If you are a perennial non-filer, or have a few delinquent fax returns, the IRS will eventually catch up with you. In this article, I will tell you why you might want to file those delinquent tax returns.
First, I believe you should take the initiative. If you wait until the IRS comes after you, it might not be at the best time. You may have cash you want to spend before dealing with them, bills that you believe should take precedence over the Service, or obligations that the IRS won’t allow you to pay.
You also run the risk of the IRS issuing a bank levy and emptying your accounts, which is never optimal, or sending notices to your employer. Being proactive and cooperating, will usually eliminate these risks.
Think of it like a battle over your assets. If you take the high ground by getting your records and finances in order and taking the initiative, you have the advantage. If the IRS seizes your bank accounts, you’re left begging to get them back, which is not a position you want to be in. I guarantee you will come out of the fight better if you go in swinging and file your delinquent tax returns before they chase you down.
If you have delinquent tax returns or are a non-filer, there are several areas where you are at a disadvantage. For example, if you have multiple delinquent tax returns, most of which show balances due, and one or two with refunds, if you fail to file those with refunds for 3 years, the refunds will be lost. The IRS will still come after you for those with balances due, but you won’t get the refunds or be allowed to use them to offset the balances due. This rule is very one sided and puts the impetuous on you to file any delinquent tax returns.
Also, delinquent tax returns affect the IRS collection status. The IRS has 10 years to come after you for a tax debt, but that 10 years starts after you file the returns or the IRS computers prepare them for you… which is never in your best interest.
So, if you file your 2005 tax return in 2014, the Service has until 2024 to collect on that 2005 balance due. The sooner you file, the sooner the 10 years will be up and the debt eliminated. I understand that 10 years seems like a long time, but I deal with clients all the time who are 7 or 8 years in to the collection process and the negotiation are much easier. The IRS knows the collection statute is about to expire, so they are willing to give concessions.
As I said above, if you are a non-filer or have delinquent tax returns, the IRS computers might prepare these returns and chase you down for the balance due. This is never in your best interest… yeah, I know you are shocked that the IRS might do something that is not in your best interest or take advantage of your delinquent tax returns.
When the IRS prepares your returns, they enter what are called Substatutes for Returns (SFRs). These are returns based on income reported to the IRS and you are allowed only the standard deduction and one personal exemption. You get no credit for dependents, itemized deductions, or any other tax deduction.
More importantly, these SFRs prepared in place of delinquent tax returns don’t include any expenses related to capital gains. The IRS sees only your stock or real estate sales and not your purchases (your basis). So, if you sell $200,000 stock in 2015, the SFR will include $200,000 as a short term gain, regardless of how much you paid for the stock… the IRS computers have no idea how much you paid or when you purchased it and they don’t care if you have delinquent tax returns.
These SFRs are based on what we call the IRS transcript. It reflects all income reported by banks, brokerages, and others like your employer and those you work for that issue a 1099. It includes no expense or tax deduction information.
If you file your delinquent tax returns after the IRS has prepared SFRs, you may be able to replace those SFRs with your return, but this is not guaranteed. Once the IRS enters the SFRs, and send out a few notices, you no longer have a right to contest them in Tax Court. Therefore, if you have seriously delinquent tax returns, and the SFRs have been posted, it is left to the IRS’s discretion as to whether they will allow you to file.
If you want to file delinquent tax returns to contest the SFRs, prepare them as you normally would and mark SFR Reconsideration at the top of the Form 1040. Basically, you are asking the IRS to compare the return you filed with the SFR, audit the new filing, and reverse out the SFR. If the delinquent tax return you just filed has a balance due, you should send in a payment or an installment agreement request. Remember that the SFR reversal is not guaranteed. If a significant amount of money is at issue, I recommend you hire a professional to review your rights.
One issue that often confounds people who want to prepare delinquent tax returns is how to find old software. It is near impossible to buy typical (non-professional) software that is more than 1 or 2 years old. Tax experts who prepare a number of delinquent tax returns each year have special systems to deal with these returns. I personally have software going back to 1998 for personal, corporate, and trust returns. Those who don’t have these systems, for which I pay about $6,500 per year, are left using the PDF forms available at IRS.gov. If you have a 1040EZ, this might work. If you have stock sales or a rental property, you will have a tough time.
One last comment on delinquent tax returns: While not being able to pay your taxes is a civil matter under Section 7203, failure to file can become a criminal matter under Section 7201. If you have a number of delinquent tax returns that need to be filed, you can avoid this risk by filing voluntarily.