Retired IRS Agent

A new client recently came to my office because the IRS had filed a lien against him for back taxes plus penalties and interest in the amount of $278,000 for the tax years 2001 to 2005. This client works in the trucking industry as an independent owner/operator and had not filed tax returns for those years. Because the IRS taxpayer had not filed tax returns the IRS had filed “substitute tax returns” for him for those years.

What is an IRS substitute tax return?

By law the Internal Revenue Service can file a substitute tax return if you do not file a return. However, the IRS must first send the taxpayer a series of letters regarding the possible action as part of the Substitute for Return Program. The IRS generally will wait three years or more before filing a substitute tax return for a taxpayer. The IRS calculates the amount of income for the substitute tax return based on the income information that has been submitted to the IRS in the form of 1099s and W-2s. As for the taxpayer’s expenses, the IRS allows only the standard deduction and one exemption when filing a substitute tax return.

Once IRS has calculated the tax liability based on the standard deduction and one exemption the IRS will proceed to add the penalties and interest to the unpaid balance. The IRS will usually access the following penalties on the taxpayer for non-filed tax returns:

• Failure to file penalty, which is calculated at 5 percent a month or part of a month that the tax return is filed after the due date. This penalty cannot exceed 25 percent of unpaid taxes. My client reached the maximum penalty each tax year after each tax return exceeded five months of late filing. Therefore, assuming my client owed an average of $11,000 in tax per tax year, he was charged about $$2,750 (25%) in late filing penalties for each of the tax returns that were filed more than five months late.

• Failure to pay penalty, which is calculated at one-half of 1 percent (.005) of your unpaid taxes for each month or each part of the month after the due date. This penalty also cannot exceed 25 percent of the balance due. On the $11,000 tax liability my client was charged approximately $2750 (25%) in late payment penalties for each year because payments were not made for fifty months.

• After the failure to file and failure to pay penalties have been accessed on the balance due the IRS will add a 4-percent interest charge (compounded daily) on the taxes and penalties due. The interest rate changes every quarter and is presently 4 percent as of July 2010.

Fortunately, my client had kept good records and receipts for his expenses such as fuel, truck repairs, per diem expenses, insurance, etc. — and after I prepared the returns for the years 2001 to 2005 using the proper business expenses I was able to calculate the correct amount of tax liability due to be $57,500, not counting interest and penalties. So even if we estimate the penalties and interest to be approximately $35,000 bringing the total due to $92,500 the taxpayer has still saved more than $180,000 in taxes, interest and penalties (original tax bill of $278,000 less the actual tax and penalties of $92,500 equals $185,500 in savings). Also, once we determined the correct tax liability we were able to set up a monthly installment payment plan with the IRS, thereby avoiding any future levies on his bank account and any other IRS enforcement action.

The question is, “What could my client have done differently to save tax dollars?”

• My client should have filed an extension for the years in question.

• He should have contacted a tax professional sooner to assist him in dealing with the unfiled tax returns.

• Prior to the due date he should have filed the tax returns on time even if he did not have the money to pay the taxes because by filing on time he would have avoided the significant failure to file penalty of 25%.

• He should have called IRS and set up a payment plan instead of ignoring the problem.

Keep in mind that ignoring any IRS tax liability will only make matters worse. My advice to all truck drivers is to file income tax returns on time, regardless of whether you have the money to pay the tax liability. Be sure to keep accurate expense records and always remember, if you file your tax return on time the IRS will not access a failure-to-file penalty.

___________________________________