Tax advisors are likely to hear from potential clients seeking advice on how to "re-enter" our tax reporting system.The reasons for failing to file tax returns vary with the client: the stress of a divorce or bankruptcy, ignorance of U.S. tax laws, or willful negligence. Similarly, the strategies for handling these cases should vary, considering the potential criminal, as well as civil, ramifications of a client's failure to file timely returns.
This article examines two contrasting situations, and provides practical advice for handling these sensitive tax issues.
Situation 1: Bob is a 67-year-old retired factory worker with a high school education who had always filed his tax returns and paid the appropriate taxes prior to retiring. He diligently invested his spare earnings while working, and now lives off his investment income of approximately $30,000 per year.
However, in recent years, Bob has experienced some significant, uninsured medical problems that forced him to sell some investment assets to cover his rising medical costs. These unexpected sales generated large gains, which created tax liabilities that Bob was unable to satisfy. For the past two years, Bob has not filed a tax return, because he mistakenly believed that not filing a return at all was better than filing one and not paying the tax owed.
Situation 2: Jane, a 34-year-old self-employed consultant with an MBA from a prestigious school, has not filed a tax return or paid the appropriate tax for four years, despite earning $200,000 annually. Before striking out on her own, she worked for a major company specializing in corporate internal control matters. Because of the increased demand for her skills created by the Sarbanes-Oxley Act, she has been so busy with work that she has neglected her own record-keeping and tax-return-filing responsibilities.
Confronted with these scenarios, what would you advise Bob and Jane to do?
Essentially, your prospective clients have three options. First, they can do nothing and hope that the Internal Revenue Service never notices their failure to file. Second, they could belatedly prepare and file tax returns. Third, they could choose to make a "voluntary disclosure" to the service.
You should advise Bob and Jane that the first option is wishful thinking. The criminal statute of limitations is typically six years, and the civil statute of limitations is open-ended as to unfiled returns (see Internal Revenue Code Sections 6501(c)(3) and 6531). Neither Bob nor Jane wants the prospect of an IRS examination looming over their heads for that long.
The second alternative - belatedly filing the delinquent returns - has the advantage of being a relatively quick fix that can be accomplished without much interaction with the IRS. Generally, for clients such as Bob, this may be the best and most cost-effective approach. Given Bob's age, health, the dollar amount of the government harm and the rationale for the non-filing, among other factors, criminal prosecution of Bob is theoretically possible, but unlikely. (The pursuit of a criminal case also is unlikely if the non-compliance involves a technical, esoteric filing requirement, even though the taxpayer may be a less sympathetic figure than Bob).
Civil examination of the late-filed returns is more likely than criminal investigation, but still not probable. In addition, to head off any IRS actions over the civil delinquency and failure-to-pay penalties, it may be advantageous to include a written statement, as described in Treasury Regulation Sec. 1.6651-1(c), detailing the "reasonable cause" for Bob's failure to file his tax returns and pay the tax.
However, belatedly filing delinquent returns likely won't resolve Jane's problems. Jane has significant criminal exposure. Additionally, her late-filed returns are much more likely to be scrutinized, and the uncertainty as to that occurring would last for years, until the expiration of the statute of limitations. Furthermore, if the IRS decided to pursue a criminal investigation or a civil examination, the delinquent return filing could be interpreted as an admission of earlier wrongdoing.
Consequently, taxpayers like Jane should consider availing themselves of the service's Voluntary Disclosure Policy, which generally provides an opportunity to belatedly comply with the federal tax reporting requirements relatively quickly and conclusively, while significantly decreasing the chances of criminal prosecution.
To take advantage of the VDP, one must take a "leap of faith" and make the IRS aware of the delinquent returns. However, before doing so, much preparatory work should be undertaken to ensure that the disclosure is complete, accurate and will withstand scrutiny.
Consideration should be given to employing an attorney so as to preserve the confidentiality of communications between the client and her representative. (Given the potential criminal ramifications, the tax practitioner privilege set forth in IRC Sec. 7525 is likely of little help.) While more involved than just preparing and filing the returns, pursuing the voluntary disclosure process on behalf of Jane warrants the additional time and effort in light of her criminal and civil exposure.
Currently, the IRS will consider a disclosure voluntary if the communication between the IRS and the taxpayer is truthful, timely and complete, demonstrates a willingness to cooperate with the IRS in determining one's tax liability, and makes a good-faith arrangement to pay all amounts owed.
The timeliness of the disclosure is often a point of contention. A voluntary disclosure is considered timely if the IRS receives it before the service has:
* Initiated (or notified the taxpayer that it intends to initiate) a civil examination or criminal investigation;
* Received information from a third party about the specific taxpayer's noncompliance;
* Initiated a civil examination or criminal investigation directly related to the taxpayer's specific liability; or,
* Acquired information directly related to the taxpayer's specific liability from a criminal enforcement action.
In addition, the VDP is only applicable when the unreported income is from legal sources.
Notifying the IRS is the first step. While there are some geographic differences, this is usually done by contacting the local official in charge of the Small Business/Self-Employed Division. The taxpayer should not yet be identified.
A meeting is then arranged that typically is attended by representatives of the IRS's Criminal Investigation Division, the civil Compliance Division and the Office of the Chief Counsel. At this meeting, the facts about the unfiled returns are provided to the IRS representatives in an effort to gauge their response. Again, this should be done on a no-name basis.
Only after CID indicates its lack of interest in pursuing a criminal case should the taxpayer's name and other identifying information be divulged. At this point, the voluntary disclosure has been made. A limited civil investigation will ensue, presumably confirming the well-prepared recitation of the facts proffered at the initial meeting and leading to a settlement of the civil case.
Just as the facts and circumstances of each non-filer's situation vary, so should your method of disclosure. For taxpayers like Jane, taking advantage of the service's VDP may well be the best means of bringing non-filers back into compliance and allowing them to get on with their life.
William Bernard McCarthy, Esq., a former senior IRS trial attorney, and Joseph A. Reese, Esq., are tax lawyers in the Miami office of the law firm of Shutts & Bowen LLP.
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