Filing Tax Returns: If You Haven’t Filed and Other Concerns
Over 50% of all people file annual federal income tax returns before April 1 of each year. Most of the rest file in the first two weeks of April, but 5% get an extension to October 15.
According to the IRS, about 10% don’t file at all. My guess is that the number is even higher. In any case, millions of folks are either illegally not filing tax returns or are filing beyond all extension dates. This number is so large that some nonfilers may never get caught—but don’t bet on it. In this electronic age, it is increasingly difficult to stay below the IRS radar forever.
How Long Must You Worry About Not Filing a Tax Return?
The tax code sets out time limits, or statutes of limitations, for the IRS to pursue nonfilers.
Criminal. The government can only bring criminal charges against a nonfiler within six years of the date the tax return was due. For example, after April 15, 2007, you can’t be prosecuted for failing to file a 2000 tax return that was due on April 15, 2001.
Civil. There is no deadline, however, on the IRS for going after nonfilers and imposing civil penalties—in addition to any taxes owed. This means that while you can’t be put in jail for not filing a 1988 tax return, you will forever owe the IRS a return—as long as you earned enough to have had an obligation to file. And fines—penalties and interest—on unfiled tax returns run forever.
IRS policy. Don’t worry too much about that missed tax return after six years. The IRS usually doesn’t pursue nonfilers after six years from the filing due date. The IRS materials on Taxpayer Delinquency Investigations (Internal Revenue Manual 0021; IRS Policy Statement P-5-133) read as follows:
Taxpayers failing to file returns due will be requested to prepare and file (them). All delinquent returns … will be accepted. However, if indications of willfulness or fraud exist, the special procedures for handling such returns must be followed…. Factors taken into account include, but are not limited to: prior history of noncompliance, existence of income from illegal sources, effect upon voluntary compliance and anticipated revenue in relation to the time and effort required to determine tax due. Consideration will also be given to any special circumstances existing in the case of a particular taxpayer, class of taxpayer or industry.
Normally, application of the above criteria will result in enforcement of delinquency procedures for not more than six years. Enforcement beyond such period will not be undertaken without prior managerial approval.
The IRS can still request a tax return for a period more than six years ago. But if you tell the IRS that you don’t have enough information to prepare a return, the agency usually will drop the request. If the IRS computer shows income information on you, such as a W-2 or 1099 form, however, the IRS may calculate and assess the tax anyway.
Don’t Forget Your State
Unless you live in Alaska, Florida, Nevada, New Hampshire, South Dakota, Tennessee, Texas, Washington, or Wyoming, the IRS is not the only tax agency to worry about. All 41 other states have their own income tax reporting requirements, and a few cities do as well. In many cases, if you haven’t filed a tax return, you may be contacted first by your state tax collector, not the IRS. If this happens, you can bet the IRS is not far behind. All states except Nevada have agreements with the IRS to trade tax information about their residents. In this electronic age, the exchange occurs automatically—if one taxing authority finds you aren’t filing, the computers will turn you in to the other. If you file a late IRS return, be sure to file a state return as well.
Consequences of Not Filing
It is a crime not to file a tax return if taxes are owed. By contrast, there is no criminal penalty if you file but can’t pay your taxes. You’ll owe interest and penalties, but you won’t be sent to jail. So even if you don’t have two dimes to rub together and owe a bundle of taxes, file your return.
If you ignore this advice and fail to file, you can be fined up to $25,000 per year and/or sentenced to one year in prison for each unfiled year. Our justice system, however, doesn’t have enough jails to put away even 1% of the nonfilers, so going to jail is highly unlikely—even if you owe hundreds of thousands of dollars.
IRS Hunting for Nonfilers
The IRS looks for nonfilers through its computerized Information Returns Program (IRP). This tremendously effective operation matches information documents—W-2 wage statements and 1099 income reports from payers (such as your boss or the bank where you earn interest on your deposit account)—against tax returns you have filed. If the computer search fails to find a return, the IRS initiates a Taxpayer Delinquency Investigation, or TDI. A TDI is an IRS search for a taxpayer to find out why he didn’t file a tax return.
TDIs usually begin with computer-generated notices. If you don’t respond to the notices, your case is eventually turned over to a taxpayer service representative for telephone contact or more letters. If the IRS is really serious, your file is assigned to a revenue officer at your local IRS office who goes out looking for you.
If you’re an independent contractor, earn investment or interest income, or sell real estate or stocks, the IRS receives payment information on you annually. The IRP will probably catch that you didn’t file. The IRS is about 12 to 24 months behind in notifying the nonfilers it discovers. So don’t think that because you haven’t heard from the IRS within a year or two after the filing due date you are home free. The IRS will catch you—it’s just a matter of time.
