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Internal Revenue Service Debt
HAVE YOU FILED YOUR RETURNS?
Pro-cras-ti-na-tion is a very long word with potentially devastating consequences when it comes to not filing your Federal Tax Returns. The IRS estimates that each year some ten million people fail to file their tax returns. This chapter will discuss the potential criminal and civil issues facing nonfilers, including the large tax debts which usually result from the filing of a group of delinquent returns, or from the IRS’s assessment of the tax under its “substitute for return” procedures.Prosecution Of Nonfiler - IRC(§7203)
The government can and does prosecute people for willful failure to file income tax returns. The good news is that this is relatively rare, and most nonfiler cases are resolved without resorting to criminal prosecution. But sometimes willful failure to file returns, with the emphasis on the word “willful,” leads to indictment, conviction and incarceration.Section §7203 of the Internal Revenue Code makes it a misdemeanor to willfully fail to pay any tax or to make a return. Four distinct situations are covered: (1) failure to pay a tax; (2) failure to file a return; (3) failure to keep records; and (4) failure to supply information. Despite this range of potential application, §7203 is used most often to prosecute the willful failure to file income tax returns, though each year the government does bring a small number of cases for willful failure to pay.
Each time the obligation to file arises and the taxpayer willfully fails to comply, a separate offense is committed. This means that each tax year for which a return is not filed is charged separately. The statute of limitations on prosecution is six years from the due date of the tax return in question.
TAX EVASION (§7201)
Violations of IRC §7203 are misdemeanors with a maximum sentence of one year per count. But in extreme cases a taxpayer’s willful failure to file returns can be shown to be part of a scheme to evade tax, and in such cases the government can prosecute for the felony offense of tax evasion under IRC §7201. Again each tax year is a separate offense.IRS VOLUNTARY DISCLOSURE POLICIES
From time to time a taxpayer, especially one who has the benefit of informed representation, will decide to correct his nonfiling before the government gives him a new wardrobe and a new mailing address. Usually this can be safely accomplished under the IRS and Department of Justice “voluntary disclosure” policies. The basic operative rule is that in general prosecution will not be pursued if a nonfiler (with income from legal sources only) corrects his past mistakes by filing his delinquent returns before coming under scrutiny by the IRS Criminal Investigation Division. There are two key requirements: (1) the disclosure must be timely, and (2) thereafter the taxpayer must fully cooperate with the government.Note also that not having the money to pay the tax in full is not an impediment to a voluntary disclosure. It is sufficient if the taxpayer “makes arrangements with the IRS to pay the tax.” This can include an installment agreement, and offer in compromise, or any other reasonable and cooperative approach to dealing with the liability.
PREPARING LATE FILED RETURNS
As should by now be clear, getting to the IRS before the IRS gets to the taxpayer can mean the difference between simply filing the missing returns and dealing with the tax, or being prosecuted and sent to jail. Accordingly, it is extremely important to get the voluntary disclosure process moving as soon as the options have been fully considered and it is determined that a disclosure is possible and appropriate under the circumstances. Unfortunately, it may take weeks or months to actually assemble the missing tax returns. Should one avoid any contact with the IRS until the returns are ready? Each case must be carefully considered in light of its own unique facts, but often it is best to make a preliminary disclosure to the Service stating that certain returns are unfiled, that the taxpayer has arranged for the preparation of the returns, and that they will be filed as quickly as careful fact gathering and preparation permits. This preliminary disclosure could offer protection if by some horrible coincidence a criminal investigation begins before the delinquent returns are ready to be filed.HOW MANY YEARS DO I NEED TO FILE?
Another question a nonfiler will want us to answer is how far back you will have to go in preparing returns. For someone who hasn’t filed for three years, the answer is easy. But what about the guy who hasn’t filed for 20 years? The three year statute of limitations on assessment begins to run on the date the tax return is filed, with the result that if the return has never been filed the IRS can assess the tax forever (or as I like to tell clients, “three years from never is a long time from now.”). This being said, in dealing with a noncompliant taxpayer who wants to correct the error of his ways, for its own administrative reasons the IRS will not insist on the filing of tax returns so old that even finding the blank forms would require a degree in archeology. Generally, the Service will demand tax returns going back only six years. Indeed, managerial approval is required if an agent wishes to pursue enforcement activity for anything more than or less than this six year retroactive compliance period.INTEREST AND PENALTIES
Once the missing returns are prepared, they will show how much tax is owed. Interest and penalties, however, must be calculated so that the full magnitude of the problem will be known. Numerous penalties can be asserted against nonfilers, including the late filing penalty and a special version of the civil fraud penalty.The late filing penalty is 5% for each month, or part thereof, to a maximum of 25% (§6651(A)(1)). It is computed on the net amount due on the return after any timely payments or credits. It accrues on the due date of the return, so interest runs on the penalty itself as well as on the tax. If the failure to file is due to fraud, the penalty is tripled to 15% per month to a maximum of 75% (§6651(f)).
