There are many reasons taxpayers choose not to file a federal return, much less state returns but the cost of not doing so can be far higher for your clients than compliance.
States yield broad powers in pursuing back taxes, penalties and fees for tax noncompliance. As an accountant, you can help clients avoid the crippling cost of noncompliance by ensuring they know their obligations and are prepared to meet them upfront.
Even though state tax rates are uniformly lower than federal rates, and some states have no income tax at all, federal tax compliance is higher than multi-state tax compliance. A Huffington Post article from 2013 articulated a few of the reasons for noncompliance at the federal level:
• Filing taxes is complicated;
• Fewer people think taxes are fair;
• Tax filing is time consuming and expensive; and
• Taxes are inherently unpatriotic.
From a state tax compliance perspective, people choose not to file because:
• Unique tax obligations in varying states;
• Unfamiliar with out-of-state tax requirements for similar types of taxes; and
• No systems and processes in place to understand state activities and identify an associated state tax obligation.
In addition, people fail to file returns for personal or business problems, feelings of hopelessness or fear due to an extended period of non-filing, anti-government sentiments, or beliefs that the penalty will not outweigh the expense or trouble of filing.
Bad things happen if clients don’t file
The United States tax system is based on voluntary compliance. If a client fails to file a return with the IRS, a number of outcomes could be triggered. Here are some important things to know regarding this possible scenario:
• Simple mistakes happen, and it is not the policy of the IRS to prosecute ordinary people. Failure to file a return, however, can be prosecuted as a criminal violation.
• If the client cooperates, they are less likely to be prosecuted. Although the IRS reserves the right to recommend prosecution, it is unlikely to do so should the client fail to pay their taxes, so long as the client voluntarily comes forward before they are contacted and arrange to pay what is owed.
• If the client derives their income from illegal sources, it is more likely that the IRS will recommend prosecution.
• The more blatantly fraudulent the client’s behavior has been, the more likely the IRS is to prosecute them. For example, a business would likely be prosecuted for failing to file returns year after year, despite repeated contacts by the IRS.
• In order to convict a client of a tax crime, the IRS does not have to prove the exact amount they owe.
• The IRS has a general policy of not enforcing the filing of returns older than six years.
• The IRS has programs in place to identify non-filers.
• The filing of a return starts the audit and collection time limits.
• If a client does owe taxes, they can probably work out an installment plan to pay off the debt.
• The client may be able to negotiate a settlement with the IRS, depending on their ability to pay, that will significantly diminish their overall tax debt.
• The IRS may owe a client money.
• If a client goes to a tax professional, they will probably not have to deal directly with the IRS.
• As a tax professional, you should be able to obtain a client’s past W-2s, 1099s, and 1098s from the IRS if they no longer have them.
• The IRS may accept reasonable estimates of charitable contributions, medical expenses, and other deductions.
• Depending on how complicated the client’s situation and how good their record keeping is, the entire process of clearing up their non-filing status could take as little as a few weeks.
States wield authority to collect and prosecute
State collection agencies have the legal authority to collect back taxes. In addition, even though a business is in a loss for federal tax purposes, it may still have state tax obligations. States may impose minimum taxes, franchise taxes (often based on in-state assets or net equity), and gross receipts taxes (e.g. Ohio and Washington), all of which are not based on federal taxable income but can add up over time.
The laws of the state where a client operates govern collection activity. Procedures generally are the same from one state to the next, and include:
• Levying a client’s bank account with an order — no civil lawsuit or judgment is needed;
• Seizing all or part of a client’s federal tax refund;
• Ordering the garnishment of the client’s wages with a notice;
• Placing a lien on the client’s house or other assets, which forces them to repay the debt if they sell the property; and finally,
• Pursuing a criminal case, which could end with fines and jail time.
Voluntary disclosure reduces tax risk
With all that, why is state tax compliance not treated with the same level of urgency as federal returns? In our careers, we cannot tell you how many Voluntary Disclosure Agreements (VDAs) we’ve negotiated for companies big and small for significant years of noncompliance.
VDAs can mitigate a tremendous amount of tax liability. Plus, clients typically get a waiver of penalties, so why doesn’t the cost of getting into compliance deter people from just staying in compliance? Why don’t taxpayers understand that dealing with one state in a delinquency situation is more expensive than getting compliant in almost every state? And yet, the culture of noncompliance and the ignorance of state and local tax obligations seem to be the norm and not the exception.
Stay tuned for part two where Judy will discuss the significant penalties of noncompliance as well as how to better manage out-of-state tax obligations.