IRS Notifying Nonfilers
How the IRS contacts you is the key to how seriously the IRS views your case. There are four ways you can be notified—and they are not mutually exclusive. If the IRS tries one of the following methods and you don’t respond, it will no doubt try another:
- Written request from the IRS over a 16-week period. Most nonfilers are initially contacted in this relatively nonthreatening manner. Threats come later if you ignore these notices. These notices usually mean that you aren’t targeted for criminal nonfiling.
- Telephone call or letter with a deadline to get your returns filed, usually within 30 days.
- Visit or call from an IRS agent. The officer will give you a deadline to file the missing returns directly with him, or will offer to help you prepare your return. If you still don’t file, the IRS can legally prepare a return for you, based on any information it has and guesses it makes.
- Visit by a criminal investigation division agent. This is the very worst way you can be contacted. This means that your nonfiling is the subject of a criminal investigation. This usually happens only if the IRS suspects you of not reporting hundreds of thousands of dollars in income over multiple years.
The IRS has no tax amnesty program, so no penalties or interest on taxes are forgiven for those who file late. The IRS typically adds the maximum penalties and interest to the taxes found due.
When the IRS Prepares Your Tax Return for You
The IRS has the power to, in effect, prepare and file tax returns for you whenever you don’t file. (Internal Revenue Code § 6060.) In IRS-speak, this is called a Substitute For Return, or SFR. Usually, it is not to your advantage to have the IRS do this. IRS preparers may give you only one exemption, no dependents and the standard deduction on your return. Beyond that, the IRS guesstimates your tax liability, usually from W-2 forms and 1099 informational reports. The IRS can also impute income to you based on tables furnished by the Bureau of Labor Statistics showing income needed to sustain a minimal lifestyle by area of the country. This can result in a much higher tax bill than you would have had if you had prepared your own tax return.
If the IRS prepares an SFR, it will mail a copy to your last known address asking you to sign it and return it. It may not be in your best interest to sign, even if the figures are accurate. Instead, prepare a return yourself and send it to the IRS with a copy of the SFR letter it sent you. Request that your return be accepted in lieu of the SFR. If your return looks okay, the IRS will accept it. The IRS can audit it first, but this doesn’t often happen.
Another reason to prepare the return yourself is because of the three-year deadline the IRS has for auditing a filed tax return. If the IRS prepares an SFR, it will be able to audit it forever, unless you sign the SFR and agree to the tax liability. But, if you prepare a tax return, the IRS normally has only three years from the time you file it to audit you.
A final reason for filing your own return has to do with qualifying to discharge (eliminate) your tax debt in bankruptcy.
If you don’t offer your own return, the IRS finalizes the SFR, whether or not you sign it. Any taxes due, plus penalties and interest, will then be formally assessed against you.
IRS Questioning About Unfiled Tax Returns
Someone from the IRS may ask you point-blank if you filed income tax returns for all years.
This creates a dilemma. If you haven’t filed but you answer “Yes, the IRS must have lost them,” you will have lied to the IRS, a crime punishable by up to five years in prison. But if you answer “No,” you may have confessed to the crime of failure to file a tax return. The best response is to say you’ll get back to the IRS after you check your records or speak with your tax adviser. You can’t get into trouble with these magic words.
The IRS might also ask why you haven’t filed all returns and how much income you had. Remember, if you answered the first question with “I’ll get back to you,” you won’t have to answer these questions.
Regardless of your answer, the IRS will set a deadline for the filing of all tax returns. If you need time to get your records together, ask for 60 to 90 days to do it and talk with your tax adviser, if necessary. Then you should start working on getting the returns prepared right away.
Nonfiling May Be a Crime
Very few people are put in jail for not filing a tax return, but it can happen. A willful failure to file a tax return is a misdemeanor if you owe taxes. You can be sentenced for up to a year in jail and a $25,000 fine—for each year of nonfiling. (Internal Revenue Code § 7201.) If your failure to file is deemed to be part of a scheme to evade taxes you can be charged with a felony, a more serious tax crime, which carries a maximum punishment of five years in prison and a monetary penalty of $100,000—but rarely is anyone criminally prosecuted for this felony. (Internal Revenue Code § 7201(1).) The felony crime requires a deceitful act beyond the nonfiling, such as intentionally using a false Social Security number. The misdemeanor doesn’t require any additional deceitful act.
