Every year I have new clients who need to file late tax returns, usually 3 to 5 years at a time. Last year, I had four clients each needing to file tax returns for 10 years. This year, I've already helped two 10-year clients. Believe it or not, filing a late tax return isn't a whole lot different than filing a current year tax return. Sure, there are some extra things to think about. But on the whole, the process can be smooth, quick, and relatively stress-free. Here's some tips from my hard-earned experience.
First things first, as the saying goes. You need to track down missing tax documents. This is usually accomplished by calling the IRS and asking them to mail or to fax you a "payer transcript" for the years you haven't filed. A payer transcript is a printout of information from W-2 forms, 1099 forms, and other tax documents filed with the IRS. This information is generally accurate and reliable. The payer transcript is limited, however. It does not contain any tax information related to the state (such as state income tax withholding). So, call your state tax agency to obtain any information about tax withholding.
Step three, prioritize your tax returns. Tax refunds have expiration dates. Generally, you have three years from the original due date to file a tax return and claim a tax refund. For example, your 2001 tax return was due on April 15, 2002. 2002 plus 3 equals 2005. You have until April 15, 2005, to file your 2001 tax return and still get a refund.
This is very important, listen up. File your 2001, 2002, and 2003 tax returns as soon as humanly possible. You can still get refunds for those years. If time is of the essence, file your 2001 tax return ASAP. The other years (2002 and 2003) can wait a little while longer. The last thing you want is to lose your refund because the time limit expired.
Step four, file the rest of your returns. There can be strategies for prioritizing your filing if you need to spread out the work over a longer period of time. But in general, once you've filed your 2001 return, you can go back and file in chronological order. This is generally the method I recommend because you get to take care of the oldest years first, and secondly because some of the later years you can still wait a few weeks to complete.
Step five, know your penalties. There are three different penalties applied to late tax returns. Pay attention to these penalties, they are very important. Just as important as knowing the 3-year expiration deadline. You absolutely must know this: if you have a refund, there are no penalties. Let me repeat this for emphasis: REFUND = NO PENALTIES. Why? The tax code is very clear about this. Penalties are calculated on the balance due. If there's zero balance due, or a refund, there's no penalties to calculate. Twenty-five percent of zero equals zero!
So, when preparing your tax return, aim for a refund. If you can dig up enough receipts to itemize, go for it. If you went to school that year, be sure to tax an education credit. If you got married, got divorced, or had kids living at home, be sure to take all that into consideration.
Let me say this another way. Let's say you are preparing your 1999 tax return. Now, your tax refund, if any, for 1999 has expired. It's beyond the 3-year deadline. That means if you had a refund, you won't get a refund check from the IRS. But showing a refund on the tax return also means no penalties for filing late! You really, really, really want to show either a zero balance (breaking even) or a refund. It doesn't matter if it's a small refund or a big refund. So, once you are in a refund territory, stop and mail your tax return.
What if you owe? Here's what you are facing. First, review the penalties: failure to file on time, failure to pay on time, and interest on the amount owed. Interest rates change every quarter, but you can guesstimate between 5% and 10% in annual interest. The late payment penalty is 0.5% (half of one percent) per month for each month your tax bill is not paid in full. Now for the biggie. The failure to file penalty is 5% of the tax due per month for each month the tax return is late, up to a maximum penalty of 25% of the tax due. You reach the maximum late filing penalty after just five months. (Note to future self: if you anticipate being late, file an automatic extension and a second extension. That will give you until October 15th to file a return.) So, using the example of a 1999 tax return with a balance due. You are already five months late, so add 25%. Add another 0.5% for every month you are late for the late payment penalty. (So, if you are 60 months late, that would be 60 x 0.5% equals 30%.) Plus add interest on the balance due for each year you are late (another 5% to 10% per year). On a five-year old tax return, this can easily double your balance due.
All the more reason to maximize those deductions on a late tax return. The smaller your balance due, the smaller your penalties.
Now, going back to your filing strategy. Let's say you have prepared five years worth of tax returns (1999 through 2004). In 2001 through present you are getting refunds, but you owe for 1999 and 2000. There's a three things you can do.
Option 1: file all the returns at the same time (but in different envelopes), and mail in a check for the balance due per the return. The IRS will send you lots of mail, and will calculate your penalties and interest on the balance due. Some of the refunds may be withheld to pay the back taxes. Or you may receive refund checks before the IRS processes your older tax years. Pay off your back taxes as quick as possible.
Option 2: file the older years first, plus the 2001 return to protect your refund. Wait for the tax returns to post, and for the IRS to calculate your penalties. Then send in the later tax returns with refunds, and allow the refunds to be withheld to pay off the balances from earlier years. Then, when the IRS has processed everything, see how much you still owe and make arrangements to pay it off as quickly as possible.
Option 3: file the more recent years first, including the 2001 return, to obtain your tax refunds. Then, file your older tax returns and use your refund money to make large payments with the tax returns.
Because the IRS takes longer to process older tax returns, all three options take about the same amount of time. How you want to proceed depends a lot on your individual tax situation, and how you want to handle the cash flow problem. Generally speaking, I have found it really doesn't make a whole lot of difference which strategy you use to mail in your tax returns. In the end, it still takes a long time, and you still need to make payment arrangements to keep the IRS from harassing you further. So unless there's some other compelling reason, I recommend people file all their tax returns at once. Send them to the same IRS service center. But mail them in separate envelopes. Send them by certified mail. And keep the certified mail receipt as proof you filed your tax returns.