Tax filing time is upon us again. But some taxpayers are in a tough spot. They may not have filed for prior years and are afraid that, if they do so now, their prior failure to file will come to light and lead to serious consequences, including criminal prosecution. This is known as the “snowball effect”, where one failure to file leads to another resembling a snowball rolling down a hill and getting bigger and bigger as each year goes by.
The consequences of not filing your tax return can be both criminal and civil. On the criminal side, if the failure is “willful”, meaning you knew you had a duty to file but chose not to, the government could charge a violation of 26 U.S.C. 7301, punishable by up to 1 year in prison and a $25,000 fine for each year. In more elaborate circumstances, the government has also charged a felony violation under 26 U.S.C. 7201, the evasion statute, citing the failure to file as the method of evasion. This crime is punishable by up to 5 years in prison and a $100,000 fine for each year involved.
In the past 4 years, the IRS initiated 977 criminal investigations of non-filers. Of these, the IRS recommended prosecution in 712 cases. Over 751 (not all cases are completed in the same year) were convicted and sentenced. Of these, approximately 83.2 percent received prison time with an average incarceration sentence of 39.7 months (there is usually more than 1 year involved).
So how does the IRS discover non-filers? The IRS has computer programs that match information returns (1099s; W-2s; etc.) to filed returns. If there is no match because the taxpayer didn’t file, an investigation is initiated. Another computer program, called the “Stopfiler” program, which identifies those who have filed a return in the past and then stopped filing, which also results in an investigation. Add to this informants, undercover operations of return preparers and tax protest leaders. The list of informants runs the gamut of whistleblowers, motivated by hopes of an award, to disgruntled ex-employees (especially book keepers), ex-spouses, scorned lovers, jealous neighbors and business partners. Often, an audit of someone or something else can lead to you as the other party may reflect payments to you and the IRS contacts you to confirm you received the payment. With the recent enactment of the Foreign Account Tax Compliance Act (FACTA), the IRS is now receiving information from foreign banks about their American customers, thus eliminating the former secrecy of those overseas accounts.
On the civil side, there can be other serious consequences. If you are convicted of a tax crime, there is a 75 per cent of the tax penalty. Accordingly, if you would have owed $100 in tax, now you owe $175. There are other civil penalties including a failure to file penalty that caps out at 25 percent of the tax owed. There is another failure to file penalty, called the fraudulent failure to file, which is a civil penalty but higher than the “normal” late filing penalty. It is 75 per cent of the tax due.
Another dangerous possibility is that the IRS can and does prepare what are known as 6020(B) returns or substitute for returns. They take the information received from third party payers, such as 1099s and W-2s and prepare a return for the taxpayer. Only the standard deduction and 1 exemption is used in computing the tax. This is then sent out to the last address of record of the taxpayer and, if he doesn’t respond, they assess that amount of tax against him. This is usually a much higher tax than that the taxpayer would have computed had he filed. While the IRS may reduce this assessment when returns are filed later, several courts have said it doesn’t have to do so.
So, what to do? The obvious answer is to file the returns. But there are a lot of considerations in doing so. Is the taxpayer already under investigation? Is any of his income from unlawful activities? Is any of it from off-shore entities or bank accounts? How much does he owe? What is his compliance history? Is he or a related entity under audit? The taxpayer needs to consult and retain an attorney who has experience in this area. While some accountants try to resolve these issues on their own, they do so at their and the taxpayer’s peril. This is because there is no accountant privilege in the Federal tax system in criminal cases. Accordingly, should a criminal investigation exist or arise while the accountant is working on the matter, everything a taxpayer tells that accountant must be disclosed by the accountant if he is interviewed pursuant to an IRS subpoena or a Grand Jury subpoena. Further, if such an investigation arises, the returns themselves may be exhibit “A” in the case. However, if an attorney, who has been retained by a taxpayer, in turn retains an accountant, the attorney/client work product privilege then extends to the accountant, thus preventing disclosure by the accountant without the taxpayer’s consent. This is pursuant to a case called KOVEL. Hence, the appellation, “Kovel accountant”. Further, there are considerations as to whether the filing of delinquent returns should be done by “quiet” disclosure or formal disclosure pursuant to the IRS voluntary disclosure policies for domestic and foreign disclosure.
The goal is to get the taxpayer into compliance while limiting the potential that he may be prosecuted. Understanding how the IRS deals with these types of cases is critical to accomplishing the desired result.