If you are contacted by an IRS agent about your nonfiling, but you are not asked to file a return, start worrying. This may mean that you’re on the way to the IRS Criminal Investigation Division, or CID. This does not guarantee you will be prosecuted, only that you might be. A small percentage of nonfiling cases result in criminal prosecutions. But, you still have to get your past-due returns prepared and filed. In deciding whether or not to recommend prosecuting a nonfiler, the CID considers many factors, including:
- the number of years you haven’t filed returns
- the amounts of taxes due
- your occupation and education
- your previous history of tax delinquencies
- whether you are in a business largely done by cash, and
- how truthful you were during the investigation
Certain types of nonfilers, such as reputed crime figures and politicians, may be prosecuted regardless of any other factors. And lawmakers are held to a higher standard to maintain taxpayer confidence in the tax administration system.
If your nonfiling case is referred to the CID, there is little you can do to influence the IRS agent’s decision regarding prosecution. If you try to talk your way out of it, you will only make matters worse. In short, if you suspect that the IRS is investigating you, see an attorney. If an agent calls you, don’t consent to an interview—in fact, don’t say anything except that you want to speak to an attorney. Then, find a tax or criminal attorney immediately and have no further direct contact with anyone at the IRS. Don’t talk to your friends or associates about it either.
It’s Better to File Before the IRS Contacts You
If you haven’t filed a tax return for a year or more, it’s never too late. The IRS has a policy of not criminally prosecuting those who file before they are contacted by the IRS. (IR-92-114.) Also, the IRS is often more gentle in collecting from voluntary filers than from the ones they catch. When you file your return on your own accord, the somewhat remote IRS campus initially handles your file. But if the IRS has sought you out, your local IRS office probably has the file and can put more pressure on you than a campus.
Uncle Jack worked in construction for 50 years. He bragged that he never filed a tax return or got an IRS notice. He changed addresses with the seasons and used many different Social Security numbers, none of which were his own. Because the IRS relies primarily on Social Security numbers to keep track of taxpayers, it never found Jack. He didn’t get Social Security benefits either. If Jack were around today, his chances of outrunning the IRS computer would be slim—better than beating the house in Las Vegas, but not by much.
Suggestions for Completing Late-Filed Tax Returns
Most people have a hard enough time getting their tax returns prepared and filed every year. It is even more difficult if you are trying to do it for years long past. The most difficult tasks are getting the correct forms and finding the information that you need to fill them out.
Obtaining Lost W-2, 1099, and Other Tax Forms
Longtime nonfilers tend to lose their old W-2 and 1099 forms. Those forms show how much money was paid to you by businesses and are vital to filing an accurate tax return. If you have this problem, start by asking the business that issued the 1099 or W-2. Many businesses don’t keep these old records around or won’t go out of their way to furnish them to you. They met their legal obligation by sending the forms to you when due; you’re out of luck.
Surprisingly, you can’t get copies of W-2 and 1099 forms from the IRS. You can, however, get an IRS computer printout with the information on it. Call the IRS at 800-829-1040 and request income data for the missing tax years. It may take several weeks to receive a written response. All your income may not be reflected on the transcript, but it will show the minimum amount you must report on your tax return.
Another way to handle missing W-2 data when filing a tax return is by reconstructing your salary records on Form 4852, Substitute W-2, available from the IRS. Attach it to the front of your tax return and file it. For missing 1099 income data, make your best guess. There is no separate form for 1099 payment reconstructions.
Use the current year’s tax form. You must use updated tax forms each year. For example, you can’t use 2006 tax forms and change the year to 2007—the IRS makes major and subtle changes to its tax forms each year.
You have several options for obtaining past years’ forms:
- Visit your local IRS office. You won’t be asked why you want the forms. You won’t even be asked your name.
- Download the forms off the IRS’s website ( www.irs.gov).
- Contact a tax software publisher like TurboTax.
- Call the IRS form department at 800-829-FORM (3676). The forms will be mailed in a week or two. The form center shouldn’t pass your name along to other departments—such as the collection or criminal division.
- If you don’t want to risk your name being passed along, have a friend or relative—who did file on time—call for you.
- Ask a tax professional for forms—she may not provide them unless you agree to hire her. After all, she has to earn a living, too.
If your state has an income tax, remember to get those old forms, too.
Preparing Late-Filed Tax Returns
If you ask, your local IRS office will help you prepare late tax returns. The question is whether this is wise. The IRS is not interested in making sure you get every deduction, exemption, or credit to which you are entitled. If you can’t afford to hire a tax preparer, see if any local tax professional or nonprofit groups donate their time to low-income or otherwise needy people—ask at your local IRS office.
