Wednesday, November 19, 2014


The November issue of NATP’s TAXPRO Monthly includes an article on “Engaging the Nonfiler”.

The article describes a “nonfiler” as “as taxpayer who simply failed to file his or her tax return – either accidentally or intentionally”.

Over the past 40+ years I have come across quite a few clients who did not file on time.  Often I have prepared two or even three consecutive years' 1040s at the same time.

I currently have a client who has not filed her 2011, 2012, or 2013 returns.  Based on our relationship I know that she really has not filed, and not just gone to another preparer.

Why would something like this happen?  I have encountered three reasons:

1. The taxpayer has lost or misplaced much or all of the information (and/or client-prepared worksheets) needed to prepare the first return.  Because the first year’s return has not been filed the second year is delayed.  By the time the third year comes around the taxpayer is already two years behind, and things just begin to snowball.  This is the reason for the current non-filing of the client referenced above.

2. The first and second returns are not filed on time because of ill health – physical or mental (this could include an addiction to alcohol or drugs), and, again, when it approaches the due date of the third year’s return the taxpayer is already two years behind, and things just begin to snowball.

3. The 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!

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 you have income that is reported to the IRS by a third party – such as W-2 wages, gross pension and annuity distributions, interest, dividends, and gross proceeds from the sale of assets.

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

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 reconstructed return will report the gross amount of income that is in the IRS computer system under your Social Security number.

ü 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.

ü 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.

ü 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.

ü 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.

ü 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’s look at a real life example of a reconstructed return from my client files. FYI, in this case returns were file late because of medical reasons –

* 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”, which 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 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 accrual of 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 another real life case from the practice of my mentor, from several decades ago, the taxpayer 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 the tax due on a reconstructed return!

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 detailed example I filed an original Form 1040 for the reconstructed year.

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!


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