Bill Harris, CFP®, is a co-founder and principal of WH Cornerstone Investments. He is a member of the board of directors for FPA of Massachusetts and a co-host of the FPA Tax Planning and Tax Strategies Knowledge Circle. Follow him on Twitter @whcornerstone or @billmharris.
Tuesday, January 20, 2009 is a day I will never forget. Although many people will remember it as Barack Obama’s first day as president of the United States, I’ll remember it as witnessing one of the most bizarre tax situations I have ever come across in my 14 years practicing as a CFP® professional.
On that cold January morning, a middle-aged prospect entered my office with a shoebox full of her financial paperwork. We sorted through the mess and conversed about her goals.
I asked her, “Where are your tax returns?”
“I have not filed in years,” she said. Surprised, I continued to probe, “Are you a citizen of the United States?”
“I am,” she said proudly.
“Why haven’t you filed your taxes?” I asked. Then she stated, “George Bush was not my president. I refused to pay. My guy is now in! I’m now ready to start filing again. What do we do next?”
I kindly advised the prospect that she needed to go see a CPA to help her with this problem. This was above my pay grade.
We often hear more about high-profile tax dodgers rather than the average citizen. Tax evaders often face large criminal penalties, including fines and imprisonment, as well as civil penalties. Filing taxes isn’t voluntary, despite what tax evaders argue. Take the actor Wesley Snipes for example. He claimed the IRS had no right to tax him. Even though he was born in the United States, Snipes claimed he was a nonresident alien. He claimed the U.S. government had no jurisdiction over him.
Snipes decided not to file his taxes for five years, and thus, he refused to pay taxes on millions of dollars of income. He also filed fraudulent forms in an attempt to recover millions he paid to the IRS in previous years. He’s lucky he only got three years in prison; he was facing 16 years.
While this may be an extreme case, non-compliance happens. Approximately seven million U.S. taxpayers fail to file income tax returns each year, that’s about 5 percent of the populace required to file, according to the IRS’ National Research Program study from 2011.
Be prepared for clients who miss a tax filing. Just explaining the consequences to them may save their financial plans from ruin. One of the largest IRS penalties in the tax code is for filing a return late. The failure-to-file (FTF) penalty, in its present form, predates the IRS code of 1939. The tax statutes were re-codified by an act of Congress on February 10, 1939, known as the “Internal Revenue Code.” In 1969, Congress added an additional penalty for failure-to-pay, or FTP.
Failure to File
The typical failure-to-file penalty, when no fraud or negligence is involved, is 5 percent per month on the total tax liability that is owed. The penalty will begin to accrue on the day after the due date if the tax return was not filed. This penalty cannot exceed 25 percent of the tax liability, so if the taxes remain unfiled for five months or more, the penalty will be 25 percent of the original tax amount owed. If you file your return more than 60 days after the due date or extended due date, the minimum penalty is the smaller of $135, or 100 percent of the unpaid tax.
Not filing is not the same thing as not paying. The IRS penalizes for both not filing and not paying. If you fail to pay your net liability due by April 15, a penalty of 0.5 percent will be added to the tax due for each month with the total penalty once again capped at 25 percent, even if you file an extension. The IRS also charges interest on any outstanding tax balance. The misunderstood aspect of the failure-to-pay penalty is that relief can be found in the form of an extension. An extension only defers the period of time you have to file the return, not to pay the underlying tax liability.
Establishing Reasonable Cause
So what do you advise your clients who may not have the money to pay their taxes? File anyway. The failure-to-file penalty is 10 times higher than the failure-to-pay penalty. The IRS has “reasonable cause” exceptions to these penalties. The failure-to-file penalty will not apply if the failure to file a tax return is due to reasonable cause and not willful neglect. The burden of proof, however, is on the taxpayer. When deciding if the taxpayer had reasonable cause, the IRS will take into consideration the taxpayer’s compliance history for payment patterns and the taxpayer’s overall compliance history. The IRS will also consider whether the taxpayer could have anticipated the event that caused the noncompliance.
The IRS provides guidance regarding establishing reasonable cause in various circumstances, including:
- Death or serious illness of the taxpayer or a member of his or her immediate family
- Fire, casualty, natural disaster, or other disturbance
- Inability to obtain necessary records
- Reliance on the substantive advice of a qualified tax adviser
- Erroneous oral or written advice from the IRS
If you come across a client with these issues, act promptly. Make sure clients file tax returns on time and pay as much as they can, then explore other payment options. Regardless of public opinion, the IRS will work with taxpayers. The IRS has programs for collecting payments. A monthly payment through an installment agreement is one option. The IRS can also grant a temporary delay on the collection of a taxpayer’s bill.
And the IRS has an offer-in-compromise program. To qualify for an offer-in-compromise, the IRS will settle unpaid tax accounts for less than the full amount of the balance due. (Note that a $150 application fee is charged when applying for an offer-in-compromise, and an offer-in-compromise is only considered after all other collection alternatives have been explored.)
Advise your clients to not ignore warning letters. After sending multiple correspondences regarding unpaid tax bills, the IRS will send a representative to your client’s residence or business to collect payment, especially if they owe $25,000 or more. Continuing to avoid this responsibility can result in automatic wage garnishments for your clients. Asset seizures, such as those on bank accounts, can ruin the best of plans. While jail time for tax evasion may be extreme, not filing taxes is a deal killer on all plans. Avoid this peril at all costs.
As we head into another presidential election season, tax policy will be high on voters’ minds. Regardless of who wins the election, encourage clients to file timely.