the return for examination by an IRS tax examiner.

If an examiner confirms a discrepancy, the IRS will initiate contact by mailing a CP2000 notice. This notice is not a formal audit or a bill for taxes due. Instead, it is a proposal that outlines the specific discrepancy and details the proposed changes to your tax liability, which may also include interest and accuracy-related penalties.

Steps to Address a Defective Allowance Notice

Upon receiving a notice like the CP2000, the first step is to analyze it thoroughly. Pay close attention to the specific items the IRS is questioning and the deadline for your response, which is generally 30 days from the date on the notice.

Next, you must gather your own records for the tax year in question. Locate your copy of the filed tax return and all supporting documents, such as your W-2s, 1099s, brokerage statements, and receipts for any deductions or credits. Carefully compare the information in your documents to the figures presented in the IRS notice to determine if the proposed change is correct or if the IRS’s information is incomplete or mistaken.

Your response will depend on whether you agree or disagree with the notice. If you agree with the proposed changes, you will sign the response form included with the notice and return it by the deadline. You can submit payment for the proposed amount with your response, or you can wait for a formal bill. If you cannot pay the full amount, you can request a payment plan by including Form 9465, Installment Agreement Request, with your response.

If you disagree with the notice, you must formulate a formal written response. This involves writing a letter that clearly explains why you believe the IRS’s proposed changes are incorrect. You must attach copies—never the originals—of any documents that support your position, such as a corrected Form 1099 or bank statements. It is advisable to mail this response via certified mail to have proof that you sent it before the deadline.