In addition, a late payment penalty is imposed at 0.5% per month for failure to pay the tax shown on a return or an assessed deficiency, again to a maximum of 25% (§6651(a)(2)). If the IRS issues a notice of intent to levy, this penalty increases to 1% per month (§6651(d)), and in some cases if the taxpayer has entered into an installment agreement it can be reduced to 0.25% per month (§6651(h)). The late filing and late payment penalties are “coordinated” so that the combination is limited to 5% for any month for which both penalties would apply.
Delinquency penalties can be avoided by showing that the late filing or late payment was due to “reasonable cause and not willful neglect.” It is therefore important to gather and fully document any facts that might support a reasonable cause argument. The IRS’s interpretation of reasonable cause for this purpose is presented in Part 20 of the Internal Revenue Manual. According to the Manual, “any reason which establishes that the taxpayer exercised ordinary business care and prudence, but was unable to comply with a prescribed duty within the prescribed time, will be considered.”
The greatest problem facing most nonfilers in securing relief from the delinquency penalties is their long history of noncompliance. The Internal Revenue Manual specifically requires considering the taxpayer’s compliance history in deciding whether to abate penalties.
FILING STATUS
Determining the appropriate filing status for the returns of married taxpayers requires far more thought and analysis than it often receives. It is not appropriate to merely assume that because the taxpayers are married their returns will of course be filed “married filing jointly.” In every engagement, particularly one involving the preparation of a series of unfiled income tax returns.
Remember, you can always amend from separate returns to a joint return, but you can’t go the other way. The decision to file married filing jointly is irrevocable. And even as expanded by the IRS Restructuring and Reform Act of 1998, the innocent spouse rules will not save you if it later becomes clear that filing the delinquent returns jointly was a strategic blunder. The innocent spouse rules work well for divorced, widowed or separated persons trying to escape tax deficiencies resulting from a spouse’s unreported income or erroneous deductions. But they are almost useless with regard to taxes shown on a joint return but not paid.In this regard, whether the tax is owed jointly or only by one spouse has important consequences when it comes to resolving the liabilities through bankruptcy or an offer in compromise. Some clients or even return preparers will protest “but filing separately results in a higher total tax. . .” However, this is only relevant if the total liability (including federal and state taxes, penalties and interest) is actually going to be paid. Always remember that one unpayable amount is the exact functional equivalent of any other unpayable amount. The minor “savings” resulting from filing jointly is completely meaningless if the total amount owed is so large that it can’t be paid anyway and will have to be resolved through bankruptcy or an offer in compromise.
TIME-BARRED REFUNDS
Most nonfiler cases involve substantial unpaid tax liabilities. Indeed, it is often the fear of filing a return showing a balance that the taxpayer can’t afford to pay that starts the cascade of nonfiling. In some cases, however, the taxpayer may actually be due a refund for at least some of the years for which returns are unfiled. One of the many nasty surprises awaiting such taxpayers is that these refunds may be time-barred. The IRS cannot issue a refund if a claim (here, the tax return itself) is not filed by the later of three years from the return due date or two years from the date of payment. This rule prohibits not just mailing the taxpayer a refund check, but even crediting the overpayment against underpayments in other tax years.Many things can happen to nonfilers, and all of them are bad. Trying to solve these problems is often difficult and time-consuming. The first place to start i to file the returns immediately.
STATUE OF LIMITATIONS
The general rule under IRC 6502(a)(1) is that the IRS has 10 years from an assessment to collect. But this limitation has many exceptions, waivers and extensions that it is often difficult to compute the true “collection statute expiration date” (known as: CSED). Nevertheless, thorough planning requires an understanding of how the statute of limitations applies to each case, and a consideration of the consequences of other actions, such as filing an offer in compromise, requesting an installment agreement, seeking a collection due process hearing, or filing a petition in bankruptcy. The IRS Restructuring and Reform Act of 1998 made substantial changes to the statute of limitations, and one provision actually terminates many “voluntary” extensions previously extracted from taxpayers as of December 31, 2002.EXCEPTIONS TO THE RULE
The 10 year statue of limitations is extended by the following:
- The time during which the taxpayer’s assets are under the control or custody of a court, plus 6 months.
