The most common reason for receipt of this letter among those with equity comp, as well as CP2000-series letters, has to do with taxation of RSU income. I will use an example to explain how this works.
Taxpayer works at Google (or other company that pays equity compensation on top of the base salary).
Taxpayer receives their compensation of $250,000 but also receives $150,000 in RSUs throughout the year
Taxpayer is told by their company that shares are being “sold to cover” the tax obligation of the RSU income. Shares are sold not only to cover their Federal tax, but even applicable state taxes.
After receiving the shares, the taxpayer sells them and takes the cash
Taxpayer is convinced that since this obligation has already been covered through the sell-to-cover shares throughout the vesting period in the year, no further reporting is necessary other than filing their own return on TurboTax quickly and easily by just entering their W2. This is where they are wrong
Four to 24 months after submitting this return, the taxpayer receives a CP2501 letter from the IRS asking for a massive amount of tax as compared to the amount received. In our example, the amount may be $60,000 or more, depending on on the other income and deduction items on the taxpayer’s return.
Confused, the client cries “but I have already been taxed on this! The IRS is attempting to double-tax me on money that I already paid taxes for! My firm was “selling to cover!”
This is where the client is wrong. Although it is correct that the $150,000 equity was correctly reported in the W2, the act of selling the shares afterward on the open market created a separate taxable event that must be reported, along with the basis of the shares. Filing a return without the appropriate schedule D, 8949, and basis adjustments will lead to this type of notice. These types of tax returns are best prepared from the start by a qualified tax professional with a background in RSU and ESPP compensation.
There is a specific way that this notice must be responded to – some taxpayers attempt to respond on their own with letters claiming “I already paid tax on this,” but that is an incorrect response. The stock sales must be reported accordingly and basis adjustments may need to be made.
Luckily, our firm has experience with hundreds of similar client situations and our success rate is near-perfect on the first attempt of responding to this notice. We will need several pieces of information, beginning with all pages of the notice. We may thereafter need your W2, 1099-B from your brokarage, supplemental schedule (this is common for taxpayers working at Yelp, for example, or any taxpayer whose firm uses Etrade as the equity administrator), prior year tax return as filed, and DOB. If you have received a CP2501, please send us these items, or share directly on a secure drive, with our email at email@example.com and we will address right away for you.
Even if a taxpayer generally understands this concept outlined, there are may pitfalls when they attempt to save a few dollars of CPA professional fees and attempt to complete this on their own. Some examples include:
Distinction between long-term and short term capital gains. This can have effects as pronounced as a 17% difference in Federal tax alone – for taxpayers receiving $100,000 (a very small amount considering RSU comp can be in the millions with some clients), this can be a substantial chunk of change
Location of basis information and how to properly compute it – clients whose employer uses Morgan Stanley are in the roughest position as that brokerage is notorious for missing or awkwardly shown basis amounts. Often, vesting schedules must be scoured for this missing basis information along with an analysis of share CUSIP, share grant date, number of shares granted, etc.
Additional upward adjustments of basis as allowed from ESPP compensation – adjustments may be permitted to save you on tax, and these are reported in a specific manner on form 8949 in boxes (f) and (g) and/or Schedule D box (g).
For clients using etrade, such as those at Yelp, Tesla, Symantec, Shutterfly, and others, identification of adjustments from your Etrade supplement is crucial. These adjustments must be separated between long term, short term, ESPP, and RSU, each with their own separate treatment and rules
Are there other situations where a CP2501 may be received? Yes, although we normally see this as it pertains to RSU and ESPP income, as so many of our clients are compensated using equity. Other reasons may include:
Missing 1099-R forms where taxpayers have distributed money from a retirement account. Do not ever do this unless you are over age 59.5 and even then, please consult with a tax professional to make sure your withholdings are adequate – money in a 401k, IRA, or any other type of deferred investment plan is a retirement account. Early distributions subject the taxpayer to penalties in excess of what you would have paid had you never put the money in a 401k to begin with. You will lose, in some cases, 50% of the money you worked hard for. This soapbox aside, missing this 1099-R reported under the pretext that money was already withheld for Federal, and possibly state, is a surefire way to obtain this CP2501 notice
Missing 1099-B or other brokerage accounts: you may have sold shares and forgotten that one brokerage. Additionally, some clients receive similar notices when a company acquisition takes place and shares are exchanged from the target firm to the acquirer. When a company is bought and shares of the new owner company are exchanged for shares of the prior company, a taxable event occurs that must be reported. If this is not reported along with the basis of the shares, then a tax bill will arrive as computed on the full value of the target firm’s share price at the time of the takeover. This may happen without the taxpayer’s knowledge as we have seen inherited shares be subjected to this. We had several cases related to the Charter Communications / Time Warner deal where a client was charged a large amount by the IRS due to this missing basis information.
If you have issues with any of the above, please scan ALL PAGES of the letter received & send (or share securely) with firstname.lastname@example.org and we will take a look right away. This includes both CP2501 and CP2000 notices, as these are the common forms for the errors outlined above.
None of this information is professional advise – professional advise is only provided for clients on retainer that have contacted & hired us to assist. We assist remotely with clients in all 50 US states and dozens of nations globally.