Another free or inexpensive option is to use computer tax preparation software, such as TurboTax. (Check Turbotax.com to see if you are eligible for the free version.) This program has helpful hints of what to do—and not do—and can take data directly from personal finance recordkeeping programs, such as Quicken (Intuit). Some even have built-in tax guides that offer advice on finding deductions and flag questionable items. The IRS has a bias in favor of computer-prepared tax returns. Computers don’t make math errors and the IRS itself relies heavily on computers—although much of its reliance is undoubtedly misplaced. You will probably have trouble locating older years’ computer tax programs, although tax professionals keep programs back as far as ten years.
Your best (but most costly) choice is to hire a tax preparer. Over 50% of tax filers do. A professional decreases the chances of mistakes and, consequently, that the return will be audited. Late returns are hand-screened by specially trained IRS personnel. In contrast, a return filed on time is seen only briefly by a human being who enters data into the computer and then sends the return to storage. IRS personnel are presumably more likely to let a return go through without question if it bears the signature of a CPA, enrolled agent, or tax attorney. Also, a good tax professional can offer advice on what you can do in the future to cut your taxes or reduce your audit risk.
Voluntary Filing to Minimize the Chance of a Criminal Investigation
The government policy is not to prosecute average citizens who haven’t filed. The IRS claims that the typical nonfiler hasn’t filed for three or more consecutive years and owes about $70,000. Nevertheless, my advice to most nonfilers is to simply start filing their tax returns—without first contacting the IRS.
Who does the IRS criminally prosecute? The most likely candidates are public figures, such as sports stars or entertainers or known criminals. But some are more ordinary folks with five or more years of nonfiling and hundreds of thousands in taxes owed.
Tax attorneys typically handle the cases of high-profile nonfilers in one of three ways:
- The attorney writes the local IRS office and makes the voluntary disclosure for her client. The lawyer then files the tax returns.
- The attorney calls the local chief of the criminal investigation division and requests a meeting. There she discusses the case without naming the client and asks if the client would be prosecuted if she were to make a voluntary disclosure. If the chief says no, the attorney makes the disclosure. Legally, the chief cannot bind the government here, but I know of no one criminally prosecuted after making this kind of deal.
- The tax attorney prepares the returns for the last six years and files them, without contacting anyone first. The tax attorney gets a power of attorney from the client—a form authorizing the attorney to act on behalf of the client—and uses her address, not the client’s, on the tax returns. This assures that any further contact about the late returns from the IRS comes to the tax attorney directly.
The advantage the tax attorney has is the attorney-client privilege. Under this ancient legal doctrine, neither the IRS nor any other government agency can force your attorney to disclose anything you say. There is also a tax practitioner-client privilege, but it does not apply to criminal tax proceedings—meaning the IRS can force a non-attorney tax professional to divulge client confidences.
What Will Happen When You File Late
The IRS can punish you for filing tax returns late by imposing civil penalties, criminal penalties, or both, and by denying refunds due you.
Civil Penalties Added to Your Tax Bill
If your seriously late tax return shows taxes due, you will probably be fined 5% per late month, up to a maximum of 25% for five months past April 15.
Your return was due April 15 and you file on October 1 of that year. You may be charged 25% extra on the amount of any taxes you owe. If you file on August 16, you will be charged 20%—four months times 5% per month. There is no daily proration of the penalty, so one day late costs the same 5% penalty as does 29 days. After five months, the late filing penalty stops increasing.
That’s not all. In addition to the late filing penalty, the IRS can impose a late payment penalty of H% to 1% per month. And here’s a little more bad news: Interest is running all the while. Interest changes quarterly, and is compounded daily. And interest is charged on the penalties, too. (In recent years, the interest rate has hovered around 6%–8%.)
Tax bill interest is not deductible on your tax return, unless it’s for a business tax debt. Penalties are never tax deductible.
The lesson here is to pay the IRS as soon as you can, even if you have to borrow to do it. Getting out of paying these penalties is not easy, but can be done under certain circumstances.
For thorough information on paying all kinds of debts, see Solve Your Money Troubles: Get Debt Collectors Off Your Back & Regain Financial Freedom, by Robin Leonard (Nolo).
The one bit of good news is that penalties and interest are added only if you owe taxes, because they are based on a percentage of the tax due. So, for example, a business with net losses for the year can generally file as late as it wants without incurring penalties and interest. This is not to say that it is good to intentionally file late—you may lose refunds or other tax benefits granted only to timely filers. Nevertheless, over one-third of all late filers don’t owe anything—or even get refunds. Many people who dread preparing and filing returns because they thought they owed the IRS get a pleasant surprise.