- The time during which the taxpayer is outside the U.S. for a period of at least 6 months, and for 6 months after his return.
- The time the IRS holds property wrongfully seized from a third party, or during which it wrongfully has a lien in place against the property of a third party, plus 30 days.The time when collection action is barred because the taxpayer is in bankruptcy, plus 6 months. In addition, an extension can result from a voluntary agreement between the taxpayer and the IRS (e.g. a Form 900 Tax Collection Waiver), or because the taxpayer invokes some other collection-related procedure, such as requesting a Collection Due Process (CDP) Hearing, seeking “innocent spouse” protection under 6015(b) or 6015(c), filing an Offer in Compromise, or requesting a Taxpayer Assistance Order from the Office of the Taxpayer Advocate.
Knowing how to determine the statute of limitations bar date is important. If you have questions about the statute of limitations, we can help.OFFERS-IN-COMPROMISE
An offer in compromise (OIC) is an agreement between a taxpayer and the Internal Revenue Service that resolves the taxpayer’s tax liability. The IRS has the authority to settle, or compromise, federal tax liabilities by accepting less than full payment under certain circumstances. An OIC is considered only after all other collection alternatives have been explored.The minimum offer amount must generally be equal to, or greater than, a taxpayer’s reasonable collection potential (RCP). The RCP is defined as the total of the taxpayer’s realizable value in real and personal assets, plus future income.
The IRS may legally compromise for one of the following reasons: doubt as to liability, when doubt exists that the assessed tax is correct; doubt as to collectibility, when doubt exists that the taxpayer could ever pay the full amount of tax owed; or effective tax administration. Under effective tax administration, there is no doubt that the assessed tax is correct and no doubt that the amount owed could be collected, but the taxpayer has an economic hardship or other special circumstances which may allow the IRS to accept less than the total balance due. Absent special circumstances, taxpayers that have the ability to pay the tax liability in a lump sum through an installment agreement will not be eligible for an OIC.
As of November 1, 2003, a $150 application fee is required unless the offer is based solely on doubt as to liability, or the taxpayer’s total monthly income falls at or below income levels based on the Department of Health and Human Services poverty guidelines. Taxpayers who claim the poverty guideline exception must certify their eligibility using Form 656–A. The poverty guideline exception applies only to individuals. The Form 656 package contains a worksheet to assist taxpayers in determining whether they qualify for the income exception. The Form 656–A and the worksheet must be submitted with the Form 656 at the time of submission.
Taxpayers requesting an OIC must have filed all required federal tax returns. If in business, they must also have filed and paid any required employment tax returns on time for the two quarters prior to filing the OIC, and be current with deposits for the quarter in which the offer in compromise was submitted. Taxpayers must also not be a debtor in a bankruptcy case.
Taxpayers may choose to pay the offer amount in a lump sum, in monthly payments over the remainder of the statutory time allowed for collection, or a combination of a lump sum and monthly payments. Generally, it is to the taxpayer’s advantage to pay the amount in the shortest time possible because longer payment terms will require a larger offer amount.
INNOCENT SPOUSE RULES - IRS DEBTS
If you sign a joint return, the IRS may be able to collect any tax relating to that return from you – even if your spouse was the one who reported incorrectly. There are three ways to get out of paying your spouse’s tax. The one described on this page is the innocent spouse rule.Requirements for Relief:
You’re eligible for relief if you meet the following conditions:
You filed a joint return on which there was an understatement of tax due to an erroneous item relating to your spouse.
You didn’t know, and had no reason to know, about the understatement when you signed the return.
Looking at all the facts and circumstances, it would be unfair to make you pay the tax.
You apply for relief under this provision within two years after the IRS begins trying to collect the tax from you.
If you meet all these requirements, then you don’t have to pay the portion of tax that relates to this erroneous item.
