Here is a one-question multiple choice quiz for all return preparers. The date is Dec. 1, 2013. You have an appointment with a married couple, Joe and Jane Taxpayer. Joe and Jane have been married for 10 years and they have never lived in a community property state. They have three children, ages 9, 11 and 12. Neither has filed a tax return for 2006, 2007, 2008, 2009 or 2010 (the "delinquent years").
For the past 10 years, Joe has been a plant manager for a manufacturing company. For each of the delinquent years, Joe earned on average $75,000.00 and claimed single and -0- on his W-4.
Jane was a self-employed lawyer who earned on average $100,000 net business income for each of the delinquent years. Jane made no estimated tax payments while she was self-employed. For all of 2011, Jane has been an employee earning around $80,000. Her W-4 form shows married with one exemption.
The IRS has not yet assessed tax for any of the delinquent years. You have prepared tax returns for Joe and Jane for each of the delinquent years. The returns show the liabilities in the accompanying chart (see "The delinquent years," below).
How should all of the delinquent returns be filed?
- A. File the returns as married filing joint, because Joe and Jane save $29,500 in tax.
- B. File the returns as married filing separate, so only one person has a liability.
- C. None of the above. I don't have enough information to make a recommendation.
If you chose A, you have saved Joe and Jane a lot of money, but that may be penny-wise and pound-foolish.
What if Jane and Joe own their home jointly, and the home has substantial equity? What if Joe has a 401(k) with $50,000? Is Joe going to thank you for putting his home and retirement at risk?
But A may be the correct answer if, for example, Joe and Jane have sufficient cash to fully pay the liability or pay the balance owed to below $50,000, and have sufficient income in future years to do a "streamlined installment agreement" to pay the balance in full within 72 months.
If you answered B, you could be wasting the Taxpayers' money for no reason. What if Jane just inherited $500,000 and is willing to fully pay the liability? What if Joe and Jane have recently qualified for a $75,000 low-interest mortgage to pay down the liability and are willing and able to pay the balance on a "streamlined installment?"
The correct answer is C. You don't have enough information! If you just prepared joint returns, showed the taxpayers where to sign and provided mailing envelopes, you likely committed malpractice.
You might say, "But I saved the Taxpayers $29,500 in tax!" So what? Joe and Jane can't pay the $91,500, let alone the $121,000. Had you asked the right questions, you would have learned that Joe just got a 20 percent pay cut, one of the kids was recently diagnosed with muscular dystrophy, and Jane -- who has diabetes -- may have to quit her job to take care of the sick child.
Whenever I speak to preparers, Enrolled Agents or CPAs, I constantly remind them to view problems holistically. Always look at the entire situation before making any recommendation.
You wouldn't file an offer in compromise if there were only 120 days left before the collection statute expires. So why would you file a joint return for Joe and Jane without first knowing whether you are saddling Joe with a liability and jeopardizing his home and retirement?
Before making the filing status recommendation to Joe and Jane, you need to know at least the following:
- Can Joe and Jane file head-of-household for any of the back years (that is, have they lived apart for the last six months of the year)?
- Do the Taxpayers have the money to pay the liability down to $50,000 or less, and can they then pay the balance with a streamlined installment agreement?
- Does the withholding for future tax periods need to be adjusted?
- What do the taxpayers own, and are the assets held jointly or separately? Find out who owns what.
- What are the anticipated future expenses, aside from current taxes?
- Can you give Jane all of the exemptions and deductions to lower her separate liability without hurting Joe's situation too much?
- How much is the state tax liability?
- Are there any state licensing issues for Jane that will affect her ability to practice law?
- Is there any potential criminal liability for either taxpayer?
These are just a few of the questions you need to ask. I'm sure that you can think of many others.
When advising married clients on filing delinquent returns, you can't just look at the bottom-line tax liability owed. You must also try to protect and preserve existing assets. One of the best ways to do that is to file some or all of the years as married filing separate. It is very difficult for the IRS to collect from jointly owned assets if only one spouse owes taxes. And the IRS cannot collect from the separate property of a non-liable spouse without proving nominee, alter ego or transferee liability.
Advising spouses to separate their tax liability must be done carefully and tactfully. The liable spouse may conclude that they are being "sold down the river." You have to show the couple how separating the liability helps both of them. Separating the debt completely protects the non-liable spouse's separate assets from IRS collection. It also makes it difficult (if not impossible, as a practical matter) for the IRS to collect from jointly owned assets.
When faced with a situation like this, you must proceed deliberately and cautiously. Always remember: Filing status on any return, no matter how simple, is not your call to make. Each spouse has the absolute right to file a separate return for any tax year.
Your job is to fully advise each taxpayer of the economic consequences (both individually and jointly) of married filing joint and married filing separate for each of the years.
Overall tax liability (joint liability versus married filing separate liability) is clearly an important factor to weigh in making the decision, but it is just one of several factors that must be considered.
Paul R. Tom is an attorney in Tulsa, Okla., who specializes in tax cases.
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