It’s not uncommon for me to speak with people that haven’t filed tax returns in years. In most instances either life gets in the way and the person neglects to file one year of returns (which turns into multiple years), or a person knows their tax return will generate a balance owing that they can’t pay, and so they don’t file the return in order to try and buy some time to catch up financially. When things don’t turn around financially, additional returns go unfiled, creating a not only a larger deficit, but a spiral of fear and uncertainty. While it’s almost always better file your return even if you can’t pay the balance owing, know that years of unfiled returns is not an unsolvable problem, though it is a problem that’s unlikely to go away on its own, and will likely only become more difficult and expensive to rectify the longer it goes unaddressed. Fortunately, by following some basic guidelines to resolve years of unfiled tax returns, you can minimize the headache and financial burden involved in coming back into compliance.
How many years of unfiled returns am I required to file to get back into compliance with the IRS?
Before the IRS will entertain a collection alternative to resolve delinquent balances, you must demonstrate to them that you’ve filed all required tax returns and are caught up with your current-year withholding or estimated tax obligations. Fortunately, the IRS has recognized that requiring any and all unfiled returns back to the beginning of time would be a practical impossibility for many taxpayers with years of unfiled returns and would only serve to frustrate the IRS’s goal of equitably and efficiently administering the tax code while maximizing its collection returns for the U.S. Treasury.
IRS Policy Statement 5-133, outlines the IRS’s official policy on how they enforce the filing compliance requirements. Though the IRS requests that a taxpayer file all delinquent returns, “the extent to which compliance for prior years will be enforced will be determined by reference to factors… [including but not limited to]: prior history of non-compliance, existence of income from illegal sources, effect upon voluntary compliance, anticipated revenue, and collectibility, in relation to the time and effort required to determine tax due… Normally, application of the above criteria will result in enforcement of delinquency procedures for not more than six (6) years.
In nearly all instances, this means that in order to get back into “filing compliance” with the IRS, you are only required to file your last 6 years of unfiled returns. Understanding the compliance requirements can be leveraged to your advantage; if the oldest return is likely to generate a substantial tax liability, it may be beneficial to wait until that return falls outside of the 6 year compliance window before getting back into filing compliance and attempting to resolve your outstanding liabilities -- though bear in mind, your legal obligation to file tax returns is not governed by the IRS’s 6 year compliance guidelines, the IRS has the discretion to require returns to be filed outside of this 6 year window, and the IRS can generate a Substitute For Return for any given tax year for which an original return remains unfiled, regardless of its age (furthermore, many states will require returns older than 6 years be filed, so you may need prepare delinquent state returns that fall outside of this 6 year window).
Obtain and review IRS Account Transcripts and Wage and Income Transcripts before preparing or submitting delinquent returns:
Prior to preparing or filing delinquent returns to come back into compliance with the IRS, it is always best practice to obtain and review transcript data maintained by the IRS on your account. First and foremost, you want to verify that the IRS has not created a Substitute For Return (SFR) for any of the tax years that are unfiled. While an SFR can be replaced by an originally filed return, this means that there is an assessment currently pending against you, so you may be under the threat of enforced collection action until the remaining outstanding returns are filed. Furthermore, if there is an SFR on file that is outside of the 6-year filing requirements, it may be beneficial to file an original return to replace it. Chances are, the time period for claiming a refund of any tax withheld towards that tax year has expired, but if the SFR has generated a balance, filing an original return to replace it can reduce or even eliminate the tax owing for that year.
Furthermore, it is helpful to get a full accounting of the wage and income transcripts on file with the IRS for each of the years that remains unfiled. Even if you’re meticulous about compiling and storing your tax reporting information sent to you each year, items can still slip through the cracks, and when you’re undertaking the preparation of numerous returns dating back a number of years, it’s helpful to cross reference the documentation you have on hand with IRS records, not only to verify that all items of income are accurately reported, but also to ensure that available deductions, such as mortgage interest and tuition payments, are properly reflected on the returns being prepared.
