Back Taxes: What are Your Options for Filing Late Tax Returns?

Thursday March 23, 2006

Lead: Today's tax question comes from an anonymous reader who asks,

"Mr. Perez, I was researching on the internet about what to do about by tax situation. I found one of your articles at taxes.about.com. I hoped you could answer my question. Of course please use an anonymous name. I had a number of rental houses and got involved in a business in 1998 which failed in 2000. I sold everything, including our personal home in an attempt to pay off the debt but this did not work which resulted in a bankruptcy in 2002. I have not filed taxes since 1997. I have started over, have a somewhat successful business, able to pay my monthly bills but not much more at this point. My biggest dilemma is that I would really not like to go back through all of that paperwork and revisit all of that failure if I could help from doing it. That is the main reason I have not filed yet, not to mention the time it will take to straighten out all of the paperwork. What are my options? Thank you."

You will have to go through some paperwork. OK, you might have to go through a lot of paperwork. But you don't have to go through it alone. There are experienced tax professionals and CPAs who specialize in helping people file their back taxes. My firm, for example, has tax software going back 11 years. I know professionals who have even older tax software.

Even though it's emotionally painful, working through your back taxes will bring a great sense of relief, a "weight off your shoulders," and you'll be able to move forward with your financial and business life knowing that everything has been cleaned up.

There's five main benefits to filing your back taxes:

If you are required to file a tax return, filing your back taxes will bring you into compliance with the law.
If the IRS has proposed any assessments based on their estimates of what you owe, filing a tax return will reverse that assessment. Then you will pay only what you owe, plus any penalties and interest.
Filing a tax return starts the clock ticking on the various statute of limitations, such as three years to audit your return and ten years to collect on your tax debts. If you never file a return, that clock never starts ticking, so theoretically the IRS would have an infinite amount of time to chase after you.
Filing a tax return can put money in your pocket. You can still get refunds for the past three tax years, plus the current tax year. So as of right now, you can still get refunds for the years 2002, 2003, 2004, and 2005.
Last but not least, filing your back taxes will provide you with immense emotional relief. You'll be able to put the past behind you and move on to more important things.

The biggest task is gathering your tax documents for the periods when you need to file. Generally speaking, the IRS can provide copies of your tax documents (such as W2 and 1099 forms) from 1999 to 2004. Every year around August or September, the IRS drops one year and adds another year to their database of tax records. So you or your tax professional can retrieve copies of tax documents, usually sent the same day via fax.

You might need more tax documents than the IRS can provide. This might include state-related information about withholding, profit and loss statements for your businesses, bank statements, or other financial records which might be pertinent to your return. An experienced tax professional can quickly look over your IRS records and tell you what additional information you need to gather up.

Prior to 1999, the IRS most likely does not have information about your income in their database. They might, but probably not. For those earlier years you'll need to dig up tax documents from places like the Social Security Administration, state tax and employment agencies, bank statements, old employers, and so forth. This can be a time consuming process. But a tax pro can tell you where to look and help you manage the process. They can even prepare a form letter for you to mail out requesting copies of these older tax documents.

Now, let's talk about practical matters. You can only get a tax refund going back three years. Right now, you can still get a tax refund for the year 2002, as long as you file by April 17, 2006. For earlier years (2001 and previous), there's no refund money you can get from the IRS. So, generally, as soon as your tax return shows zero tax liability or a small refund, you can stop preparing your return. As long as you don't owe, there's no penalties for filing late. In fact, you've already paid a penalty, in forfeiting your refunds. This is the general strategy.

In your case, we may want to accurately tally up your business losses. Any loss in excess of your income generates what is called a Net Operating Loss. That happens when your adjusted gross income is a negative number. Net Operating Losses are special, because the loss can move backward or forward in time. So for example if you have a Loss in 2001, you could carry that forward to 2002 and increase your refund. Similarly, you might owe for 2001 because you made more money, but you might have losses from 2000 when you business collapsed. It would be to your advantage to make sure those losses calculated accurately and are carried to the year you need them. This will help keep your overall tax liability low.

Again, this is part of a general tax strategy: keep your tax liability as low as possible. The smaller your balance due to the IRS, the smaller will be the penalties for filing late. And any year where you don't owe, there will be no penalties.

Once you get your tax returns filed, you will be back in the drivers seat, so to speak. You can start planning ahead, always keeping one eye on how to manage your business affairs, and another eye on keeping your tax liability as low as possible. By planning ahead, you will be in full control of your financial and tax situation, and so you'll be much more prepared when tax time rolls around again.

So, right now, your options are:

File your taxes yourself. It's not hard, but will require a few days or weeks of intense paperwork.
Hire a tax professional. Again, it won't be hard, but it will take a few weeks of constant communication.
Do nothing, but then you'd still be living in dread. Taking time now to file your back taxes will actually help protect you legally and financially.

Hope this helps clarify your situation.

Essential Information:

Throughout the tax season I will be answering one tax question per day. Do you have a question? Visit the Ask a Tax Question page. Disagree with my answers? Post your comments in the Tax Forum.