For my own tax practice, I get lots of requests to help out with unfiled tax returns — and this should not really be a surprise. The consequences can be severe for noncompliance.
Keep in mind that the failure-to-file penalty comes to 5% per month of the unpaid tax bill for a maximum of 25% (when you have an unfiled tax return, the IRS will send out letters, which have an assortment of code numbers like CP515, CP516, CP518 and CP515B). But there may also be penalties for not paying the tax. Oh, and more importantly, there is even the potential for criminal sanctions! The fine is up to $25,000 per year and the time in the slammer is as long as one year for each year you have an unfiled tax return.
Of course, there are various reasons for not filing. For example, one is where your business loses money. Hey, why go through the filing process when there is no taxes owed, right?
Well, you should still file. The reason is that you can apply your losses to future years — or prior years — when you make profits, which can help lower your tax bite. Something else: if you have lean years – which is certainly common for new businesses – then you may be eligible for certain tax credits that can put money in your pockets, like the Earned Income Tax Credit.
The irony is that you may have been entitled to refunds anyway. However, according to the rules, you can only go back for three tax years. In other words, you could potentially miss out on getting back money that you were entitled to.
No doubt, another situation regarding an unfiled tax return is when you owe money but somehow think the IRS will not figure this out. Granted, the agency can be glacially slow but it does eventually take action (this is often done by using sophisticated computer systems that match up filings, such as with forms like 1099’s). The IRS is particularly concerned with unfiled tax returns because the US tax system is based on the concept of voluntary reporting of income and deductions.
Now if you do receive a notice, it’s critical to be proactive. The IRS may not only seize your assets but even put together a tax return on your behalf – called a Substitute For Return or SFR — that provides no advantages (you will get a measly one exemption as well as no deductions for your business). If you owe more than $25,000, you’ll also probably get a visit from a revenue officer.
All in all, it’s advisable to avoid the situation from getting to this point. Instead, the best approach is to file your returns before you get contacted by the IRS. Yet this does not necessarily mean you’ll expose yourself to criminal liability. The IRS policy is to encourage cooperation (criminal actions are very rare anyway and usually involve activities that go well beyond your taxes, such as a major fraud scheme).
Although, it can certainly be tough to put together unfiled tax returns. You’ll need to find the right forms as well as get the necessary documentation about your income and deductions, such as with bank statements. Because of the complexities, the recommended approach is to get the help of a qualified tax professional, like a tax attorney, CPA or Enrolled Agent. Such a person will not only help with the process – which can involve plenty of paperwork and managing through the IRS bureaucracy — but also find ways to deal with paying for your tax debt and perhaps even eliminating the penalties.