by Lawrence J. Danny, CPA
If you think you're doing yourself a favor by failing to file taxes and living underground, think again. You are probably doing yourself more harm than good. This article explains why you're better off staying current and in compliance with tax filing requirements, and the consequences you face if you don't file your income tax returns in a timely manner.
Late Filing Penalty
Let's say you want to file but you know you owe the IRS and, for various reasons, cannot pay the tax due with your returns. By not filing on time, you automatically subject yourself to the late filing penalty, IRC 6651(a)(1), unless you have reasonable cause for filing late. The first month or fraction of a month that your taxes go unpaid, you will be charged 5 percent of the total tax you owe as a late penalty. Each subsequent month that the taxes go unpaid, you will be charged an additional 5 percent of the total tax you owe, not to exceed 25 percent of your total tax bill. By filing late, you've just added to the taxes you know you already owe.
Interest on Penalties
In general, interest on penalties will only be imposed if the penalty or additional tax is not paid within 10 days after notice and demand, and then only for the period from the date of notice and demand to the date of payment. Most people who procrastinate and file late usually can't pay their taxes and penalties within 10 days of notice and demand to do so. Now, in addition to the taxes owed and late filing penalty, you will be assessed interest on penalties. This is on top of the regular interest on the balance of taxes due. Fortunately, the IRS doesn't charge excessive rates of interest.
Payment Options
What are your payment options when you can't pay your taxes after filing them? Requesting and obtaining an installment plan is one. An offer in compromise is another. Another is discharging the taxes through bankruptcy.
Installment Plan
In order to obtain an installment plan, all of your tax returns must be filed. So if you receive a wage levy at work and want to obtain an installment plan in lieu of the IRS grabbing up to 25 percent of your take-home pay, you must have all of your past years' taxes filed. If not, the IRS won't deal with you because you lack "good faith" and are not in "compliance."
Offer in Compromise
An offer in compromise (OIC) is an offer to pay the IRS in settlement of tax liabilities less than 100 percent on the dollar but as much as they otherwise would expect to collect.
The recent IRS Restructuring And Reform Act of 1998 includes provisions making the IRS more receptive to and even encouraging offers in compromise in settlement of tax liabilities. However, all tax years must be filed or the IRS won't consider an OIC. By not filing past years' tax returns, you may be missing a great opportunity to settle with the IRS, depending on your current financial position, for substantially less than the total taxes, interest, and penalties you owe them.
People think the best time to make an offer is when they're financially sound. Actually, the best time to make an offer is when they're financially distressed because the IRS usually accepts OICs when they otherwise could not expect to collect the full amount owed. One other caveat: If the IRS accepts your OIC, you must remain current for five years by filing on time and paying timely otherwise the IRS can revoke your OIC.
Discharging Taxes Via Bankruptcy
In general, you can discharge personal income taxes through bankruptcy if the following three rules are met:
The Three-Year Rule. The tax return due date, including extensions, must be more than three years old before the bankruptcy petition date.
The Two-Year Rule. No discharge will be allowed if a tax return, including extensions, was not filed or a delinquent tax return was filed within two years of the date of the bankruptcy petition.
The 240-Day Rule. Any tax must be assessed more than 240 days before the bankruptcy petition date to be dischargeable.
If a Chapter 7 is filed and the rules above are met for each tax year, one can discharge individual income taxes completely. The rules vary for a Chapter 13 bankruptcy petition. In certain circumstances a taxpayer may completely discharge his or her taxes for a given tax year even though no return was filed for that year.
For the most part, in order to completely discharge individual income taxes through bankruptcy, tax returns need to be filed.
Don't Make This Mistake
I had a client engage me to prepare seven years of back tax returns. Four of the seven years he was due refunds totaling $10,000. He lost those refunds because he filed them too late. Yes, there is a statute of limitations on collecting tax refunds. Generally, if no return was filed, the claim for refund must be filed within two years from the time the tax was paid.
Criminal Implications
Criminal penalties may apply when a taxpayer willfully fails to file a tax return, fails to keep records, fails to supply required information, or fails to pay any tax or estimated tax. You don't want to risk the IRS construing your not filing as being willful. The cost of hiring a criminal tax attorney is expensive and the mental anguish of undergoing a criminal investigation can be devastating. 
The Bottom Line
The bottom line is, if you have unfiled tax returns, stop procrastinating. You may be hurting yourself and ruining your chances of getting an installment agreement, obtaining a refund, getting an offer in compromise or having your taxes discharged through bankruptcy. Why live in hiding? It's not pleasant to live without a bank account. If you can't locate income records, you can hire a tax professional, give them power of attorney, and then they can request your income records from the IRS under the Freedom of Information Act. There's no better time to get your unfiled tax returns filed and get current. Once you start the process, you'll feel better. Once your returns are filed, your chances of settling your tax liabilities will be enhanced.
Lawrence J. Danny, CPA is a former IRS agent who currently practices as a sole practitioner in Northridge. His phone numbers are (818) 886-1605 or 886-7183. His email address is LJDCPA@earthlink.net.
Have a question for a CPA? Ask it here.