Criminal Charges May Be Brought
As mentioned earlier, nonfiling is a misdemeanor. You can be sentenced to one year in prison and be fined $25,000 for each year you didn’t file, up to six years. You cannot be criminally prosecuted for nonfiling a return once six years pass from its due date. However, you can be civilly fined beyond six years. (See Chapter 10.)
Refunds May Be Denied
If you file too late, you may lose your tax overpayment refund. (Internal Revenue Code §6511(a).) Only by filing within two years of the original due date (April 15), will you qualify for the refund. Filing more than two years from the original due date qualifies you for the refund in two instances only:
- If you pay any of the tax after the due date of the return, the refund time period is extended to two years from the payment date. For example, your tax return was due April 15, 2008. Instead of filing the return, you file an extension request. On August 15, 2008, you file another extension request and make a payment for the amount of taxes you think you will owe. You don’t file your return on October 15, 2008, and in fact don’t get around to filing it until June 2010. That’s more than two years after the April 15, 2008 date, but less than two years from the August 15, 2008 date when you made a payment. You discover that your August 15, 2008 payment was too much. When you file your return in June 2010, you’ll be entitled to a refund.
Getting Your Returns to the IRS
Get your late return to the IRS by either:
Hand filing. It’s safer to hand file tax returns at a local IRS office than to mail them in, especially late returns. If you file in person, ask the IRS clerk to file-stamp a copy of the first page of the tax return. This shows irrefutably that the return was filed and the date of the filing. And it is better than a post office return receipt or card which shows only that something was sent to the IRS on that date—but not what was sent. Take along your own extra copy for the IRS to stamp; the IRS won’t make a copy for you.
Mailing. Late-filed returns are more likely to get delayed in processing or lost by the IRS than current ones. If you plan to mail in your late returns, send them by certified mail, return receipt requested, to the IRS. Again, hand filing is the better way to go.
Electronic filing. You can electronically file a late return. Get an electronic receipt back from the IRS and keep it for your records.
- If you can show that you suffered from a physical or mental impairment at the time the return was originally due, the IRS can grant the refund—at its discretion—if you file the return within three years of its original due date. You will have to document your impairment with a supporting letter from a medical provider.
Andy filed ten years of back tax returns at one time. For the first five years he was due refunds, but in the later five years he owed taxes. Andy requested that the IRS offset the taxes owed with the refunds due. The IRS denied the request because all the refund years were beyond the two- and three-year cut-off periods.
Bells Won’t Go Off When Nonfilers Start Filing
If you haven’t filed for many years and decide to hop back in with this year’s return, don’t worry about the IRS automatically checking for all the other years you’ve missed. IRS computers aren’t set up to do this, primarily because the IRS doesn’t want to discourage nonfilers from starting to file again. So nothing will happen if you file anew even after a ten-year hiatus. If you later get a notice asking about tax returns for other years, chalk it up to coincidence—most likely due to income information already on file (W-2 and 1099 forms) in the IRS computer.
Requesting an Extension to File
The only good reason for filing your tax return by April 15 is if you need a refund quickly. If you are getting large refunds, however, that is a sign that your wages are being overwithheld or you are sending in too much in estimated tax payments. If you look at tax refunds as a kind of forced savings plan, realize that you are making an interest-free loan to Uncle Sam. It may make more sense to adjust your withholding or quarterly estimated payments so that you break even or even owe a little to the IRS instead. In the meantime, you can invest the money and collect the interest, which, of course, is taxable.
The alternative to filing by April 15 is to apply for an extension to October 15. Each year about 5% of all taxpayers request extensions to file their tax returns. It’s no big deal, and won’t get the IRS excited or increase your chances of being audited.
Extension to October 15
To get an extension to file, complete Form 4868, Application for Automatic Extension of Time to File U.S. Individual Income Tax Return, and send it to the IRS by April 15. This form changes each year. To get a current copy, visit your local IRS office, call 800-829-3676, or visit the IRS website at www.irs.gov. Your extension is granted automatically until October 15, and you won’t incur any late-filing penalties.
If you live outside the United States, you get an automatic two-month extension to file to June 15. In the past, anyone physically outside the United States on April 15 could get the automatic extension. The law was changed to disqualify day trippers who made short April trips to Mexico and Canada just to get the extension. Even if you live outside the United States, however, you do not get extra time to pay the taxes you owe.
Some tax professionals contend that filing tax returns on extension decreases your chance of being audited. They reason that the IRS local offices fill their annual audit inventories before the returns on extension are processed. The IRS denies it works this way, but at the same time the agency won’t say that returns filed on extension have a higher audit frequency. At worst, extensions are a neutral factor; they can’t hurt and just might help. I always file my own return on extension—and I’ve never been audited. Maybe just a coincidence.
