Tax Advice for Clients Who Are Chronically Late or Delinquent Filers

Make sure clients are aware of the risks—and lost savings opportunities—that substitute returns entail

By CEG’s Elite Advisor Report interview with Sidney Kess

Key Takeaways:

  • It’s easier for the IRS to find delinquent taxpayers because it receives electronic reports of more kinds of income than it did several years ago.
  • Substitute returns prepared by the IRS do not factor in helpful deductions for mortgage interest, big charitable contributions, extensive medical bills or supporting large numbers of dependents.
  • Substitute returns can be particularly disadvantageous for clients who are self-employed or small business owners.

Substitute tax returns are really no substitute for ones that clients could have filed themselves. That’s because the IRS uses data from only the income side when it creates such a return, which means that it doesn’t include all kinds of items that might offset that income.

The IRS works from W-2 reports of wages paid filed by employers and reports of payments to self-employed people from companies that used their services. The agency also uses reports from financial institutions about interest and dividends paid and reports from brokers about assets sold. All these things are taxable income.

Sidney Kess, a CPA and tax lawyer at Kostelanetz & Fink in New York, says it’s now easier for the IRS to find delinquent taxpayers because it receives electronic reports of far more kinds of income than it did several years ago.

What the IRS does not consider, Mr. Kess says, are offsetting amounts such as exemptions for large numbers of children or deductions for mortgage interest, big charitable contributions or thousands of dollars of dental work. For self-employed people, there is often a big disparity between payments they receive and taxable income, because much of what they receive goes for supplies or salaries or other expenses. But the IRS will know only the gross payment and will plug that figure into its return for clients who are nonfilers.

It does not even know about the original cost of assets that were reported sold.

In other words, the IRS does not include many of the deductions to which a nonfiler may be entitled. But this doesn’t mean that the IRS is being vengeful. The Service doesn’t even look for deductions. A substitute return is a “basic” one that “will not include any of your additional exemptions or expenses.” It’s a move of last resort, or as Kess calls it, “the worst possible result for the taxpayer.”

The IRS says it investigates about a million “nonfiler situations” a year, but it does not prepare a substitute return for everyone whom it believes failed to file. People in the underground economy do not leave a trail that can contribute to such a return, tax experts say. If those people are caught, they may not get an official printout in the mail. They’re more likely to be arrested.

Once a ghost return appears in the mail, simply avoiding it isn’t a viable option. The IRS will send reminders, Mr. Kess says. If there is no response, it will start collection efforts, based on its calculations.

Missing out on substantial deductions

The worst thing a taxpayer can do is not file a return and then ignore letters from the IRS. It’s not only stressful and potentially unlawful, but it can mean your client is missing out on sizeable deductions that could greatly ameliorate the pain.

Take family finances. If a widow or a widower is supporting adult children, he or she may be able to list them as dependents and file as head of household rather than as single, Kess explains.

Another consideration involves long-term capital gains and dividends. That income is tax-free for people in the 10 percent and 15 percent tax brackets, meaning taxable income no higher than $35,350 for a single filer or $70,700 for a couple filing jointly in 2013. In some cases, it may be advantageous for affluent people to give investment assets to low-income relatives, Kess adds. Provided that the low-income relatives aren’t subject to what is known as the kiddie tax, they would owe no taxes on the income.

This would also reduce the affluent person’s income, and that reduction could have significant benefits. That’s because taxpayers in the new top bracket of 39.6 percent will be taxed at 20 percent on such income, five percentage points higher than for those in the 25 through 35 percent brackets. In addition, single filers with adjusted gross incomes above $250,000 ($300,000 for married couples) face phase-outs of itemized deductions and personal exemptions this year.

About the Author

Sidney Kess, CPA, J.D., LL.M., is of counsel to Kostelanetz & Fink LLP in New York City and is one of the nation’s most prominent lecturers on continuing professional education. Mr. Kess was recently selected “Most Influential Practitioner” by CPA Magazine and is a nationally renowned tax expert and author of hundreds of tax books about financial and estate planning.