FEDERAL & STATE TAX PROBLEMS COMMON TO THE SELF-EMPLOYED
Perhaps you have been self-employed and have received 1099 Non-Employee Compensation tax reports from your clients and your vendors for years, or perhaps the downturn in the economy has forced you to make your own way by going into business for yourself. Perhaps you are contemplating moonlighting to augment your regular wages. Whether you have an outstanding tax liability due to non-payment of estimated taxes on self-employment income or if you just want to know the ropes in taking on a new venture, there is no time like the present to understand the basics which led to owing taxes, how to go about addressing the problem, or even better still, how to avoid having an outstanding balance owed in the first place.
REDUCTION OF IRS & STATE TAX ASSESSMENTS WHEN NO RETURN HAS BEEN FILED BY THE TAXPAYER
At least fifty percent of my clientele are self-employed persons working in a colorful variety of industries that have not filed tax returns for several years and wonder how it is that the IRS or state revenue agency has assessed tax against them for years during which they worked but never submitted a tax return. There are two basic ways this happens, depending upon whether you received tax assessments from the IRS or the state.
How Does the IRS and State Figure Out Where I Bank or Who My Employer Is?
Most employers must report to the IRS and the California Franchise Tax Board (“FTB”) all compensation they pay to wage earners (W-2) via a paycheck and all compensation paid to individuals working as independent contractors (1099) via a flat fee or commission. The reason these employers must report such payments is they are legitimate business expenses to the employer, reducing the employer’s taxable income. These business expenses also represent taxable income paid to and earned by someone else (i.e., the employee or independent contractor). The IRS uses W-2 and 1099 information reported by an employer to identify income received by other parties, namely, the employees or independent contractors. The income reports submitted by employers to the IRS are processed and tracked by social security number or employer identification number (“EIN”) in the IRS system. Often, the FTB and IRS work cooperatively together and share resources for collecting old tax liabilities. From these reports, the IRS and FTB know when you have earned income and calculate tax owed against this income. These same reports can be retrieved to help you know what income has been reported under your SSN or EIN.
Most taxpayers can confirm the income that has been reported to the IRS by requesting an IRS Wage and Income Transcript. Information about California state income taxes that are credited to your account can be retrieved by calling the FTB. The IRS Wage and Income Transcript is an annual record of all types of income received by each taxpayer from a variety of sources. Not all sources of income are employers, some are banks, stock trading organizations and government agencies such as the Employment Development Department (“EDD” which issues unemployment insurance benefits) or the Social Security Administration. There are several types of 1099 income reports, the most common is the 1099-Miscelanneous (1099 Misc), which is used to report non-employee compensation (independent contractor income). The IRS keeps records of many types of income reported by payors that should be claimed by taxpayers in filing a return. These reports are used by the IRS to assist the IRS in tracking taxable income and deductible business expenses claimed by individuals and corporate entities. A limited example of these are reports from lenders of mortgage interest paid to a mortgage lender by a borrower, student loan interest paid by former students who took out educational loans, tax deferred retirement accounts liquidated in some amount during the year, or proceeds received by a taxpayer for the sale of stocks. The IRS also keeps record of federal income tax withholdings and estimated tax payments. Tax withholdings are payments made by taxpayers to account for their income tax by having them withheld by their employer and submitted to the IRS and state on their behalf by the employer or by instructing an agency to withhold tax when liquidating an asset that is taxable as income. The IRS does not keep record of state income tax withheld or paid; therefore, the IRS Wage and Income Transcript is not a complete record of all tax payments a particular taxpayer may have made during the year to all agencies. To learn information about state tax withholdings, it is best to contact your state revenue agency for this information. Estimated tax payments are payments which should be submitted on a quarterly basis by persons receiving 1099 income to account for federal income tax, federal Medicare tax and federal social security tax. Estimated taxes must also be submitted to the state of California (FTB) to pay state income tax, employer training tax, unemployment insurance and disability insurance. It is important to determine all tax payments made during the year (i.e., state income tax) as these may be deductible expenses on a federal tax return.
