Working with Nonfilers – Strategies to Avoid Prosecution

Working with Nonfilers - Strategies to Avoid Prosecution

By Deborah J. Weber

Where to begin with the non-filer:

Non-filers generally come in two different categories: worried, distraught and ready to come forward; or arrogant, stubborn and needing to be convinced. For the worried, distraught individual, very little convincing is necessary to have the client come forward to the IRS. However, for the arrogant and/or stubborn individual, a little more work is necessary. If your client is the later, here are a few reasons to present to your client that may persuade him to come forward.

  1. The IRS will eventually find the client anyway:Generally, when a taxpayer has failed to file returns for a number of years, it is only a matter of time before the IRS catches up to him. There are several ways in which this can happen, but most notably the reporting requirements of all kinds of financial transactions allows the Service to track and locate taxpayers. Some of the forms and filings that may lead the IRS to your client are W-2 information; 1099 information: reporting of cash transaction of $10,000 or greater; and informants. Ex-spouses and ex-employees are also a great source of information to the IRS.
  2. Living underground has many problems and limitations:If your client has not filed returns in several years he may have entered the world of the “underground” economy. However, there are many problems that exist for the cash only lifestyle. For example, if your client needs credit to make a major purchase, such as a house or a car he will be unable to get it because he has no reported income to prove his ability to repay. He may be held back in his career and be unable to take a better job for better wages because he will surface. Finally, his ability to claim many benefits such as Social Security, Unemployment or Worker’s Compensation are seriously diminished because he has no wages on which these benefits can be based.
  3. If the IRS owes the client money, the client must claim it in a limited period of time:The client may think that if money is owed, it is offset by a prior years withholding. This may be true, but what the client often does not realize is that the offset is not automatic. The client must file the return to claim the refund of money in any given year. Generally, a taxpayer must file a claim for refund within the later of 3 years of the due date of the return or two years from the date the tax is paid. Withholdings on wages are considered paid on April 15th of the year following the year in which wages are earned. As such, the client will have no more than 3 years from the due date of a return to claim a refund of the overpayment made to the government through the clients withholdings.To illustrate the above, provide your client with this example. Taxpayer has not filed returns for the last 5 years, 1998-2002. Taxpayer was a W2 wage earner in 1998 and 1999 but did not file because he was going through a bad divorce and he knew he overpaid any tax due through his withholdings. Then the taxpayer starts his own business in 2000 and has done well with that business to the present. The taxpayer has not filed for the last three years (2000, 2001, 2002) because he has been so busy with the new business and he believes he is ok because he knows he overpaid his tax through withholding in 1998 and 1999. Unfortunately for the taxpayer, the 1998 return was due 4-15-99. As such, the taxpayer had until 4-15-02 to file the return and claim the refund. The 1999 return was due 4-15-00. As such, the taxpayer had until 4-15-03 to file the return and claim the refund. The end result is that the client will forfeit the refunds for 1998 and 1999 but will still owe the full amount, plus interest and penalties, for tax years 2000, 2001 and 2002.

What Can the IRS Do?

The IRS has many ways to obtain information about a taxpayer. If a taxpayer does not voluntarily come forward, when the IRS eventually locates him, it will proceed against the taxpayer either civilly or criminally.

Once the Service determines that a taxpayer may have a filing obligation, if the IRS intends to initially proceed with a civil case, the Service will generally contact the taxpayer and request the return. If the taxpayer does not produce the return or explain why no return is due, the IRS will proceed to prepare a substitute return for the taxpayer based on the information it has or will obtain from third parties. The IRS can use its summons power to obtain a wealth of information about a taxpayer, including but not limited to bank statements, credit card and investment statements.

Once the return is prepared by the Service, it will then ask the taxpayer to sign the return. If the taxpayer signs the substitute return, then the return is treated as a return for all purposes, including the statute of limitations. If the taxpayer fails to sign a substitute return, but agrees to an examination report that incorporates the substitute for return, the Form 870 Agreement is treated as if the taxpayer signed the return.

However, if the taxpayer refuses to sign the substitute return, and if the taxpayer refuses to sign a Form 870 Agreement which incorporates the substitute return, the 6020(b) return is treated as prima facie, good and sufficient for all legal purposes. Nevertheless, prior to assessment of a tax shown on a substitute return, the IRS must issue a Notice of Deficiency (or 90 Day Letter) because the taxpayer has not agreed to the tax shown on the return. The normal procedures for a Notice of Deficiency must be followed and the taxpayer will have 90 days to petition the United States Tax Court, if he disagrees with the amount of tax in the Notice of Deficiency.