Don’t File a Tax Return During an Audit
Avoid filing an income tax return while an audit is in progress—you risk having the audit expanded to include that return. For example, in 2009 you are being audited for 2007. If the auditor finds errors she will want to know if you made the same mistakes in your 2008 return. If you have not yet filed for 2008, don’t. She cannot force you to file or even provide her with any 2008 information. Instead, file a request for an extension until October 15 on Form 4868.
If the audit is still alive on October 15, consider not filing until it is completed. As long as you have paid all the taxes due and have no fraudulent intent, you won’t incur any penalties or interest for not meeting the deadline. If you owe additional money, send in your payment with a letter stating that the payment is to be applied to the tax year on an extension. Also, write this notice on your check or money order for payment. Some states impose late-filing penalties on whether or not you owe taxes, however, so you may want to file your state return on time.
And if you didn’t read this in time and have already filed a return during an audit, politely decline to give a copy to the auditor if she asks. It’s not as easy for her to get it as you might think. That’s why she’s asking you for a copy. You are not legally obligated to give it to her.
An extension to file does not extend your time to pay. Pay all expected tax due with your extension filing forms. Otherwise, you’ll get hit with late payment penalties and interest for the underpaid amount. It is very difficult to get an extension of time to pay without incurring an underpayment penalty. Try by filing IRS Form 1127, Application for Extension of Time for Payment of Tax (available on the IRS website), by April 15. Follow the instructions on the form, but don’t get your hopes up.
Filing a Return When You Can’t Pay What You Owe
If you owe taxes, but don’t have the money to pay the full amount, file a return and send what you can. Remember—you can incur up to a 25% fine for the first five months you’re late. Any partial payment will cut down on the penalty and interest owed.
When sending a partial payment, don’t send a personal check. The IRS always records your bank account number with your payment. If you ever owe the IRS and can’t pay on time, the agency can easily seize this account to get the balance of the taxes owed—and cause your outstanding checks to bounce. (See Chapter 7.) Instead, use a money order, cashier’s check, or an attorney’s trust fund check to make payments if you anticipate any future IRS collection problem.
Keep photocopies of the check or money order sent to the IRS. Write your last name, Social Security or employer ID number, type of tax—income or payroll—and year of tax in the lower left-hand corner of the payment instrument. To make sure your payment is credited quickly, use the payment slip and bar-coded envelope provided by the IRS for payment.
Filing a Tax Return When You Live Out of the United States
The long arm of the tax code does not stop at the U.S. border. If you live abroad and have income, you will still have to file a tax return (by June 15). You must also have taxes withheld or pay quarterly estimated taxes if you are working abroad. But the tax bite may be substantially reduced if you qualify for a foreign earned income exclusion of $85,700 per year (2007), the foreign housing exclusion, and the foreign housing deduction. (See IRS Publication 54, Tax Guide for U.S. Citizens and Resident Aliens Abroad.)
You may also owe taxes to the government of the country where you reside. Some countries give you credit for taxes you pay to Uncle Sam; others won’t. Also, estate and inheritance tax laws vary widely across the globe.
Renouncing your U.S. citizenship to beat the IRS won’t work, either. You remain subject to U.S. tax laws for ten years after renunciation! Norman Dacey, author of How to Avoid Probate, found this out when he became an Irish citizen. He challenged this law in the U.S. federal courts—and lost.
There is one bit of good news. While you are subject to U.S. tax laws, it is very difficult for the IRS to grab your wages or assets located outside of the United States. Some countries, mostly in Europe, have treaties with the United States in which their tax agencies can cooperate with the IRS to collect from Americans, but most governments place a very low priority on working these kinds of cases. You claim the Foreign Earned Income tax exclusion on IRS Form 2555.
Reducing the Chance of an Audit When Filing
There is no sure-fire way to audit-proof your tax return, though you can cut the odds. Nevertheless, a messy return—cross-outs, sloppy handwriting, smudges—almost screams “audit me.” This tells the IRS that you are careless and disorganized. So does the use of round numbers for deductions—$1,000 or $12,000 instead of $978 or $12,127. It’s an indication that you are estimating things rather than keeping good records.
Here are some suggestions which may—or may not—work to reduce your audit risk:
- If you claim large deductions for unusual items, such as an earthquake, flood, or fire loss, attach documentary proof to the back of your tax return. Copies of repair receipts, canceled checks, insurance reports, and pictures are advisable. This won’t stop the IRS computer from flagging your return. These attachments, however, should catch the attention of the IRS classifier who next screens computer-picked returns for audit potential. If she thinks your documentation looks reasonable, you won’t get audited.
