Tuesday, November 11, 2008


It is very important that you file your federal income tax return on time – by the original April 15th deadline or by October 15th if extended – whether or not you can afford to pay all or any of any tax due. There are several reasons.

First of all it is the law.

Second, filing a tax return starts the clock running on the statutory three (3) years that the IRS has to audit the return. The IRS has three (3) years from the due date of a return – again April 15 if filed on time or October 15 if extended – or the date the return was actually filed, whichever is later, to audit the tax return. If you file your return after October 15th the clock does not start until the return is filed.

And perhaps most important, the monthly penalty rate for “filing late” with a balance due is ten times as much as that for “paying late”.

I should point out that if “Sam” owes you money there is absolutely no penalty for filing your Form 1040, or 1040A, late. You can file a 2007 tax return in January 2009 and not be penalized if you are getting a refund. However, the three year clock will not begin running until January 2009.

This year there was a special reason to file your 2007 federal income tax return on time. An economic “stimulus” election year bribe check will not be mailed to you this year, if you qualify for one, if your federal income tax return was not filed by October 15, 2008.

Granted if you do not receive a check in 2008, based on 2007 information, and the rebate was not used to offset outstanding federal or state tax liabilities, all is not lost. You can claim the rebate, based on 2008 information, as a refundable credit on the 2008 tax return. However, if your situation changed in 2008 such that the amount of the rebate to which you are entitled is reduced you could be a loser. If you had a dependent child who was under age 17 in 2007 you would be entitled to an additional $300.00. But if that child turned age 17 in 2008, and you did not file your 2007 return on time and therefore did not get a rebate check, you would lose the $300.00.

On the other hand, a taxpayer who would not have received a rebate check in 2008 based on a timely filed 2007 return because the money was withheld to offset outstanding prior year income tax debt can hold off mailing his/her 2007 Form 1040 to “Sam” until January 2009 and it is believed that he/she will be able to claim the rebate amount as a credit on the 2008 return.
Over the past 35+ years I have come across quite a few clients who did not file on time. Often I have prepared two consecutive years' 1040s at the same time.
If three or four years pass since the due date of a return and it is still not filed there is an excellent chance that the Internal Revenue Service will reconstruct the return for you, using the information it has available in its computer “matching” system. Of course this will only happen if your have income that is reported to the IRS by a third party – such as W-2 wages, gross pension and annuity distributions, interest, dividends, gross proceeds from the sale of assets, and income “passed-through” on a Form K-1.

Why would this happen? I have encountered two reasons.

One is that the first and second return is not filed on time because of ill health – physical or mental (this could include an addiction to alcohol or drugs). When it comes time to prepare the third year’s return the taxpayer is already two years behind, and things just begin to snowball.

Another reason is that a taxpayer just stops filing tax returns because of the misconception that he/she no longer has to file tax returns. For some unknown reason there are those who think that you do not have to file tax returns any more once you reach age 65 or age 72. This is bull-pucky (technical IRS term). You are required to file a federal income tax return from the day you are born until the day you die, whether you go to your final audit at age 66 or 96, as long as you have sufficient net taxable income!

The problem with the IRS “reconstructing” a tax return is that they prepare the return in the worst possible way.

If you are married they will calculate the tax as Married Filing Separately – reconstructing two returns if there is income reported under both spouse’s Social Security numbers. If you should be filing as Head of Household the IRS will classify you as Single.

You will not be given any exemptions for dependents, even if you had claimed dependents in the past. The only personal exemption that will be included in the calculation is that for yourself, which may be reduced due to a truly “gross” AGI. If there are no dependents there will be no corresponding Child Tax Credit.

The gross amount of income that is in the IRS computer system under your Social Security number will be included in AGI.
* If you were issued a Form 1099-R for $50,000 for a distribution from an employer pension plan or an IRA that was rolled over within the 60-day “grace” period, and therefore not taxable, the full $50,000 will be included in AGI, and you will be assessed the 10% premature withdrawal penalty.
* There will be no provision for the cost basis of any asset sales reported on a Form 1099-B – 100% of the gross proceeds will be included in income and taxed as short-term gains.
* No deductions will be taken against business income reported as “non-employee compensation” on a Form 1099-MISC, and self-employment tax will be calculated on the full amount.
* There will be no “above the line” deductions (i.e. qualified tuition and fees, IRA contributions, health insurance premiums for self-employed), with the one exception of 1/2 of any self-employment tax assessment.

* The tax liability will be calculated using the Standard Deduction.

It is not unusual to receive a bill from the IRS for assessed tax, penalties and interest on a reconstructed federal income tax return for $50,000 - $100,000!

Let us look at a real life example from my client files. FYI, in this case returns were file late due to medical reasons –

* The taxpayer’s 2002 Form 1040 was reconstructed by the IRS.

* Although the taxpayer had consistently filed his tax returns as Married Filing Joint in the past, his filing status for the reconstruction was Married Filing Separately.

* The calculation showed $260,610 in “total income reported by payers”.

* This included $205,000 in gross proceeds from the sale of investments reported on a Form 1099-B.

* There were no “adjustments to income” , the one personal exemption allowed was totally phased out due to the inflated AGI, and the Standard Deduction allowed for Married Filing Separately was claimed.

* The total tax assessment was $84,459, which after deducting withholding became $71,375 in net tax due. Adding interest of $4,823 and penalties for late filing, late payment and underpayment of estimated tax of $23,392 the total amount due came to $99,590!

The spouse only had W-2 income reported under her Social Security number. Her withholding was enough to cover the tax liability, even filing separately with no deductions, so she did not get a bill from the IRS. She also did not receive a refund for the overpayment on the reconstructed return.

Here are the facts from the 2002 Form 1040 that I eventually prepared –

* The joint total income was $128,751.

* After subtracting the cost basis of the investments sold there was a net capital loss, and the $3,000 maximum loss deduction was claimed.

* There were adjustments to income for the educator expenses and qualified tuition and fees.

Schedule A was filed to report $40,961 in total itemized deductions.

* The couple had two dependent daughters and personal exemptions of $3000 each were claimed in full for 4 individuals.

* The final tax liability was $15,552, which was more than covered by withholding.
While we eventually got everything straightened out with the IRS, as a result of the late filing the taxpayer became subject to “back-up withholding” and for several years had 28% in federal income tax withheld from his interest and dividend income, which reduced the potential accrued earnings on this money.

You should note that even if there is an overpayment on the properly constructed return the taxpayer will not receive a refund if that return is not received by the IRS within 3 years of the original due date for the return. While the three-year clock for audit purposes begins on the date the return is actually filed, the clock for refunds begins on the actual due date for the return.

In the case of a taxpayer who was convinced that he no longer had to file once he turned age 65, he became our client only after the IRS attempted to foreclose on his home to pay his reconstructed debt!

If you receive a reconstructed return, which is referred to by the IRS as a “Substitute For Return” (SFR), you should not file an amended Form 1040-X to report the correct information. While an SFR is considered to be a valid tax return it does not constitute an original return filed by the taxpayer. In the above case I filed an original 2002 Form 1040.

So if you want to avoid hassles with the IRS, possible excessive penalties and interest, and a potential lien on your personal residence you should always file your income tax returns on time, even if you do not have the money to actually pay the tax due. It is much “more better” to submit a balance due return with no payment than to submit nothing at all.

And if you have not filed your 1040 for the past year or two or three, get thee to a tax professional!


1 comment:

Anonymous said...

Thanks for posting your tax article
I find it very helpful and informative.

Tax Wonderer