If a taxpayer refuses to become active in the process at any point in time, the tax will eventually be assessed and a liability created. Technically, the taxpayer’s only recourse is to pay the tax and make a claim for refund. In reality, other options may exist that are beyond the scope of this article. However, the other options are often costly and there can be no guarantee of success in raising issues so late in the process. Additionally, after assessment, the IRS can begin active collection against the taxpayer and these options may not be successful in delaying collection.

Civil Penalties

The two most frequently assessed penalties related to late filing are the failure to file and failure to pay penalties under IRC §6651. Failure to file penalty under IRC §6651(a)(1) provides that in the case of a failure to file any return by its due date, in addition to the tax, a penalty of 5% per month to a maximum of 25% can also be assessed. Failure to pay penalty under IRC §6651(a)(2) provides that in the case of a failure to pay the amount shown as tax on any return by its due date, in addition to the tax, a penalty of half of 1% per month to a maximum of 25% can also be assessed.

In addition to the failure to file and failure to pay, the taxpayer could be assessed a penalty for fraudulent failure to file under IRC §6651(f). Fraudulent failure to file penalty under IRC §6651(f) provides that in any case where a failure to file any return is fraudulent, in addition to the tax, a penalty of a penalty of 15% per month to a maximum of 75% can also be assessed.

The IRS has the burden of proving fraud by clear and convincing evidence. However, fraudulent intent may be established by circumstantial evidence and reasonable inferences drawn from the record. These “badges of fraud” include: (1) Understating income, (2) maintaining inadequate records, (3) failing to file tax returns, (4) giving implausible or inconsistent explanations of behavior, (5) concealing assets, (6) failing to cooperate with tax authorities, (7) engaging in illegal activities, (8) attempting to conceal illegal activities, (9) dealing in cash, and (10) failing to make estimated tax payments. IRC §6651(f) is not to be confused with the Civil Fraud Penalty under IRC §6663. IRC §6651(f) applies in the case of fraudulent failure to file a return. IRC §6663 applies in the case of a fraudulent filed return.
Criminal Sanctions and Penalties

A tax evasion charge under IRC §7201 is the most frequently charged tax crime. Tax evasion is a felony defined as the willful attempt to evade or defeat any tax imposed by Title 26. The elements are: the existence of a tax deficiency; an affirmative act constituting an evasion or attempted evasion; and willfulness. Willfulness is the voluntary and intentional violation of a known legal duty. The same standard of willfulness applies to all criminal offenses under the Code.

Proof of willfulness is often circumstantial. “Badges” of willfulness include, but are not limited to: failure to report a substantial amount of income; pattern of underreporting; dealing in cash that does not reconcile to income reported on the return; keeping false books; concealment of assets or income; structuring of activities that avoid the usual transactional records; destruction of records; and or any act likely to conceal or mislead.

A good faith misunderstanding of the law, even if objectively unreasonable, is always a defense to the element of willfulness because it negates the required specific intent. However, the Supreme Court in Cheek v. US, 111 S. Ct. 604 (1991) clarified that although the defendant’s good faith belief must be evaluated on a subjective, rather than objective, basis of reasonableness, a defendant’s claim that he or she in good faith believed that the tax laws did not apply to him or her because said laws are unconstitutional is not an appropriate defense. Such a conclusion reveals full knowledge of the existence of the law and a conclusion (however wrong it may be) that the laws do not apply to him or her.

If convicted, the defendant may be fined, imprisoned, or both. Currently the fine is no more than $250,000 for individuals or $500,000 for corporations and imprisonment can not exceed 5 years. A taxpayer may also have to pay the costs of prosecution and other special assessments. The statute of limitations is 6 years under IRC §6531. However, IRC §6531 includes a tolling provision where the offender is outside of the US or a fugitive from justice.

A lesser criminal charge is willful failure to file a return under IRC §7203. To obtain a conviction under IRC 7203, the government must establish willfulness and the omission of at least one of the following duties: payment of any tax or estimated tax as required by the Code; preparation and filing of a return as required under the Code; maintenance of records required to be kept under the Code; or failure to supply of any information required to be supplied under the Code. Willfulness requires the government to establish beyond a reasonable doubt that the defendant deliberately and intentionally failed to file a return (or perform any of the other above detailed legal duties) with knowledge that he or she was required to do so by law.

