By Julian Block
Despite continuous cuts in IRS budgets and shrinking staffs, the agency remains able to deal with taxpayers who fail to file returns. The law authorizes and encourages it to step in and handle things on the basis most favorable to it.
ScienceWriters Spring 2017 cover
Internal Revenue Code Section 6020 allows the IRS to complete returns and make assessments for taxes, penalties for failing to file, and for late payment of taxes and interest charges. How quickly does an inexorable IRS invoke Section 6020? Only after mailing multiple messages saying that a person had reportable income and didn't file Form 1040.
How do the feds' always-alert computers prepare a "substitute for return" for a hypothetical writer we'll call Fredericka C. Dobbs? And just what caused the feds to focus on Fredericka? She obstinately ignored filing deadlines and shredded unopened letters asking about an unfiled 1040. Their patience ran out; they had their computers create a substitute 1040 only on the basis of her reportable income.
Completion of a substitute was a piece of cake, as Fredericka does editing work for several California companies. The computers located W-2 forms filed by her employers that showed wages and withholding for federal and state income taxes, and information forms from financial institutions revealed payments of dividends, interest, and sales of assets.
The computers never take into account that she's entitled to claim offsetting amounts. Fredericka's offsets include: exemptions for several youngsters; hefty write-offs on Form 1040's Schedule A, where the law allows her to itemize deductions for such payments as California income taxes (more on California taxes in a moment), mortgage interest, and charitable donations; deductions on page one of the 1040 form for, say, moving expenses; and deductions on Schedule D for losses on sales of investments.
The computers always base substitute-return calculations on: Filing status as a single person; a standard deduction (for someone who opts not to use Schedule A, this is a flat amount determined by filing status and age); and one exemption. It makes no difference, for example, that just her Schedule A deduction for state income taxes exceeds the standard deduction for a single person or that she qualifies for a higher standard deduction because she's older than age 65.
To really twist the knife, her substitute Schedule D will reflect amounts on 1099 forms for sales prices and show zero as the purchase price for shares sold. For instance, it will show a gain of $10,000 on the sale for $10,000 of shares that actually cost $15,000.
The IRS blandly characterizes this kind of return as "basic," meaning that it ignores all of her additional exemptions and expenses. This is the worst possible outcome for Fredericka.
Can it become even worse for Fredericka? Yes, when she freelances and information forms filed by clients show payments for book royalties and magazine articles. How does a substitute return calculate taxes for a self-employed individual with income listed on Schedule C and Schedule SE (self-employment)? It always calculates on the basis of her gross receipts, allowing nothing for office supplies and other expenses.
Sure, Fredericka can eventually use accountants or other tax professionals to file returns prepared to her best advantage, so as to sharply reduce taxes, penalties, and interest charges (it doesn't take too many years for penalties and interest to top unpaid taxes), or even to yield refunds.
But meanwhile, an aggressive agency might be seizing assets like wages and bank accounts, disrupting her life in all kinds of unpleasant and expensive ways. The tax code permits the IRS to, among other things, place a lien on Fredericka's home and levy on her paychecks from employers and amounts due from clients — enforcement efforts that agency staffers are easily able to accomplish without help from Eliot Ness.
Back to California. The IRS shares information with it and other states. Someone who runs afoul of the IRS also will hear from California, New York, etc. California will similarly assess penalties and interest on the basis most favorable to it.
Tardy taxpayers' tsoris: Suppose Fredericka finally files the 1040 that she should've submitted in the first place. Mirabile dictu, it shows that she reaps a refund and avoids all penalties and interest charges. But not if more than three years elapsed after her return's due date. Fredericka forfeits the refund and can't offset it against liabilities for other tax years.
Julian Block is an attorney and author based in Larchmont, N.Y. He has been cited as: "a leading tax professional" (New York Times); "an accomplished writer on taxes" (Wall Street Journal); and "an authority on tax planning" (Financial Planning Magazine). Information about his books is at JulianBlockTaxExpert.com.
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