The IRS estimates that more than 7 million individual taxpayers didn't file a 2010 tax return. The IRS bases this estimate on information statements it received for taxpayers who should have filed but didn't.
That number doesn't include taxpayers who don't receive information statements reporting income, such as small business owners. Add to that the growing number of taxpayers who still need to file returns to continue receiving advance payments of the premium tax credit to pay for their health insurance. In all, there are likely millions more people who need to file back tax returns.
For tax professionals, it can take months to get a nonfiler back into compliance with the IRS. The time and effort it takes depends on the number of returns the client needs to file and how far the IRS has already gone to enforce the late returns. Clients should be reminded that the statute of limitation starts to run only when the return is filed and tax is paid, so the IRS can examine years that would otherwise be closed if the taxpayer hasn't filed a return and paid the tax.
The most common question: How many years back should your client file to be in compliance with the IRS?
The answer lies in a little-known IRS policy statement.
Policy statements form the basis for procedures and instructions on how the IRS will operate programs and activities. IRS Policy Statement 5-133, Delinquent Returns—Enforcement of Filing Requirements, provides a general rule that taxpayers must file six years of back tax returns to be in good standing with the IRS. The policy also states that IRS management would have to approve any deviation from that rule.
Sometimes, IRS managers will require tax returns from even further back than six years, depending on:
- The degree of flagrancy.
- A prior history of noncompliance.
- The impact on future voluntary compliance.
- The existence of income from illegal sources.
- Whether there is minimal or no tax due.
- The IRS's costs to secure the return versus anticipated tax revenue.
The IRS will require more back tax returns in three common situations
Practically, these are the most common reasons the IRS requires returns from more than six years back:
1. There's a large potential liability: The IRS may extend the return requirement if the taxpayer's wage and income information (found on wage and income transcripts) indicates a potentially large tax liability for the older, unfiled years. The most common red flags are Forms 1099-MISC, Miscellaneous Income, property sales, and large wages with no withholding.
2. There are business returns involved: The IRS will closely scrutinize business returns, for several reasons:
- Businesses often have unknown activity with potentially large balances owed.
- Businesses aren't subject to much reporting with information statements.
- The IRS knows that businesses have the largest potential for noncompliance.
3. A revenue officer is on the case: Delinquent-return investigations can involve local field collection personnel (revenue officers), who perform in-depth investigations on nonfiling and collection. Because they often handle business and payroll collection, revenue officers often require more than six years of back tax returns. For most individual cases when taxpayers don't have a revenue officer, the IRS usually accepts the past six years of returns to put clients in good standing with the IRS.
When filing past returns, remember these important points and best practices
Confirm that the IRS is looking for only six years of returns: Call the Practitioner Priority Service (PPS) line to confirm the unfiled years.
The IRS does not pay old refunds: Your client can recoup refunds only for returns filed within three years of the due date of the return. Refunds for prior years are lost and can't offset any balances due.
Transcripts can be helpful in completing back tax returns: It's essential to prepare an accurate return that matches IRS records. With back tax returns, you should trace your client's income history. While you are on the PPS line, request your client's wage and income transcript. Make sure the return reports all items on the transcript. Without this match, the IRS can question the accuracy of your client's return.
If your client made estimated tax payments that can be credited to any balances owed, request your client's account transcripts to verify the amounts your client paid.
There can be hefty penalties on balance-due returns: Years with balances due will have associated penalties:
- Failure-to-file penalty (5% per month, maximum of 25%).
- Failure-to-pay penalty (0.5% per month, maximum of 25%); combined with the failure-to-file penalty, together they can reach a maximum of 47.5%.
- Fraudulent failure-to-file penalties triple the normal failure-to-file penalty—increasing the maximum penalty from 25% to 75%.
Request penalty abatement, if applicable: With most back tax returns, you can request that the IRS not assert applicable failure-to-file or failure-to-pay penalties on balance-due returns. Use first-time abatement for the first year if your client qualifies. Otherwise, consider reasonable-cause arguments for late filing and payment to get your client some relief from penalties.
The IRS may have filed a return for your client: The IRS usually starts this process, called a substitute for return (SFR), about three years after the due date of the return. When your client files a return to replace an SFR, the IRS will closely scrutinize the replacement return and compare it to information statements on file. Because of that scrutiny, it will take the IRS more time than usual to process the replacement return—more than four more months in some cases.
Delinquent returns may need special processing: The IRS may take longer to accept back tax returns. If your client has received a delinquent-return notice or an SFR in the past, filing the return will require special processing. For example, for SFRs, you will need to file the replacement return with the IRS SFR Reconsideration Unit.
If your client owes and can't pay, set up a collection agreement: Remember to get your client into an agreement if he or she can't pay. There are several types of agreements, depending on what your client needs. If your client doesn't establish some type of payment plan with the IRS, a second wave of IRS enforcement, i.e., collection, will follow.
Use an authorization: You will need a signed authorization to request client information by phone, request a stay on enforcement activity, and follow up to ensure the IRS accepts the return. Use Form 2848, Power of Attorney and Declaration of Representative, to request additional time to prepare the return. Or, have your non-Circular 230 staff use Form 8821, Tax Information Authorization, to request information and status updates. Both forms also allow you to get copied on future client notices, which is helpful in monitoring activity on your client's account.
When a new client arrives with a worried face, a bunch of documents, and a request to file back tax returns, be prepared. Generally, the IRS will require up to six years of returns, but sometimes it will require more, especially for potentially large liabilities, business returns, and cases handled by a revenue officer. The essential knowledge outlined in this article will help you bring your clients back into good standing with the IRS.
Jim Buttonow, CPA/CITP, directs tax practice and procedure product development for H&R Block. He has more than 28 years of experience in IRS practice and procedure. To comment on this story, contact Chris Baysden, senior manager, newsletters at the AICPA.