Prepared June, 2002
One of the most difficult types of cases to handle is that of the Non-Filer, an individual who has not filed state and federal tax returns for many years. While Tax and Business Professionals does not directly handle such cases, our related firm, Newland & Associates, has handled many Non-Filer and late-payer cases. This article is based upon that experience.
Surprisingly, Non-Filers as a group are a diverse mix, including CPAs, politicians, military and police officers, to name but a few of the unlikely types who fail to file. In our affiliate office, Newland & Associates, we have handled many such cases involving non-filing for periods of as long as 20 years. In fact, the 20-year Non-Filer was a commercial photographer who received 1099s each year from Fortune 500 firms and, prior to coming in, had never been contacted by the IRS.
While the common perception is that the IRS computers would not, could not, miss such non-filings, the opposite is true. Anecdotal experience is that many Non-Filers escape detection for long periods of time. How the IRS system can operate in this manner is somewhat of a mystery.
At the first meeting with a Non-Filer, two documents are usually signed: (1) a retainer-fee agreement (with the retainer replenishment delineated); and (2) an IRS Power of Attorney Form 2848. The amount of the retainer has already been discussed prior to the meeting to avoid misunderstandings and to prevent wasting time with clients who are not serious and merely want free information and advice.
It is imperative first to obtain a retainer and make sure the Non-Filer Client always has a credit balance. Stated differently, extending credit or providing services without advance payment should not be considered in such cases. Non-Filers, generally, are people who cannot safely be given credit, because they tend to be expert procrastinators, which is usually what created their problems in most instances. In addition, frequently they are risk-takers, and, if they are willing to take risks with the IRS, they are just as likely to try to avoid paying tax professionals.
At the first meeting, the basic facts should be obtained and an opening memorandum prepared outlining what the Non-Filer’s reasons were for failing to file in the first years. Often it is a divorce, job layoff, or illness which creates the non-filing. In addition to needing to know the basic facts, the reasons for non-filing become important if penalties are imposed by the IRS. In some situations, late filing and payment penalties can be abated or compromised.
While it is difficult to imagine someone in the tax profession being concerned about the psychological problems of their clients, one needs to be in this situation. It is common for clients who have become Non-Filers to try to talk their way out of every problem and constantly and consistently to blame others (such as a prior spouse, former associate, or former employer) for their problems. It is necessary to get the taxpayer-client to shoulder the responsibility, both financially and mentally, of going forward.
The retainer payment and replenishment system helps enforce discipline. Most people don’t pay money to resolve their problems unless they are serious. Often Non-Filers are trying to get their act together because they are considering remarrying or are tired of hiding from the IRS and shaking with fear. IRS wage garnishments and levies are also powerful motivations for getting into compliance.
Whatever the reasons, Non-Filer clients often have to be pushed into the compliance mode and counseled about getting things done.
The IRS Power of Attorney Form 2848 (“POA”), should be filed as soon as possible. Why? The filing of the POA shows the IRS that the taxpayer is trying to get into compliance by retaining a representative. In 30 years of practice, we have not had a client referred for criminal prosecution after an attorney has been retained, nor have we heard of such a criminal case. Representation and the filing of the POA does not prevent the government from seeking a criminal indictment for tax fraud. Anecdotal evidence, however, indicates that if the taxpayer is trying to get into compliance, the IRS will usually wait until the returns are filed in order to consider further action.
Filing the POA immediately does not disadvantage the return preparation process by causing what some perceive as an IRS compliance-return clock to begin ticking. In many cases we have handled, return preparation has taken many months. In some cases, over a year may pass between the filing of the POA and the filing of the late returns. It is rare for the IRS even to call and ask where the returns are unless a local IRS Revenue Officer (“R/O”) has already been after the taxpayer to collect delinquent returns. Even in such cases, the R/Os understand that it takes time to assemble data and get facts for return preparation for older years.
Many practitioners who are not attorneys engage in the preparation of tax returns for delinquent taxpayers without considering the possibility of criminal fraud prosecution and the Attorney-Client Privilege. While there is an accountant-client privilege, it generally does not apply to criminal matters. In other words, if there is a possibility of criminal prosecution and the non-attorney practitioner has not advised the client of the possibility of criminal prosecution, there could be problems related to protecting evidence from the government.
