The postponed tax-filing deadline is here on Wednesday and some clients are facing an important question: What happens if you've skipped filing tax returns in past years?
It first helps to understand why even a wealthy client might have skipped filing. “Predominately they’re afraid they owe and don’t have the money to pay,” said Paul Miller, CPA and founder of New York-based Miller & Company LLP. “They’re also worried they’re going to get audited. They’ve lost their documents, are lazy or don’t want to deal with it.”
“Once a person takes a year off ... reluctance to file future returns can take hold as the consequences of drawing a taxing authority’s attention to the first skipped return grow,” said Brandon Smith, director of the integrated planning group at Summit Financial in Parsippany, N.J. “Years of unfiled returns can begin to snowball.”
“Loss of a job or business, stock decline, divorce, health emergency. A person experiences a difficult situation and falls into a non-compliance pit,” said Barbara Taibi, partner in the personal wealth advisors group at EisnerAmper in Iselin, N.J. “As their situation improves, the cash is needed for other necessities, so the tax burden is overlooked. Then because of delays in being notified, another year goes by and then another until the IRS catches up with them.”
High-net-worth clients may be more susceptible to this problem today. The Treasury inspector general for tax administration recently found that nearly a million high-income individuals who didn’t file returns from 2014 to 2016 failed to pay a cumulative $45.7 billion in federal taxes. The IRS—strapped as never before by budget cuts and a pandemic-related backlog—also reports that the agency is now auditing less than 1% of millionaires.
“There are many things to be concerned about when a person has not filed for several years. Some are valid and some not,” Taibi said. “The first is the fear of the balances, interest and penalties overwhelming them financially. Sometimes the task seems so daunting that the person just continues to put it off. Another fear is that they could face criminal charges. This really should only be a main concern for someone who has committed fraud or some other criminal activity.”
“If you underreport income, you’re committing a felony and can go to jail. All tax documents that you receive are also submitted to the IRS electronically, so the IRS is aware of what your income is,” Miller said. “If you don’t file and the computer calculates that you owe money, the IRS will prepare a return on your behalf.”
Flow-through entities can be a main area where a client might try to avoid paying taxes, he added.
When addressing unpaid tax liabilities, taxpayers should verify whether the IRS filed a substitute return on their behalf for any year at issue, especially since substitute returns tend to not account for most deductible expenses and tax credits, Smith said.
“Taxpayers may be able to reduce what they owe the IRS by reaching an offer-in-compromise, which settles an outstanding tax bill for a lower sum,” Smith said. “Depending on the amount involved, a person could also qualify to repay over time by entering into an installment agreement with the IRS.”
States also usually offer repayment programs for back taxes, sometimes free of penalties.
“Get your documents together. The returns will need to be filed before a payment plan can be set up,” Taibi added. “Get the past years’ returns filed, make whatever payments you can and then wait for a notice to come from the IRS. You need to face your fears and get it over with.”
“Almost every client is afraid they’re going to get audited,” Miller said. “If you file your returns and pay your taxes, you really have nothing to worry about. Keep in mind that until you file, the statute of limitations is open. Once you file, the IRS can only go after you for 10 years for unpaid taxes.”