Howard's IRS and the Law Blog

What if you have not filed your taxes in years, but have paid taxes to the IRS all the while? In other words, you have unfiled taxes, but probably do not owe the IRS much of anything because your employer took taxes out of your paycheck. How much trouble could you be in with the IRS?

The good news is you likely are not in much trouble at all if you have not filed and do not owe any money to the IRS.

Here’s why:

  • You are not going to jail for not filing the tax returns.  The IRS likes to prosecute people who do not pay their taxes.  That’s not you.  You paid your taxes, but just did not file your returns.  There is a difference, and the difference takes you out of any IRS criminal exposure.
  • No IRS any penalties for not filing your returns. Common penalties are for late-filing, late-payment, and not making estimated tax payments. The amount of the penalties can be as much as 20-25% of the tax owed on the return. The key here is the phrase tax owed on the return.  You had withholding, paid your taxes, and do not owe any tax on your returns.  Since the penalties are calculated on money owed, you will not owe the IRS any penalties – even for not filing the return on time.
  • There will be no interest charged to you.  The IRS likes to charge interest – but it needs money owed to calculate the interest charges on.  If you do not owe the IRS, and have a refund on the returns, regardless of how long it has been since they were to be filed, you will not owe the IRS any interest.
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It’s an old story that the IRS combats everyday:  When a business struggles and cash flow is tight, when there is not enough money to pay both rent and employment taxes, the IRS takes a back seat, and the business uses employee withholding taxes to keep the lights on.

The result is that the IRS is made an unwilling lender to fund operations.   Your hope is that the tide will turn and the IRS can be repaid before they come calling.  Your business is your baby, but this is can be a dangerous bet, and as we will see, it is especially dangerous in employment tax cases.

Liability for employment taxes does not just stay with the business; rather, the IRS spreads it to you, too – the business owners, officers, and even employees – anyone who had decision-making power over the company’s finances can be personally liable for a part of the unpaid taxes.  This is called a trust fund recovery penalty investigation.

Simply put, unpaid employment withholding taxes are a cancer.

As the IRS casts a wide net to collect employment taxes, a three-tiered defense is usually required:  to the initial collection of the employment taxes from the business (Tier-1); to the ensuing trust fund recovery penalty investigation into who in the company made the decisions not to pay the IRS (Tier-2); and to the eventual collection of the trust fund taxes from those in the business who were responsible for the decisions not to pay the IRS (Tier-3).

The best employment tax defense will recognize each step the IRS will pursue in advance, will see what is coming, and will prepare for it.   With that background, here is the IRS’s step-by-step game plan in a civil employment tax investigation.

STEP 1.     ASSIGNMENT OF AN IRS REVENUE OFFICER TO COLLECT THE TAXES FROM THE BUSINESS.

The IRS considers employment tax liabilities to be a serious matter, and as a result, will assign an employment tax case to its highest level collection personnel, a Revenue Officer.

Chances are, the first move the Revenue Officer will make is to have an unannounced visit your business.  Expect the Revenue Officer to drop off her business card, along with (1) ) Form 9297, Summary of Taxpayer Contact and (2) Letter 1058, Final Notice of Intent to Levy and Notice of Your Right to a Hearing.

The Revenue Officer’s initial knock on the door is to collect the employment taxes from your business.  That will soon change.

You do not know it yet, but the Revenue Officer does not intend to just investigate collection of the employment taxes from your business.  The Revenue Officer will also be launching an investigation into the operations of the business.  The investigation will be focused on control over company finances:  Who had the decision-making authority that resulted in the employee withholding taxes not being paid to the government?  That could be you, that could be your CEO, a co-owner, or your spouse.

This is called a trust fund recovery penalty investigation.  It permits the IRS to collect part of the unpaid employment taxes personally from the individuals who were in control of the business and were able to make financial decisions to not pay the IRS.

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You paid your subcontractors, but did not send them a Form 1099 for the payments. You get audited, the IRS requests verification of the labor expense, and you provide the auditor with copies of your checks verifying the payment.  No problem, right?

But the IRS auditor says you cannot deduct an expense if you did not send out Form 1099.  Your subcontractor labor can be a pretty significant amount, maybe your largest expense.  The tax you would owe if your subcontractor labor expense is disallowed would be staggering.

But you paid the expense, and can prove it.  Huh? Is that possible, it seems so unfair.

It is not possible, and its wrong.

The IRS auditor is confusing two separate rules.  Here are the rules, what they mean, and how to navigate the audit to get your expenses allowed:

  • Rule 1:  Proving that the expense was a necessary part of your business, and that you paid it.

Section 162 of the Internal Revenue Code allows a deduction for ordinary and necessary business expenses that are paid or incurred during a year.  In the case of subcontractor labor, you would need to show the IRS auditor that the work the contractor performed was done in the ordinary course of your business and was necessary to it, and then prove that you paid the contractor.  A check to the contractor proves the payment (it is best if the check has a notation in the memo portion, notated along the lines of “labor for Smith job,” but that’s not absolutely necessary, just good practice for the future.)

And it’s even okay if you paid in cash, not by check.