While it is true that many return preparer services (non-CPAs usually), particularly the larger ones, prepare delinquent tax returns without any consideration of, or advice about, criminal prosecution, it is better practice to consider the possibility and advise the clients accordingly. For those non-attorneys reading this, remember that attorney involvement to protect the Attorney-Client Privilege does not, per se, mean that the practitioner loses the ability to prepare the returns. Many tax attorneys, like Newland & Associates, do not prepare the returns themselves but instead retain accountants to prepare the returns for Non-Filers. Thus any attorney can provide Attorney-Client protection and still retain the initially contacted accountant to prepare the returns for the attorney. While it is often better practice to use an attorney with a tax background, there is no rule that dictates only tax attorneys must be used in Non-Filer cases.
One thing about the Attorney-Client Privilege is certain. If statements and evidence have been provided to a non-attorney, before an attorney is retained, the privilege is forever waived and cannot be asserted at a later date. Incidentally, if a corporate client is involved there is no Attorney-Client Privilege since the privilege only extends to individuals in tax matters.
At the initial meeting with the Client, usually without the accountant present, the gravity of the situation is explained. First on the agenda is an explanation that non-filing for a period of years can result in criminal penalties. If criminal penalties are imposed, then, usually, the IRS will also assert the Civil Fraud Penalty, which is why a tax criminal case is called a “double headache.” The policy of the government is to suspend all civil return reporting and collection matters as long as criminal tax prosecution is being considered or acted upon.
Despite the Draconian effect of criminal penalties, the Special Agents enforcing tax criminal laws are rather selective and tend, with some exceptions, to pursue more egregious cases. Probably to keep everyone on their toes, it seems that “small potato” taxpayers will occasionally be prosecuted criminally.
More often than not, the IRS does not impose criminal penalties, and is much less likely even to consider criminal prosecution if the taxpayer comes forward and begins compliance. This is one of the reasons early filing of the POA is suggested.
After explaining the possibility of criminal penalties, the next topic is the imposition of civil penalties, beginning with the 75% Civil Fraud Penalty. This, worst-of-all civil penalties, is almost always imposed if criminal sanctions are pursued (whether successfully or unsuccessfully ) by IRS Special Agents. In addition to possible criminal penalties and jail time, if the civil fraud penalty is successfully asserted, the taxpayer will owe the delinquent tax, plus basic interest, plus the 75% penalty, plus interest on that penalty. The effect on the criminal and civil fraud penalties, plus related interest, can be devastating.
As the late Howard Cosell, might have said, there are a plethora of lesser penalties which may be imposed by the IRS. These include, to name but a few, penalties for late filing, late payment, and substantial understatement, and for underpaying estimated tax. While interest is not considered a penalty, in reality the interest on the tax and the penalties taken together are usually staggering for late payers.
If the late returns are 10 or more years old, the accumulated penalties and interest will often triple the amount of any tax due. For example, for each dollar of tax due in, say, 1990, the amount to be paid to the IRS in 2002, with penalties and interest (even ignoring civil and criminal fraud), may be three dollars or more.
When late returns are filed, the chances of the imposition of some non-fraud penalties are probably virtually 100%. Almost without fail, the late filing and late payment penalties are imposed, and usually the substantial understatement penalty is also imposed.
When the late returns are prepared, no penalties or interest are estimated on the returns. The reason for not showing penalties or interest on the return is that, in some cases, the IRS may not impose penalties, although that is quite rare. In any event, usually not all the penalties are imposed. There is no sense in trying to guess what penalties the IRS may choose to impose.
After the initial meeting, work can begin on preparing the returns. Don’t expect the Late Filer or Non-Filer to have good records, or even any records. Most have the typical “flood or fire” reasons for their lack of records. Since many are, or have been, in financial distress, it is common to have records lost or destroyed because storage fees were not paid and a storage company threw the records away. If the tax professional is lucky, there may be W-2s and 1099s reflecting some, or all, of the income.
