The Treasury Inspector General for Tax Administration reported in May 2020 that the IRS knew the identities of more than 10 million non-filers, many of whom are considered high-income earners, and that it should be doing more to pursue them. The IRS has responded with more aggressive enforcement against non-filers, including filing an automated substitute for tax return against many of these taxpayers using third party information, such as1099s or a W-2.
When the IRS does not have this information, it will pursue those clients with in-person exams. Further, given the identification of the continuing concern regarding lack of enforcement against high-income individuals, the IRS is now taking a more direct approach to compliance, using revenue officers to visit and collect the information to assess the tax.
If you are one of those non-filers, how best do you get back into the tax system and avoid anything particularly nasty, like a criminal referral? Should you just file the income tax returns and, if so, how many years do you have to submit? Is it a better option to file a request to come in through the IRS’s voluntary disclosure program?
It all depends on why you haven’t filed and how you’ve been making your money.
According to the IRS Policy Statement 5-133, a taxpayer must have at least the last six years of tax returns filed with the service to be considered in compliance. For taxpayers today, this would mean filing 2015–2020 returns and ensuring 2021 is on extension. Alternatively, filed returns for 2016–2021 would be sufficient for a taxpayer to be in tax compliance. Each state has its own rules, which may be different than the IRS’ rule.
Should one adhere to the voluntary disclosure program or just file the missing returns? If the taxpayer can prepare accurate returns, and their failure to file was not intended to defraud the government, then simply filing them with the service is usually the best and cheapest option. But there are certain taxpayers who either may not have records or who, by their actions, may not be able to comply with filing an accurate return. For these taxpayers, the IRS’ voluntary disclosure program is typically the best option available.
By making a voluntary disclosure, the taxpayer is coming to the IRS and, based on providing compliant returns, is assisting in resolving the taxpayers tax issues. Taxpayers may participate in the voluntary disclosure program if their income is derived from legal sources and they are not under IRS audit or investigation, or if they’re under audit or investigation but the disclosure is unrelated to the pending examination.
By seeking a voluntary disclosure, the taxpayer agrees to file accurate returns and correct all other inaccuracies (limited to the last six years), cooperate with the assigned IRS examiner, pay a 75% civil fraud penalty on the largest tax year, and make good-faith efforts to resolve the outstanding balance in full. In exchange, the IRS generally will agree not to refer the taxpayer for criminal prosecution.
The voluntary disclosure program is best suited for a taxpayer who faces criminal exposure or is unable to file an accurate return. These can include actual tax evaders who have failed to properly report their income. It also often includes those who have household or other employees who are off the books and now can’t file proper returns because they don’t have the amounts paid or real Social Security numbers of the people they employed.
The voluntary disclosure program allows for taxpayers to be pre-cleared before providing all of their information to the IRS. The taxpayer is not allowed to make a voluntary disclosure if the IRS already has information about the taxpayer’s non-compliance, and it is impossible for taxpayers to truly know what information the IRS has about them. Submitting Part 1 of the IRS Form 14457 to begin the pre-clearing process is the first step.
While pre-clearance is pending, it is critical for the taxpayer to prepare their books and records and, if possible, the corrected tax returns. Assuming the taxpayer is accepted into voluntary disclosure program, they’ll need to submit Part II of the Form 14457 to the IRS, which includes the specific information of the tax issues and an estimate of the taxes owed. After Part II is reviewed by the IRS, an examiner will be assigned to work with the taxpayer, review their corrected returns and information, and accept the taxpayer’s filing (or not).
A taxpayer who’s considering making a voluntary disclosure must understand the need for complete transparency. Failure to be honest or a lack of cooperation can prompt rejection of the disclosure and may cause the taxpayer to be referred for prosecution.
It is worth noting that most states offer their own voluntary disclosure program, which vary widely in administration. For instance, Massachusetts requires non-residents to file three years of returns, but residents must file seven years of returns. New Jersey requires only four years regardless of residency. Taxpayers and their professionals should consult their state’s program to determine what has to be done and how many years will need to be filed.
Whether preparing and filing accurate tax returns, or by submitting a formal request to come in under the voluntary disclosure program, it is critical for taxpayers to resolve their tax problems. There is a cost in preparing returns and resolving the tax debt, but the downside of being caught by the government may be much worse.
This article does not necessarily reflect the opinion of The Bureau of National Affairs, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.
Eric Green is one of the managing partners of Green & Sklarz LLC, where he focuses his practice on civil and criminal taxpayer representation. He is also the founder of Tax Rep Network, where he coaches accountants and attorneys on building their IRS Representation practices.
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