- Avoid filing an income tax return with Schedule C, Profit or Loss from Business, that reports a net loss from a small business venture. IRS auditors go after these returns like bees toward honey.
- Report side-job income as other income on line 22 of your tax return. This should be done only if this income is relatively small, and you are not claiming any business deductions against it. Technically, side-job income is usually reported on a Schedule C, Profit or Loss from Business. But filing a Schedule C undoubtedly increases your audit chances.
- Prepare your tax return by computer. A neat, computer-prepared return looks more official to IRS classifiers and avoids math errors which catch the IRS’s attention. Most professional tax preparers now use computers. There are also tax preparation programs, such as Intuit’s TurboTax, that you can use to prepare your own return.
- Don’t use electronic filing or the IRS preprinted address label on your tax return. These enable the IRS to get your return into the processing cycle, including the audit cycle, more quickly than otherwise would happen. Anything that slows down the IRS machine can’t be bad. On the flip side, however, using electronic filing or the label usually means that any refund will come faster. If you expect a refund but fear an audit, you’ll have to weigh the pros and cons.
- Live in a low-audit area. Your audit chances are radically different depending on where in the United States you live. For example, Nevada taxpayers are audited four times more than people in Wisconsin. While this is extreme, it might make sense if you travel most of the time or have addresses in several areas. If you have flexibility in choosing your tax reporting address, choose the one with the lower audit rate. If you’re really interested in this, ask a tax professional or check the IRS website for audit statistics.
- If you can, report less than $100,000 in total positive income from salaries, self-employment, and investments. These people have the lowest audit rate.
- Don’t report less income than is shown on your W-2s, Form 1099s, and other third-party forms you receive. If one of them is incorrect, get the issuer to correct the form and reissue it.
Amending Tax Returns
You can change your tax return, or amend, in IRS-speak, after you’ve filed it. You can voluntarily correct a mistake, such as an overlooked deduction, to get a refund. If you fail to report income, the tax code requires you to amend. The sooner you do so, the less penalties and interest you’ll be charged.
To amend your return, file IRS Form 1040X, Amended U.S. Individual Income Tax Return.
To get a refund, you must file a 1040X within three years from the date the first return was filed or within two years from the date you paid the taxes due on that return—whichever is later. For example, if you filed your 2006 tax return on April 15, 2007, you can file a 1040X any time up until April 14, 2010, and still get a refund. If you filed an extension, you can add the extended period on as well. One exception: If you file an amended return to claim a refund based on a worthless security or bad debt loss, you have up to seven years after you first filed.
How to Amend a Tax Return
File Form 1040X, Amended U.S. Individual Income Tax Return, with documentation to support your changes. (If you don’t feel comfortable with or understand this form, hire a tax preparer or use a software program like Turbotax.)
It’s best to hand deliver the 1040X to the nearest IRS office and get a stamped copy as your filing receipt. If you use the mail, send it certified, with postal return receipt requested, to the IRS where you now file your tax returns.
Don’t forget to amend your state tax return at the same time. Get the proper forms from its tax department. If you don’t feel comfortable or understand Form 1040X (it’s a little tricky), hire a tax preparer to do it.
Audit Alert for Amended Tax Returns
Filing amended returns claiming refunds slightly raises your audit likelihood—and not just for the amended items, but for the whole tax return. This is partly because 1040X forms are scrutinized by IRS employees rather than just computer processed.
On the other hand, the IRS ordinarily has only three years to audit a return from the date it was filed. An amended return filing does not extend the time the IRS has to audit the first return. Filing an amended return near the three-year audit deadline gives the IRS very little time to audit your tax return and it may simply pass it through.
This ploy can backfire on you, however, as the IRS is not legally obligated to accept an amended tax return. If you file an amended return near the three-year audit deadline, the IRS may be willing to accept it only on the condition that you agree to extend the time for audit beyond the three-year deadline. If you’re considering this strategy, you may want to talk to a tax professional first. (See Chapter 13.)
A Word About “Aggressive” Tax Filing
A question I am often asked is, “What deductions and tax benefits can I safely take, and which ones are risky?” The best answer is that it depends on your personality. Are you very conservative? Or are you a risk-taker by nature? Most people have at least a little of each trait in their personality. In the end, go with your comfort level.
Aggressive tax filing means interpreting the gray areas of the law in your favor—and taking the chance that you will either not be audited or survive if you are. It doesn’t mean making up numbers. You may want to peruse Chapter 3 first to find out what happens at an audit if you cross the line.