Now, we have a sense of how and where information is gathered and used by the agencies to make assessments of tax against you with or without your participation. We also know where you can go to retrieve information about what income was reported to the federal and state government, as well as, any tax against this income you paid during the year for purposes of filing an original return.
IRS Tax Assessments in Lieu of Filing Your Own Return
When the IRS receives a return which they want to select for audit or if the IRS fails to receive an original tax return from a taxpayer it has three years from the date the return was processed or due (usually April 15th of the following year) to assess additional tax against the taxpayer. Should the IRS fail to assess tax within the three year time frame, it loses the opportunity to assess additional tax owed. This is referred to as the Assessment Statute or Assessment Statute Expiration Date (“ASED”). The state of California has four years to assess additional tax once a return is filed and has no restriction for assessing additional tax if no return is filed by a taxpayer. R&T Code §19087.
When the IRS uses reports of income it has received to assess tax against a taxpayer who fails to file a return (before losing the opportunity to) the IRS does not have record of tax deductions that could have been claimed by the taxpayer during the year the income was earned because it has received no information about such deductions from the taxpayer. As a result, in many cases an assessment of tax made by an agency against a taxpayer who has not filed a return will be higher than the tax assessed after submitting a return claiming legitimate credits and deductions. IRS unilateral assessments are called Substitute for Returns or “SFRs.” The state of California calls such assessments Notices of Proposed Assessment or “NPAs.”
If you have worked and received 1099 income in an amount sufficient on its face to implicate an income tax liability (i.e., if you have received income in amounts reaching minimum income thresholds requiring that a return be filed) and you have not filed a return but have an assessment which appears to have been made by the IRS or the state, then it is probably advantageous to file an original return as doing so will likely reduce your tax assessments. It is always advisable to evaluate your SFR balances or Proposed Assessment balances against the balances that would be due if you filed your own return (being sure to add charges for interest and penalties) to confirm it is more beneficial to file.
“SFR” balances are typically assessments of tax in excess of what your actual tax would be, particularly if you are self-employed and incur business expenses (tax deductions) as a part of earning your income. The IRS and state assessments are made based on income alone and contemplate that you are single and have no deductions or credits to claim. These types of assessments are made without knowing what operating expenses you might have incurred, without knowing the basis in stock you sold and without accounting for marriage deductions, deductions for dependents, or deductions for medical insurance to name a few.
State Tax Assessments
Generally speaking, the state is far more rigid and outrageous in its practice of assessing tax and collecting tax. In California, the Franchise Tax Board will assess “an industry standard” amount of income tax against a taxpayer that fails to file a return even if there is no report of income or very low reports of income showing in the FTB system. For example, a person holding a real estate broker license, a license to practice law, or a license to practice medicine who had no reports of income would still be assessed at least $7,000+ in income taxes simply by virtue of the FTB’s having received report that the taxpayer held a professional license in the state. The state can in some cases suspend a professional license when balances owed become very high ($300,000 to $500,000 in range) or when they become very old and near the time for expiring completely. State income tax assessments often occur when a taxpayer holds a professional license and fails to file an original return on their own. Such suspensions can be lifted and tax assessments can be reduced by filing an original return.
Can I Reduce Tax That Was Assessed by the IRS or State When I Did Not File a Return?
Yes. In many cases tax as assessed by the IRS or FTB without your input can be reduced by filing an original return. A taxpayer may lose their ability to collect a refund due to state and federal statutes limiting the time during which a taxpayer may claim a refund, but reductions to tax assessed can almost always be accomplished by filing an original return to reduce SFR or Proposed Assessment balances. When faced with a potential tax balance owed, concerns about a lost refund go out the window and the focus is instead on reducing the tax liability. Reducing or eliminating a tax liability to avoid collections is far more satisfying long term than worrying about the fact that you have missed the opportunity to receive an old refund from years ago.
