IRS Says I Owe Money From 2 Years Ago. What Should I Do?

Receiving a notice from the IRS about owing money from two years ago can be unsettling. Understanding why this situation may have arisen and knowing the steps to take next is crucial. Ignoring such notices can lead to further complications.

This article will help you understand possible reasons for past tax debt, verify the accuracy of the IRS’s claim, and explore options for resolution.

Common Triggers for Owing Past Tax Debt

Understanding the reasons behind past tax debt is essential for addressing the issue. The IRS often determines additional taxes are owed due to discrepancies in reported information or adjustments made after the initial filing. Identifying these triggers can help taxpayers navigate their situation and take corrective actions.

Underreported Income

Underreported income is a common cause of past tax debt. This happens when taxpayers fail to include all income sources, such as freelance work, investment earnings, or rental property income. For instance, a taxpayer might receive a Form 1099-MISC for freelance work but omit it from their return. The IRS uses its Automated Underreporter Program to detect such omissions by comparing taxpayer-reported income with employer and financial institution records. If your notice relates to underreported income, review your financial records to ensure all sources were reported. Correcting this may involve filing an amended return using Form 1040-X and paying any additional tax owed, plus interest.

Incorrect Deductions or Credits

Claiming deductions or credits incorrectly can also lead to past tax debt. Errors often occur when taxpayers fail to meet eligibility criteria for credits like the Earned Income Tax Credit (EITC) or deductions such as charitable contributions or mortgage interest. The IRS may request documentation to verify these claims through its Correspondence Audit process. If your notice identifies an issue with a deduction or credit, re-evaluate the criteria for each claim. Understanding the relevant Internal Revenue Code sections, such as the rules for claiming the EITC, can help resolve these issues.

Late Return Adjustments

Adjustments to previously filed returns may also result in owed taxes. These adjustments can arise from an amended return filed by the taxpayer or corrections made by the IRS based on updated information, such as revised W-2 or 1099 forms. The IRS typically has three years from the original filing deadline to audit and adjust returns. Review the IRS notice to understand the changes. If the adjustment appears inaccurate, taxpayers can appeal and provide supporting documentation to dispute the changes.

Confirming the Accuracy of the IRS Notice

When you receive an IRS notice, confirming its accuracy is a critical first step before making any payments or disputes. Carefully review the notice, which explains why the IRS believes additional taxes are owed. Each notice includes a unique number referencing specific issues or discrepancies. Compare this information with your own tax records to identify potential errors.

To aid verification, request a transcript of your tax account from the IRS. This document provides a record of your filings, payments, and any adjustments. Comparing it with your records can help pinpoint discrepancies. If inconsistencies are found, consult a tax professional to ensure no details are overlooked.

Sometimes, the IRS notice may result from a clerical error, such as a misapplied payment. Contacting the IRS directly can often resolve such issues. Keep detailed records of all communications, including dates, times, and the names of representatives you speak with.

Potential Penalties and Additional Charges

Understanding potential penalties and charges is essential when addressing an IRS notice. The failure-to-pay penalty is one of the most common and accrues at 0.5% of unpaid taxes per month, up to 25%. This penalty increases to 1% after a final notice of intent to levy is issued.

Interest is also charged on unpaid taxes from the original due date until the balance is paid. The interest rate, determined quarterly, is the federal short-term rate plus 3%. These charges compound daily, which can quickly increase the amount owed.

If underpayment is due to negligence or disregard of tax rules, an accuracy-related penalty of 20% may apply. Taxpayers can avoid this penalty by demonstrating reasonable cause and good faith, supported by documentation and explanations for the error.

Payment Arrangements and Options

The IRS offers several options for managing tax debt. One common option is an installment agreement, which allows taxpayers to pay over time rather than in a lump sum. This can be arranged using Form 9465 or the IRS Online Payment Agreement tool. However, interest and penalties continue to accrue until the balance is fully paid.

For those facing financial hardship, the Offer in Compromise (OIC) program may be an option. This allows taxpayers to settle their debt for less than the full amount owed. To apply, taxpayers must complete Form 656 and provide detailed financial information on Form 433-A (OIC). The IRS evaluates offers based on income, expenses, asset equity, and ability to pay.

Disputing or Requesting Abatement

If you believe the IRS notice is incorrect or penalties have been unfairly assessed, you have the right to dispute the claim or request abatement. Begin by identifying specific areas of disagreement and providing supporting documentation. The IRS notice typically includes instructions for responding and deadlines for submitting information.

For factual errors, such as misapplied payments or incorrect income reporting, submit corrected documents directly to the IRS. For more complex disputes, such as differing interpretations of tax laws, you may need to file a formal appeal through the IRS Office of Appeals. This involves submitting a written protest outlining your position and referencing applicable tax laws. Taxpayers can also request a Collection Due Process hearing if a lien or levy has been issued.

To request penalty abatement, taxpayers must demonstrate reasonable cause for noncompliance, such as a natural disaster, serious illness, or reliance on incorrect professional advice. Submit Form 843 along with a detailed explanation and supporting evidence. The IRS also offers first-time penalty abatement for taxpayers with a clean compliance history over the past three years.

Ongoing Compliance Measures

After resolving past tax debt, maintaining compliance is crucial to avoid future issues. The IRS monitors taxpayers with a history of noncompliance, making it essential to adopt proactive measures. Keep detailed financial records, such as receipts and invoices, to ensure accuracy in reporting income and deductions.

Stay informed about changes in tax laws and filing requirements, as these can impact tax liabilities. Consulting a tax professional or using reputable tax software can help reduce errors. For those with complex financial situations, such as self-employment income or foreign assets, additional steps may be necessary. For example, self-employed individuals must make estimated tax payments to avoid underpayment penalties, while those with foreign accounts must comply with reporting requirements like the Foreign Account Tax Compliance Act (FATCA) and FBAR.

By staying organized and informed, taxpayers can avoid the pitfalls of noncompliance and ensure smoother interactions with the IRS in the future.