(MONEY Magazine) – What would you do if the Internal Revenue Service mailed you an unexpected check for $11,515? If you're like John and Toni Ryerson, who received just such a surprise in July 1996, you'd first try to figure out what the check was for and then call the IRS for confirmation. You might even put it in the bank for safekeeping until the situation was straightened out. Simple, right? No way.

Accepting an undeserved tax refund entangled the Ryersons in a nerve-racking two-year dispute with the IRS. Along the way, they received a bill totaling $15,090 for overdue taxes plus interest and penalties and more than half a dozen harassing notices, including a "final notice" last February saying that the IRS would levy their paycheck, bank account, car or other property.

"It was a mistake that just snowballed," says John, 58, a retired computer hardware and software designer.

"We hadn't done anything wrong, so we thought the IRS would figure it out," adds his wife Toni, 54. "We're a lot wiser now."

Here is their story and some advice (see the box on page 68) on how to avoid your own IRS tale of woe.

THE BIG MIX-UP

After three years in retirement, John and Toni Ryerson finally sold their Boca Raton, Fla. home in 1995 and moved to a scenic hillside in Pisgah Forest deep in the North Carolina mountains. They were looking forward to the area's lively cultural life and abundant opportunities for sports and volunteerism. Plus, thanks to lower housing prices, they'd netted more than $40,000 in profit on the sale of their Florida house. Looking ahead to the day when they might want to sell their new home, the pair passed up the one-time capital-gains exclusion then available to a taxpayer over age 55 in case they wanted to use it in the future. Although the law then gave taxpayers up to two years to pay capital-gains tax on a house sale, John and Toni included the more than $40,000 profit on their 1995 tax return.

That's why the couple mistakenly assumed the $11,515 refund check was the agency's way of reminding them they were eligible to take the exclusion on their gain. "We couldn't be sure, though," says John, "be-cause there was no explanation included with the check." To learn more, he dialed the customer service number listed on the refund form, but the representative couldn't help them. "All he had in the computer was the same notice I had," recalls John. "He advised us to wait to hear further."

It wasn't until nine months later that the Ryersons realized that the unexpected refund had been an early-warning sign of trouble. In March 1997, they received a form letter from the IRS asking whether John's 1995 pension payout was taxable. After a 32-year career at IBM, John had converted his lump-sum pension benefit into an insurance annuity paying $42,398 a year for life. The couple knew they'd reported the pension and paid the tax--John was scrupulous when it came to figuring their taxes, and Toni, who stayed at home to raise their two now grown children, double-checked his entries. They replied in writing that the pension was taxable. "I sensed something was wrong, though," acknowledges John, so he also called the 800 number listed on the letter. The number was different from the one he'd tried a year earlier to ask about the refund, but the result was the same: The computer records available to the phone representative contained only the correspondence John had already received. "What use is calling when all they can tell you is what you already know?" he says in exasperation.

NO HELP FROM THE IRS

Instead of telling John to wait for a written response to his letter, the IRS service representative should have referred him to the Problem Resolution Office--the official IRS resource for beleaguered taxpayers--for further assistance. For their part, the Ryersons probably should have have consulted a tax accountant or attorney. They didn't, says John, "because we had not violated any tax law. I felt aggravated but not really vulnerable."

The bombshell came in June 1997, when the couple were notified that their 1995 return did not include an annuity payout of $42,398 that had been reported by John's insurance company. The IRS demanded either an explanation or $15,090 to cover tax, interest and a stiff 20% penalty for nonreporting of income. That's when the Ryersons realized that the unexplained refund was for the tax they'd paid on the pension,not the capital gains from the sale of their Boca Raton house.

But why had the agency refunded tax that the couple rightly owed? No one at the time had an answer. Nevertheless, the couple agreed they should pay back the $11,515 refund because it was tax they actually did owe. But they didn't feel they should ante up $3,575 in interest and penalties, since the IRS had sent them the check and, despite many phone calls and letters, could not explain why. John then sent a letter appealing those assessments to the local service center listed on the bill they had received.

THE IRS ANSWERS

Miraculously, within a week, the frustrated duo received a letter from the IRS agreeing that the $2,304 penalty was undeserved and would be removed. The letter said, however, that the $1,271 interest assessment would be evaluated by another office.

A month later, the couple got a four-page letter from Richard Marsh, director of the Doraville, Ga. service center, explaining why he would not remove the interest due on the mistaken refund. According to Marsh, the problem originated when John reported his 1995 annuity payout on both lines that cover pensions on a 1040 return: line 16a, which is labeled "total pensions," and line 16b, which reads "taxable pensions." (The 1040 instruction booklet tells taxpayers to record fully taxable pensions on line 16b only.) The double entry caused the IRS computers to "zero out" his pension, resulting in the unexpected refund.

However, when the IRS compared its records with John's 1099-R (retirement) income statement from the insurance company, it appeared as if he had never declared the $42,398 annuity payout on his 1995 return. Marsh would not remove the interest charge because the Ryersons had made the initial filing error. He also felt that they hadn't tried hard enough to correct the resulting IRS error. "That logic infuriated me," sputters John.

Irate, the couple paid the $11,515, but once again contested the interest assessment. Meanwhile, the IRS started threatening to levy the Ryersons' property. Although the case was in appeal, they received three notices by certified mail warning that the agency would put liens on their property unless the interest debt was settled.

The couple then called their congressman, Charles Taylor, who notified the IRS. "He found out they'd lost the appeal documents," says John. "Can you believe this? They're threatening our property, the appeal is stopped dead, and no one at the IRS even calls me?"

The Ryersons resubmitted their appeal, but by now they were worried that an IRS action would taint their credit record. So they reluctantly sent a check for the interest--which had oddly diminished to $1,236 on a notice that was dated Jan. 29, 1998. Despite their attempt to end the harassment once and for all, a "final notice of intent to levy" arrived on Feb. 2. "At that point, we called our congressman again and even our senator, Lauch Faircloth," says John. Congressional intervention seemed to stop the levy notices, but it took two more months for the couple to receive a letter abating the interest and closing out their debt with the IRS. (They finally received a check from the IRS returning their interest payment in mid-May.) "A lot of people probably give up and just let them keep the money," observes John. "I think that's what they're counting on."

IRS spokeswoman Jodi Patterson agrees that the agency mishandled the Ryersons' case but insists the agency is trying to do a better job of seeing problems from the taxpayer's point of view.

If so, the IRS has a perfect opportunity to try out their new techniques on the Ryersons. The budget bill passed by Congress last summer expanded the capital-gains tax break on home sales. The Ryersons can now take the exclusion they passed up in 1995 by filing an amended return for that year, which they did last August. The refund should total nearly $12,000. The agency lost their paperwork twice and they had to resubmit it, but the end may finally be near. On May 27, they received word that their refund check would be coming in June. "Terrific," says John wryly. "Only nine months have gone by. That must be their new rapid-response team in action."