Preparing to File Original Returns on IRS Substitute For Return Balances or FTB Notice of Proposed Assessment Balances
The first order of business if you are self-employed and have not filed returns is to prepare original returns using your business expense information from the year in question to claim business expenses against the gross income received during that year. Information from bank statements is very helpful and recommended as it is a source document generated at the time the income was earned or expenses incurred, further bank statements are maintained in the regular course of a neutral third party’s business and can be used to verify expenses claimed on a return if you were ever to be audited. Check images and check carbons, receipts and credit card statements are also helpful source documents to use in tallying up previous years’ business expenses. Often vendors you paid have records of invoices they submitted to you, as well as, your payments to them in satisfaction of invoices they have issued. It is worthwhile to reach out to vendors should you have gaps in records you kept internally. Medical insurance premiums and mortgage interest can also be claimed on previous years’ returns. There is a wide plethora of events that may be claimed on a tax return to reduce your income tax liability. Examples include federally recognized natural disasters, stolen property, depreciation on equipment and vehicles, and charitable contributions to a qualified charity.
Both the IRS and the state take a lot longer to process an original return when a government assessment of tax has previously been made, but the good news is, assuming the return matches their reports of income and tax deductible expenses, or is a legitimate deduction that you actually incurred during that year, the return will be accepted and the principle tax will be reduced along with interest and penalties accrued on that portion of the original principle tax assessed that has been reduced by virtue of submitting an original return. This represents the first most important and cost effective way to reduce principle tax assessments in situations where returns were missing and taxes were assessed by a revenue agency.
There is another reason to file an original return beyond reducing principle tax. In most cases the agencies will require all returns be filed before they will negotiate a settlement with a taxpayer for all balances owed. The IRS and state will not entertain settlement discussions over past tax liabilities unless or until all taxes owed are known to them. While the IRS and state may have assessed tax against you for previous years, likely they have not assessed the most recent years’ tax returns; therefore, it is common to find you must pull your documents together to file originals because all missing returns must be on file before the negotiations may begin. If there was no requirement to file because you earned too little income, you may avoid filing a return for years having no filing requirement. Further, the IRS and state will not require an original return for a year having an agency assessment (SFR or NPA) but it is usually in the best interest of the taxpayer to file an original in this situation anyway, for the reasons just explained – it will probably reduce your principle tax liability and the interest and penalties accrued on the difference between the principle tax reflected on your original return and that of the principle tax assessed by the revenue agency.
In some cases, it may not be advisable to file an original return if you have very old balances assessed by the IRS as an SFR. This shall be discussed in more detail below.
The IRS has ten years to collect tax it has assessed against you before it loses the opportunity to collect it completely. These statutes are commonly referred to as Collection Expiration Statute Dates, or “CSEDs.” This is true whether you filed a return showing a balance owed or the IRS assessed an SFR against you. The Franchise Tax Board is quite different as it has twenty years to collect tax owed pursuant to an original return filed by a taxpayer. This means your tax balances, no matter how high, return to zero once the collection statute expires. There is no statute of limitations for collections on Franchise Tax Board balances owed pursuant to a Notice of Proposed Assessment. Therefore, it is best to file an original return with the state even if doing so does not reduce your balances significantly.
Collections Statutes are important to note for two reasons, 1) in most cases, though the tax will be there a long time, it will not be there forever, and 2) it is important to analyze government assessment dates as this impacts the time the agency has to collect the tax and how long you may be dealing with the debt. In some cases, it is not advisable to file an original return on an IRS SFR balance. This is typically because the collection statute is set to expire very soon. Filing an original return restarts the ten year collection statute. For example, if the IRS assessed an SFR tax liability in the amount of $40,000 against you for tax year 2000 in 2003, then the ten year collection statute started on that assessment date in 2003 which means the tax should expire sometime in 2013. If that is the case, it may not be advisable to file an original return for tax year 2000 to reduce the tax liability to $10,000. If the entire $40,000 balance expires in several months it may be more effective to manage the $40,000 owed through a payment plan long enough to see the balance disappear. If the original 2000 tax return was filed now, there would be another ten years from the date the original is filed for the IRS to collect the $10,000 owed (plus interest and penalties on that balance accrued since April 16, 2001).
Unless the IRS SFR assessment was made on what is now a very old year, or the assessment is lower than what it would be if you filed an original, it is usually advisable to prepare an original return for any year having a government tax assessment of income tax on file.