Tax professional litmus test. I have never met two tax professionals who agreed on the meaning of aggressive. Find out how aggressive your tax adviser is by asking her opinion on deducting something. For instance, if you are self-employed, ask her about deducting business lunch expenses, a combined business and pleasure trip, or health club dues. Or, if you have investment income, ask her about financial publication expenses and trips to check out investments.
How the tax adviser responds clues you into how aggressive or timid she is. If she repeatedly says “you can’t do that,” instead of offering advice on how to make that expense deductible, then she may be too government oriented. At the other extreme, if she says not to worry, deduct anything you want because chances are you won’t be audited, she could get you into trouble.
Comfort level. When I first interview a tax return preparation client, I check out his IRS comfort level. I ask outright how concerned he is about facing an audit, and if it happens, whether he will be able to document all the benefits claimed on the tax return.
I do not counsel tax cheating. But there is a fine line between being aggressive and being dishonest. No reputable tax return preparer will sign a tax return that she believes is a work of fiction. And, if the preparer is not reputable, you don’t want her name and identification number on your return. The IRS tracks crooked tax preparers and may reward you with an audit for choosing one.
Finding and using a tax professional is covered in Chapter 13. Some things to look for and types of preparers to avoid are covered there. Don’t take picking a tax preparer lightly.
The people most often concerned about audits are small business owners wanting to know how far they can go in taking deductions. Generally, the tax code lets you take a deduction for just about any expense that helps you produce income. On the other hand, the expense must be ordinary and necessary. For the aggressive tax filer, this means that as long as there is a reasonable basis for claiming a deduction, he will take it. (For more information on business deductions, see Tax Savvy for Small Business, by Frederick W. Daily (Nolo).)
Dennis, a lawyer, buys and deducts an antique $10,000 grandfather clock for his home office. He could have bought a reproduction for $500 or a simple wall clock for $25—the $25 clock with the quartz movement probably will keep the best time. The tax question is, does the $10,000 clock help Dennis produce more income? If he is ever audited, Dennis could argue that the clock is ordinary and necessary because it conveys the impression to his clients that he is successful. Will Dennis get this by an auditor? In similar cases, the courts have upheld the right of professionals to take this kind of deduction—but it’s a close call.
Creativity has its limits. In the example above, Dennis would have gone too far if he had:
- bought the antique clock and put it in his bedroom, or
- bought the clock for $1,000, added a zero to the receipt and claimed a $10,000 deduction.
In these examples, the deduction would no longer be gray, but black—it would be fraud. Where creativity ends and fraud begins is covered in Chapter 10.
Beware of joint filing. Never sign a joint tax return if you know your spouse is cheating the IRS. Your separate income and assets may be fair game if the IRS discovers the fraud. (See Chapter 9, “Filing Tax Returns—Joint or Separate?”)
Tax Shelter Investments and the IRS
Higher-income folks, meaning six-figure earners, are often targets for “tax shelter” investments. These deals promise great tax benefits by using tax losses and deductions to offset other taxable income. Don’t get me wrong, this can be perfectly legitimate. For example, the depreciation write-off for a rental property you own can be a great tax shelter. If the property you rent out produces a paper or tax loss, you can use that loss to offset other income.
IRS problems are more likely to arise with investments in exotic-sounding products, like foreign currency options, that promise tax benefits that exceed the amount of your investment.
The IRS now scrutinizes these investments to make sure their underlying purpose is not to avoid paying taxes. To pass muster, the investment program “must possess a reasonable possibility of profits beyond the tax benefits.” Or, as other courts have put it, “the transaction must be entered into for a business purpose other than tax avoidance.”
If the deal doesn’t pass scrutiny, it is termed an “abusive tax shelter” and any tax benefits will be disallowed, with penalties and interest tacked on. As with most things in life, if it sounds too good to be true….
- Not filing a tax return can be a crime if you owe taxes; most nonfilers, however, are not prosecuted if and when they are caught.
- If the IRS asks you if you filed returns and you haven’t, don’t lie, but don’t answer. State that you want to consult a tax professional or check your records first.
- Filing before the IRS catches you is the safest policy.
- The time limit for criminally prosecuting a nonfiler is six years. The time limit for collecting from a nonfiler is ten years, but the clock doesn’t start until you actually file a tax return.
- Penalties and interest for late filing are substantial and rarely forgiven. (There is no penalty if you didn’t owe any taxes, however.)
- Don’t file a tax return while you are being audited. It gives the auditor another year to look at it.