Available while still married. Innocent spouse relief may be available even if you’re still married to, and living with, the spouse who should have reported additional tax. If you have assets of your own and want to protect them from collection by the IRS, these rules determine whether you can be held liable.Erroneous item. Innocent spouse relief applies only to tax liability that arises from an “erroneous item.” That means you can’t use this provision for relief if you sign a correct return and your spouse simply fails to pay the amount shown on the tax return. If your return was correct and your spouse didn’t pay, see EQUITABLE RELIEF
Lack of knowledge. This requirement is one of the biggest problems in obtaining innocent spouse relief. You don’t get relief if you knew the return was incorrect – or even if the court thinks you should have known. Some court decisions indicate that you can’t satisfy this condition unless you actually examine the return and ask questions about anything that doesn’t seem right – an unrealistic expectation in many marriages. Sometimes the decisions seem to punish a spouse for being well educated, suggesting that anyone with a good academic background should have identified the problems in the return. This part of the rule is a major source of unfairness, but it remains part of the law. A more favorable “lack of knowledge” requirement applies under the Separate Liability Election.
There was one improvement in this rule when Congress changed the law in 1998. Congress made it clear that if you only knew (or had reason to know) about part of the understatement of tax, you’re only stuck for that part. If you had reason to believe your spouse was cheating to the extent of a few hundred dollars and it turned out to be many thousands, you should only have to pay the smaller amount.
Equitable considerations. This is a provision of prior law that should have been fixed in 1998, but wasn’t. The rule is that you’re eligible for relief only if “taking into account all the facts and circumstances, it is inequitable to hold [you] liable for the deficiency in tax.” The problem with this rule is that the courts sometimes have a strange idea of what is inequitable. Different judges have different ideas on this count. For example, if the judge feels that you had a high standard of living while your spouse was cheating on taxes, you could be stuck paying the tax bill even though you didn’t know about the cheating and had no reason to know. The judge may think you received a benefit from the cheating in the form of a high life-style, so you should pay the tax — as if you should have lived more modestly on the off chance it turned out your spouse was a tax cheat! Our hope is that the courts will interpret this provision more favorably in the future, in light of Congressional intent to provide more generous relief.
INJURED SPOUSE CLAIMS
Many married taxpayers file joint tax returns because the aggregate tax is often a little less than if separate returns are filed. But when a joint return is filed, both spouses may be held responsible for the tax due (including subsequent audit adjustments), even if only one spouse earned all of the income.
On the other hand, if you are due a refund on your joint return and the IRS takes it to cover a tax debt owed solely by your spouse, you may be eligible for “injured spouse” relief, and thus to the recovery of your share of the intercepted refund. Here’s a series of questions to help you determine whether you might qualify for relief:- Did you file a joint federal income tax return?
- Did the IRS take your refund to satisfy your spouse’s past due federal tax, child support, or a federal non-tax debt such as a student loan?
- Did you have income to report on your joint return?
- Did you make tax payments to the IRS through withholding or estimated tax payments, or did you claim an earned income credit or other refundable credit on the joint return?If you answered yes to these questions, you may be entitled to relief. To secure this relief (and to recover your share of the refund), a Form 8379 must be filed with the IRS.
IRS INSTALLMENT AGREEMENTS
If you can’t pay the full amount you owe the IRS, and you don’t presently qualify for an Offer in Compromise, an Installment Agreement may be your next best option. In some cases, an Installment Agreement will allow you to pay the tax liability in smaller, more manageable amounts.
Installment Agreements generally require equal monthly payments. The amount of your monthly payment will be based more on your ability to pay than on the amount you owe. You should know, however, that an Installment Agreement can be more expensive than borrowing money from other sources to pay what you owe. This is because the IRS charges interest and penalties even during the period of the Installment Agreement. The interest rate on a bank loan, or even a cash advance on your credit card, may be less than the combination of penalties and interest charged by the IRS. Also, if you can get a second mortgage or home equity line of credit the interest may be deductible, whereas interest and penalties that you pay to the IRS are not deductible. The IRS charges a $43 “user fee” for implementing an Installment Agreement.Even though you enter into an Installment Agreement and you make the required payments, the IRS may still file a Notice of Federal Tax Lien against you. However, the IRS can’t levy (seize) your property or your wages:
- while a request for an Installment Agreement is pending;
- while an Installment Agreement is in effect;
- for 30 days after an Installment Agreement request has been rejected; or
- while an appeal of the rejection of the Installment Agreement request is being appealed.CONCLUSION
When dealing with unpaid IRS debt there are several complicated factors to consider. The following factors should be considered in light of your particular circumstances:
For every action you take there can be serious consequences which affect your other options.
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