A charge under IRC §7203 is often a lesser included offense of a charge under IRC §7201. Additionally, a case that begins as an IRC §7203 can be upgraded to an evasion case under IRC §7201 with the commission of one affirmative act. IRC §7203 is often used to prosecute tax protesters who fail to file return based on constitutional grounds.

Willful failure to file is a misdemeanor punishable by imprisonment of not more than one year, a fine or both. Currently the maximum fines is $100,000 for individuals and $200,000 for corporations. The defendant may also be made to pay the costs of his or her prosecution. The Statute of limitations is 6 years under IRC §6531.

What to do with the non-filer: Bringing the Client back into the System

Disclosure of the Non-filing:

The first step to bring the client back into the system is to disclose the non-filing to the IRS. To do this, with the client’s permission, contact the IRS and disclose the non-filer. Be ready to give some background regarding the reason for the non-filing, ex. marital problems, divorce, drinking, drugs, death of spouse or family member, etc. During this initial disclosure you can also request all income data on file with the IRS for all years in issue. Finally, set a date by which all returns will be filed or a schedule for filing returns in phases, if numerous years are involved. Make sure you memorialize the disclosure with a follow-up letter that reiterates that the contact was voluntary, the reason for the non-filing, and the date(s) by which all returns will be filed.

Reconstruct the Income

There are many sources of information that can be used to reconstruct a taxpayer’s income in past years. Obviously, if the taxpayer has maintained accurate books and records that information and documentation can be used to reconstruct the income. However, if the taxpayer has not maintained adequate records (which is often the case), several sources of information can be used to reconstruct the taxpayer’s income, including but not limited to: payer information obtained from the IRS; bank statements; information obtained from prior employers; information obtained from credit card companies, brokerage houses, etc.

Prepare the Returns

If the taxpayer’s returns are simple, the client may wish to prepare the outstanding returns himself to save money. If the returns are more complex or if the taxpayer does not want to prepare the returns, the attorney should assist the client in retaining the services of an accountant or return preparer.

During the return preparation process, many clients get hung up on deductions. It is important that the attorney not allow the deduction issue to derail the compliance train. Often the deductions are not relevant or should be secondary to the central focus of keeping the case on a civil rather than criminal basis. As to the first matter, if the client cannot afford to pay even an estimate of the tax due, focus on preparing the return and accurately reporting the income. The client who intends to file an offer-in-compromise or bankruptcy can be less worried about the deductions. As to the second matter, if the client has real criminal exposure, due to numerous years of non-filing or affirmative acts of evasion, focus on accurately reporting income. Returns can later be amended to claim deductions.
File the Returns

The IRS has a section that deals with non-filers. The Practitioner should attempt to develop a relationship with an individual who works with Non-Filers in her Territory. All contact and filing should then go through this person. If returns are filed in person, copies of the returns should accompany the originals. The Practitioner should request that the returns are stamped in her presence and should request that copies be stamped as proof of filing. If returns are mailed to the IRS, they can be addressed: Attention: Non-filer Section and should always be mailed Certified Mail, Return Receipt Requested. A letter reiterating the voluntary nature of the filing should accompany the returns whether filed in person or by mail. If no payment is being made with the filing, intent regarding payment can also be addressed.

Conclusion

Congratulations, the client is back in compliance (and not in jail). After all returns have been filed and the taxes assessed, the taxpayer may be in collection. There are various approaches and strategies that can be used to assist the client in resolving outstanding tax liabilities such as an offer in compromise, installment payment agreement or bankruptcy. A complete discussion of these strategies are outside of the scope of this article. However, since one very important strategy for dealing with a collection case for a non-filer is a Chapter 13 bankruptcy (where non-filing may exempt the taxes from priority status while still allowing for discharge), it is very important that the practitioner discuss collection strategies with the client before filing the outstanding returns. This is necessary because filing the returns will affect the immediate use of this option. As such, a Practitioner who is advising a client in this area is strongly urged to develop a plan for resolving the outstanding liabilities even before the returns are filed. By developing the collection strategy before filing the returns, the Practitioner provides the client with the maximum amount of options for resolving the tax liabilities.