Taxpayers can obtain their own transcripts via the IRS.gov “Get Transcript” tool, though the pertinent information will be scattered across multiple transcript types for each tax year in question. Wage and Income transcripts are generally available for the current tax year and 9 preceding tax years. Account transcripts are often still accessible dating back to the early 1990s. For the uninitiated, combing through piles of IRS transcripts to make sense of the data contained therein can be a daunting undertaking. Alternatively, once a third-party representative’s authorization has been processed by the IRS, that representative can obtain tax transcripts on a client’s behalf. At O’Connor & Lyon, we utilize advanced software that allows us to quickly obtain all available transcripts under a taxpayer’s account and collate the information into a single, easily digestible report. We can then review the report with you, explain where you stand, and offer tailored advice on how to best resolve any apparent issues.
Note that one potentially critical piece of information that you cannot glean from the IRS transcripts is state income tax withholding information, as the IRS does not track state withholding information recorded on income reporting forms such as W-2s. If you no longer have original copies of the relevant income reporting documents, there are a few options to pursue to try and track down that information. The first option is to reach out to the relevant state revenue agency to request a breakdown of withholding information they have on your account. However, the availability of withholding information from state revenue agencies varies from state to state. If you cannot obtain withholding information from the state revenue agency, the next best option is to try and reach out to the relevant employer or financial institution to see if they still have withholding information available. In the absence of available state withholding information, you should still prepare the necessary state income tax returns using all available information; if you file IRS returns and neglect to file the concomitant state returns, chances are the state in question will prepare substitute returns when notified by the IRS that original returns have been filed for those years, sometimes accompanied by penalty assessments that can be avoided if the returns are filed proactively. It’s better to file the state returns without withholding information entered than to not file at all; I’ve seen instances where state revenue agencies have corrected income tax returns filed reporting no withholdings to account for withholding information they had on file, even after the state indicated such information wasn’t available upon request.
Filing the Returns:
Once the returns have been prepared, it’s helpful to do an analysis of the forthcoming tax, penalty, and interest assessments in order to evaluate your options for resolving the tax liabilities so that work can get underway assembling the necessary paperwork to pursue a given resolution while waiting for the returns to get processed. The time that it takes for the IRS to process returns can be highly variable; in most instances, the IRS will process the more recent tax returns first, while the older returns can take considerably longer to process. Original returns filed to replace SFRs can often take many months for the IRS to process.
Unless the balances generated are small enough that they can be paid in full without requiring a collection alternative, such as an installment agreement or Offer in Compromise, my general recommendation is to avoid sending in any payments with the returns until after the returns have been processed and bills issued, in order to avoid any unanticipated surprises or payment application issues. If payments are to be made, it generally makes the most sense to designate any payments towards the newest tax periods first. As failure-to-pay penalties are calculated and assessed back to the original due date of the return and max out at 25% of the tax owing, depending on the age of the returns being filed, the failure-to-pay penalty may have already maxed out (or be close to maxing out) on the older returns. Once the failure-to-pay penalty has maxed out on a particular year, the costs associated with carrying that balance are reduced considerably.
For a myriad of reasons, before using available funds to pay off the IRS balances, consideration should be given to prioritizing the repayment of any state income tax balances generated by filing the delinquent returns. Many states have far more stringent repayment requirements than those afforded by the IRS, and many are likely to require a more aggressive repayment plan than the IRS might offer on the federal balance of tax owing. Using available funds to either pay off, settle, or enter into an installment agreement with your state revenue agency can put you in a better position to negotiate a more favorable resolution with the IRS. In most instances the IRS will allow at least a portion of your monthly installment payment to the state revenue agency as an allowable expense in determining your ability to repay your federal debt. Furthermore, if you’re in a position to submit an Offer in Compromise with the IRS, the IRS will generally increase the minimum acceptable Offer amount dollar-for-dollar with any liquid funds you may have available. By using these funds to first settle your state tax obligations prior to submitting an Offer in Compromise to the IRS, you can reduce the amount necessary to settle your IRS tax obligation, making your money go further.
If you’re dealing with years of unfiled tax returns and are hesitant to move forward for fear of opening a can of worms, please reach out to us. We can discreetly obtain and review your IRS transcripts with you to determine how best to proceed. We can handle preparing the returns on your behalf and navigating the processing, resolution, and payment of the resulting liabilities on your behalf. When dealing with unfiled returns, oftentimes the hardest part is taking the first step. At O’Connor and Lyon, our goal is to do all the heavy lifting and give you the peace of mind that comes along with knowing your tax matters are in capable hands and will be handled expeditiously. Give us a call today so we can discuss your situation and how we can help you get your tax affairs in order.