Back Tax Returns (< 2019)
Individual tax returns (Form 1040) are due April 15th and there are consequences if you do not file on time. If you owe money, there will be penalties and interest assessed on the tax balance. Conversely, if you are due a refund greater than 3 years old, you likely will not be able to claim it. There are many reasons taxpayers fall behind on overdue tax returns. It starts with one year, then another and then snowballs to several years before long. Taxpayers become hesitant to stay in compliance for future years because they are overwhelmed with missing the tax filing deadline for the prior year and are unsure on what to do.
Common reasons for late filed tax returns include health reasons, unavailable records or not having the money to pay taxes. Based on my experience, taxpayers usually come forward to address their back tax situation for these reasons: receiving contact from the IRS via an inquiry letter or actual in person visit; they are getting married; they are applying for a home mortgage; applying for a job, or are seeking an upgrade in their immigration status.
Consequences of Not Filing:
The penalties for not filing are 5% per month for the first 5 months for a total of 25% of the balance due on Form 1040. This is the most striking penalty that can really add up quickly. Each day counts, so if you are in this monthly window, you should file as soon as possible. After the fifth month, the penalty continues at ½ percent per month until it reaches another 25% of the balance due. These penalties are in addition to the variable interest rate that is tacked on, which hovers around 5% per year. Additionally, each state assesses penalties in a similar fashion. As you can see, the financial penalties for non-compliance are very severe. Accordingly, taxpayers should always file on time or request an Extension to time to File (via Form 2848), even if they do not have the money to pay.
Another consequence of non-filing is that the IRS may assess taxes in a process called Substitute for Return. The IRS calculates your taxes based on third party income information it has received without regard to any deductions, credits or adjustments. Accordingly, this process serves to vastly overstate your taxes and often serves as a wake-up call notice to the taxpayer who receives the figures my mail. The situation usually can be corrected by filing the actual tax return which will serve to adjust the balance on the notice.
Consult a Tax Advisor:
Taxpayers who need to file delinquent tax returns should always consult a tax professional. For starters, Turbo Tax does not support prior year filings, despite the IRS allowing electronic filing of tax returns for the last 3 years. Electronic filing is definitely the way to go for the speed and ease of processing back taxes. A good tax pro will also order your tax wage and income transcripts and cross reference them with your source documents to make sure all income is being captured. This is useful because as many years have passed, all the taxpayer W-2s and 1099s may not be readily available or have been misplaced. Also, the tax advisor will confirm with the IRS which years the IRS is looking for outstanding tax returns, which may be different or lesser than what is actually outstanding. A good tax professional will also evaluate whether a state tax amnesty program might apply to address late filing of state tax returns.
The IRS imposes penalties to encourage compliance. However, penalties for non-filing are subject to abatement for reasonable cause. Reasonable cause exists where the taxpayer, acting as a prudent person and exercising ordinary business care, was unable to file taxes within the prescribed time for circumstances beyond your control. Reasonable cause is based on all the facts and circumstances and will include an evaluation of your prior compliance history and length of time taken for corrective action. The strongest situation that gives rise to reasonable cause for abatement is death or serious illness (incapacitation) of the taxpayer or an immediate family member. Other secondary supporting situations that may help to reduce penalties include unavailability of records, reliance on erroneous advice, mistake, ignorance of law and forgetfulness. If you can show a combination of these situations, requesting penalty abatement is usually worth a shot and the taxpayer does not even have to pay the penalty first to make the request.
After all overdue tax returns have been filed, taxes assessed, and penalties evaluated for forgiveness, your tax advisor will help set up a monthly payment plan or other collection alternative for the balance owed, so you can get back on track.
