Non-taxable does not mean non-reportable

This time of year, I spend part of my time assisting clients with responding to IRS Notices that they have received.

These notices are often when the information that the IRS has received from various organizations do not correspond with the information reported on the income tax returns.

Usually the notices are more than a year after the actual tax filing when the IRS is matching the tax filings with their records. Many of these notices occur because a taxpayer did not think that they needed to report the information because the item in question is not taxable income for the taxpayer.

However, in many of these cases the item in question still must be reported and certain forms filled out to inform the IRS that the income is in fact, not taxable. Without the proper reporting, the IRS automatically assumes that the transaction is taxable income and sends out a tax adjustment accordingly.

These adjustment notices can amount to thousands of dollars, and had they been properly reported with the initial tax filing the notice would have never come.

The first of several in this category is the sale of the primary residence.

Although the sale of a primary residence is generally not a taxable transaction, the sale must be reported. You may exclude up to $500,000 of any capital gain associated with the sale of a primary residence that you have lived in for at least two of the previous five years. The title company usually issues a form 1099-S to report this transaction.

If you do not correspondingly report this sale on your return the IRS has no idea of the actual amount of any capital gain or even if this sale was associated with a qualifying primary residence.

Another type of reporting that will generate a notice is the failure to properly report the qualifying distributions from a College Savings plan such as a 529 plan.

The financial institution reports the distribution on a form 1099-Q. However, to be a qualifying and non-taxable distribution the proceeds must have been utilized for certain specific qualifying higher education expenses. The IRS has no means of knowing if the distribution was used for these qualifying educational expenses without proper reporting by the taxpayer.

Unfortunately, an IRS computer matching issue often crops up when the 529 account owner, as opposed to the account beneficiary, receives the Form 1099-Q.

Look for the box on the Form 1099-Q that reads “Check if the recipient is not the designated beneficiary.” If that box is checked, the IRS computers are apt to send out deficiency notices assessing tax, interest, and penalty, even when you know with certainty that the withdrawals were tax-free based on your beneficiary’s qualifying college expenses.

Similarly, I have also seen taxpayers receive notices when they sold a security for no gain, or even a loss. The taxpayer figured that they did not need to report this transaction to the IRS because they sold the secu- rity without making any money.

However, in many cases the IRS does not have information on how much the taxpayer actually paid for the investment and so the transaction must be reported by the taxpayer.

No one wants to receive a notice from the IRS.

Proper reporting of any and all transactions is essential to help alleviate the chance of receiving an IRS Notice.

Just because a certain transaction ultimately is not taxable does not mean that the IRS is aware of this non-taxable situation. The IRS assumes that any transaction that generates income for the taxpayer is taxable and the burden is on the taxpayer to prove why and how this transaction meets the specific rules of the tax code to be considered a non-taxable transaction.

Paul Pahoresky is a partner in the accounting firm of JLP CPAs. He can be reached at 440974-1040x14 or at paul@ jlpcpas.com. Consult your tax advisor for your specific situation for additional information and guidance on these topics.

Paul Pahoresky