One important reason for filing an IRS POA is to get basic and needed information. Once a POA is filed, the tax professional can request IRS Transcripts and Master File information. IRS transcripts provide a history of each year’s activity. How, you may ask, can there be activity if the individual never filed; shouldn’t it be a “blank year?” No. Even if a return is missing, there may be withholding credits and estimated tax credits. Surprisingly, some individuals who stop filing have made estimated payments and have such tax credits.
How can a Non-Filer have collection activity if the returns were not filed? The answer is a Substitute For Return, abbreviated “SFR,” which is basically a return prepared by the IRS. On many transcripts, the return filing is reflected as 1040A. The “A” for a Non-Filer is usually code for SFR or Substitute For Return. If the IRS has evidence of income from 941s or 1099s, it may assess a tax liability, using the SFR regime, and proceed to collect the tax. Such SFR tax assessments are always overstated because only one standard deduction is allowed even if the Non-Filer is married, has children, and other potential deductions.
IRS Transcripts can provide one of the most basic facts of all; namely, has the Non-Filer, in fact, filed a return for an earlier year? Surprisingly, some Non-Filers are not sure if they filed for some years and heaven forbid they keep copies of what was filed.
Another source of basic facts, especially for businesses, is the IRS Master File information. Master File information reflects 1099 income and the source of the same that should have been reported by the Non-Filer. In other words, the Master File, may provide the only record of gross receipts for some businesses. Master File records should not be blindly followed and care should be taken when exploring such information because some 1099 issuers inflate 1099 expenses (for those they suspect of not filing) in order to deal the issuer a lesser tax liability.
Deductions are often problematic because of inadequate records or sloppy record keeping. People who are Non-Filers are not usually pack rats. If a taxpayer has a Schedule C business or owns investment rental properties, what can be done about establishing the expenses? Here, the need for Attorney-Client Privilege becomes important because often income and expenses must be estimated, and the discussions and documents related to such estimates are best kept confidential.
Confidentiality in this setting does not imply there is a sinister plot to defraud the government. Many Non-Filers attempting to “come clean” don’t recall what happened because of the common tendency to suppress memories of the bad times which led them to neglect filing in the first place – the divorce or whatever. Often the attorney and accountant, at later meetings, trying to reconstruct income and expenses, have to suggest avenues to explore. For example, what is the ratio of current expenses in business operations to current income? How many square feet of whatever was installed in an average day or week? Freedom to hold such conversations and related estimates should be free of government discovery.
There is nothing in the tax laws which make reasonable estimates of income and expenses, wrong, per se, when no documentation of income and expenses exists. For example, if records exist for years 1, 3, and 4, but not year 2, it is not wrong to estimate what year 2 income and expenses may have been based upon the interpretation of the known information and discussions with the taxpayer.
In some cases of extreme stupidity, Non-Filers will ask the IRS to prepare their returns. The wisdom of asking the IRS to prepare one’s tax return is akin to an adult believing in the Tooth Fairy, but still some ask the IRS to prepare their returns.
It is reasonable to assume that IRS agents assisting a Non-Filer will not delve into expense areas and related estimates. Furthermore, even if the IRS agent wanted to help with business expenses estimates, they generally lack experience in the relevant business.
If the IRS has prepared the returns and the statute of limitations has not expired, amended returns should be filed. Even if the statute has expired, consideration should be given to having corrected returns attached to an Offer in Compromise (Form 656).
Once the returns are prepared, they need to be filed. It is important to have a record of filing. Don’t simply mail late returns to the Service Center, even by certified mail.
It is recommended instead that the practitioner take the returns to a nearby IRS Processing Office and get date-stamped copies of the late returns. In Northern Virginia, the Internal Revenue Service offices will date-stamp a copy if you hand-carry the original returns in and ask to have a copy date-stamped.
After late returns are filed, the local IRS office sends them to the appropriate Service Center. The Service Center will eventually get around to processing the returns. When a series of late filed returns are filed, it usually takes months to receive bills from the Internal Revenue Service with regard to the late returns.
Do not expect to receive one document listing all of the years and outstanding tax amounts due. Typically, the first notification of the returns’ processing at an IRS Service Center is a separate bill for tax due for each year. In addition to there being a six-month wait, often, after the late returns are filed, there is the problem of credits being properly applied. Frequently there are credits from prior years that are applied in a haphazard way.
