The Consequences for Not Filing Your Federal Income Tax Returns
Have you ever wondered what would happen if you decided to stop filing your income tax returns with the IRS? Or, like many of my clients, are you waiting in absolute terror to see what the IRS does after years of not filing your returns? The answer to these questions is actually quite simple and can have a somewhat good ending or a very bad one, depending on a multitude of factors.
How does the IRS know I have to file?
The IRS’ first action when a taxpayer fails to file a return largely depends on what others have reported to the IRS. Each year, taxpayers who paid employees or independent contractors/self-employed individuals have filing requirements with the IRS. For employees, compensation is reported on a W-2. For self-employed taxpayers, compensation is reported on a 1099. This information is stored electronically by the IRS and is linked to your taxpayer identification number (your social security number). Once the IRS filing deadlines have passed, the IRS cross-checks this information and compares it to what was reported on your tax return. If no return was filed and income was reported to you on a W-2 or 1099, your file is flagged for further inquiry. For example, if you owned a commercial construction company that generated $500,000 in revenue, which was reported to the IRS by your customers, the IRS would compare that figure to what was reported as gross income on your tax return.
If the IRS determines that you had a filing requirement based on this information, a series of increasingly demanding letters are mailed out. These letters start with a friendly “hey, it looks like you forgot to file” and may ultimately lead to “if you don’t file, we will make you file.”
What happens if I don’t respond to the IRS?
The IRS has wide discretion when a taxpayer fails to file a return and fails to respond to the IRS. In fact, the IRS is authorized by statute to file a return for you based on the information reported to them. In this situation, the IRS files your return based on the information it has. That means there will be no itemized deductions, credits, or business deductions taken into account. The result could be devastating as your taxable income will generally be significantly higher, leading to a massive tax liability including accrued interest and penalties. Take the commercial construction company example from above. Let’s say the company had $300,000 of business deductions to apply toward the $500,000 of revenue, resulting in a $200,000 profit. If no tax return is filed, the IRS will generally report $500,000 as taxable income, resulting in $300,000 of additional taxable income, plus penalties and interest.
How bad can it get?
The IRS takes failure to file a tax return very seriously. In addition to filing a return for you, including massive penalties and interest, the IRS could conduct a criminal investigation for tax evasion, tax collection evasion, or obstruction of justice, in addition to other serious criminal charges. The risk of your matter being referred to the IRS criminal investigation unit largely depends on the facts and circumstances surrounding why you did not file returns, including the amount of tax at issue. Call a tax attorney immediately if you have any reason to believe that the IRS is conducting a criminal investigation regarding your failure to file tax returns. It is critical to have experienced tax counsel representing you during an IRS criminal investigation as it often reduces the chances of indictment.
What are my options if the IRS files the return for me?
Fortunately, tax law provides several options for taxpayers. Knowing which option to choose, however, is usually what separates a losing battle from a winning solution. The option that is always on the table (and is often the best option to begin with) is to file a tax return to replace the one the IRS filed for you. This option allows you to report your income and expenses and will replace any calculations made by the IRS. While this may seem like an easy solution, there are several consequences. The IRS will still assess costly interest and penalties on the reported tax you owe. Failure to file penalties can reach up to 25% of the tax owed in addition to failure to pay penalties of 0.5% to 1% per month and interest calculated at the federal short-term rate plus 3 percent. It is not uncommon for taxpayers’ tax liabilities to double due to accrued interest and penalties. In addition to these penalties, your filed return is more likely to be audited by the IRS SFR review team, which could lead to further assessments, penalties, and interest.
Another option available to taxpayers is to set up a payment agreement with the IRS and attempt to remove any assessed penalties. This would generally occur after a taxpayer has filed a correct return with the IRS. The difficulty of negotiating a payment agreement depends on how much tax is owed. If your tax debt is under $100,000, the IRS allows you to enter into a payment agreement where the liability is divided into monthly payments until the liability is paid in full. Penalties and interest continue to accrue during this period. If your tax debt is over $100,000, a detailed financial statement is required to demonstrate your ability to pay monthly installments. This IRS sets forth stringent caps on allowable expenses and analyzes your assets and liabilities, which often create disputes between the taxpayer and the IRS. Once the assessed tax has been paid, a penalty abatement can be requested. The IRS uses a reasonable cause standard for granting penalty abatements, which is a high standard and usually a difficult standard for taxpayers to satisfy. Interest is generally never removed, although like virtually everything in tax there are extremely rare exceptions.
Finally, some taxpayers may have the option of settling their tax debt for less than what is owed through an IRS offer in compromise or through bankruptcy. Determining eligibility for these settlement options is complex and depends on several factors. Taxpayers considering one of these options should consult a tax attorney to apply the law to their specific facts. Generally speaking, though, these programs offer taxpayers (typically facing a significant tax debt) who do not have the ability to fully pay the debt the ability to settle for a fraction of the liability. These options involve detailed personal and/or business financial analysis, including comprehensive financial statements and supporting documentation. A skilled tax attorney can easily navigate through these options and advise you on whether they are worth pursuing.