Many fear and assume that all late filed returns are audited. Typically they aren’t. Our experience indicates that less than 5% of later filed returns are audited, even if many years of non-filing are involved. The probably 95% chance of no audit is a further incentive to make reasonable estimates of income and expenses. While the use of such estimates is not for the faint of heart, it is also essential to remember always that the basic goal should be not getting the Non-Filer in more trouble by inviting criminal or civil fraud penalties. Expressed differently, estimates are needed in some situations, but they should be reasonable and properly documented so that the methodology can be explained and justified later, if severe penalties are being considered.
Will such estimates satisfy the IRS requirements for contemporaneous and reliable records? Of course not. With Non-Filers, often, there is no option but to estimate. For items like entertainment expenses, which require contemporaneous documentation, if there is an audit, of course, estimates of such expenses will be disallowed. Other business expense areas are subject to the “Cohan” rule (which refers to name of a court case) and should be estimated.
If the late filing goes as “hoped,” which is to say, there is no audit, when the IRS bills are received the penalties first become known. At the time of tax and penalty notification, credits, if any, will be applied. Concerning credits, clients should be steeled to the fact that credits (potential refunds) that are more than three years in arrears will not be refunded, or applied to other years, but they will, at least, be credited to tax due for the year for which they were withheld or credited.
When the IRS bills begin arriving, usually many months after filing, they will arrive in no particular order. There appears to be no system for processing late returns, and the order in which bills are received often seems to be completely random. If returns for six years are filed late, it is recommended that the clients not make any payments until all of the bills, for all six years, have been received. Many clients are inclined to pay the first bill received in the feeble and unfounded belief that prompt payment of the first statement will improve the atmosphere for dealing with the IRS for subsequent amounts due. It won’t. If one of six years of delinquent returns is paid early when received, the Revenue Officer assigned to collection of the remaining five years, does not and cannot give “brownie points” to the late filer.
Unless the taxpayer is flush with funds, which is a rare occurrence, it is always better to wait until all IRS invoices for all years are received, even if it takes many months. If the amount due is large enough, the case will be referred to a local R/O for collection. If a smaller amount is due, the tax professional may have to eventually deal with an Automated Collection Service (“ACS”) office in some distant city. If you are lucky, you or the client may receive a call from a local R/O. At that point, either an Installment Payment Agreement needs to be negotiated or an Offer in Compromise needs to be considered. Click here to read our 1999 newsletter, “An Offer You Can’t Refuse,” for guidance on the process of making an Offer.
If an Offer in Compromise might be considered at a later date, the taxpayers should be advised against entering into an Installment Payment Agreement that is “too rich” for their ability to pay. If taxpayers enter into an Installment Payment Agreement and pay more than their cash flow justifies, it may be difficult at a later point to negotiate an Offer in Compromise, because the amount being paid on a monthly basis is so large that the taxpayers cannot reasonably be expected to keep up such payments, but the IRS might still treat this as evidence of an ability to pay, which may thwart an Offer in Compromise.
There are companies that look for local IRS lien filings and then contact those against whom liens have been filed. While lien searching and the resulting solicitation are not forbidden, some of the advertising practices of such companies can be quite misleading. For example, some buzzard companies advertise settlements for “pennies on the dollar.” Ninety-nine cents is “pennies on the dollar,” but also represents virtually all of the tax due.
Some companies may insist upon taxpayers making a lump-sum initial payment and then fail even to file an IRS power of attorney. Another common complaint we hear is that after the lump-sum payment is received by the company hired to assist the taxpayer, the company becomes increasingly irritated by requests for information about the progress of the case. Eventually, friction increases and all communications are terminated, usually without a refund of the initial lump-sum payment. If you direct Non-Filers away from such companies, you will probably have done the Non-Filer a favor even if you chose not to represent the Non-Filer.
While the process of handling Non-Filers is not glamorous, it is necessary and can be financially profitable if handled correctly. Even if you decide against such representation, these newsletters should help you advise those who contact you.
If you need further guidance in this area, please call us at (800) 553-6613.
By Tax and Business Professionals, Inc.
9837 Business Way
Manassas, VA 20110
While designed to be accurate, this publication is not intended to constitute the rendering of legal, accounting, or other professional services or to serve as a substitute for such services.
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