These are evidentiary problems, but they are solved by application of the case of Cohan v. Commissioner, 39 F.2d 540 (2nd Cir. 1930).

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It is always an honor to be invited to speak at the Annual Conference of the National Association of Enrolled Agents.  Over the past 20 years of working with enrolled agents, I have seen firsthand their strong commitment to education, to learning and staying at the forefront of IRS representation.  In addition to the education, the conference is a great opportunity to make lasting friendships with enrolled agents across the country.

This year, the conference is on August 3-5, 2014 at the Cosmopolitan Hotel in Las Vegas.

At the conference, I will be presenting on the use of bankruptcy to solve IRS problems; defending against IRS employment tax investigations and the trust fund recovery penalty; and how to prove to the IRS that a levy would cause economic hardship. Here is an overview of each topic:

  • Using bankruptcy to solve IRS problems.

Bankruptcy can be a very effective tool to eliminate tax liabilities and get out of a tough bind with the IRS.  But the bankruptcy code has rules that must be followed detailing when a bankruptcy petition can discharge a tax debt.  We will learn those rules, and how bankruptcy operates on the IRS.  We we also dig into how the most common bankruptcies work (Chapters 7 and 13); cover the advantages of bankruptcy on the IRS, including benefits that are not available from direct negotiations with the IRS; and discover how bankruptcy can be a better alternative to offers in compromise, installment agreements or currently uncollectible.

  • IRS employment tax investigations and the trust fund recovery penalty.

Liability for unpaid employment taxes can be a cancer, with the tax laws allowing the IRS to go past the business and sweep owners and employees into the collection mix. We will develop a comprehensive understanding of how the IRS can get tough in employment tax cases, and learn how to (1) defend against the IRS’s initial pursuit of collecting unpaid employment taxes from the business (2) defend against the IRS’s methods of finding out who in the business could be found personally liable for repayment of the taxes (known as the trust fund recovery penalty) and (3) prepare for the IRS’s eventual collection of the employment taxes from those who are assessed with personal liability.

  • Preventing an IRS levy from causing economic hardship.

How do you prove to the IRS that an attempt to levy would cause economic hardship?  We will learn how to prove economic hardship – and prevent levies – in the tough cases, when the IRS wants a retirement account, or wants to seize equity in a house, or take a vehicle or valuable business equipment.  We will cover the limitations the Internal Revenue Code puts on the IRS’s ability to seize, including rules against no equity seizures and court approval for seizures of personal residences.  We will also learn the internal polices and procedures that the IRS must follow in the Internal Revenue Manual before making a seizure, all of which can prevent, not cause, economic hardship.

Hope to see you there!

A concern frequently voiced by my clients is whether entering into an installment agreement with the IRS automatically extends the time the IRS has to collect.

The perception is that if you agree to an installment agreement with the IRS, you are in it forever.

Quite simply, you aren’t.  IRS installment agreements have end dates.  The end date is 10 years from when your IRS liability began.

When does an IRS liability begin?  The time the IRS has to collect begins when they place your debt officially on their books.  This is called an assessment.  Assessments typically occur in three situations: (1) after you file your tax return and there is an amount due but not paid (2) if you did not file a return, the IRS will make an estimated return filing and put an estimate of your debt on their books (3) after the IRS completes an audit of your tax return.

After the debt is put on the IRS’s books (assessed), the IRS has 10 year to collect the tax debt from you.  The legal reference is Internal Revenue Code 6502(a)(1).

During those 10 years, the IRS can levy your wages, your bank account, or take your property (possible but unlikely).

Agreeing to an payment plan with the IRS – a better approach than letting them have it at – does not change how much time they have to collect.  If you enter into an installment agreement with the IRS, the rule remains the same:  They have 10 years to collect, and you have no more than 10 years to pay.

An IRS installment agreement does not extend the time frame the IRS has to collect.

Let’s put this to practical application with an example.

Example:

Your IRS liability started, say, 4 years ago, maybe you were self-employed and did not understand how to handle your taxes, or maybe you took a retirement plan distribution and did not have enough taxes withheld.  Either way, 4 years ago the IRS made its assessment against you, and put your debt on their books.  The IRS made their assessment 4 years ago, and they have 6 years left to collect, for a total of 10 years.  An IRS Revenue Officer contacts you, or maybe you are prompted by a threatening letter from the IRS Automated Collection Service. Either way, you agree with the IRS to make monthly payments.

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Owing money to the IRS comes with fear – fear of losing your house, your property, your bank accounts, even going to jail.  And the fear of your employer finding out you have a tax problem.

Your employer would discover your IRS problem if the IRS sent a wage levy to your job in an attempt to garnish your paycheck.  That’s embarrassing.

But can your employer fire you for it?  Can you actually lose your job because of your IRS problem?

The good news is that you cannot be fired from IRS attempts to levy your paycheck.

The Consumer Credit Protection Act protects you from termination due to a wage garnishment, including one from the IRS. But that’s not the end of the story for your employer.  An employer can fined up to $1,000 for retaliating against your IRS problem, and can actually be imprisoned for up to one year.  These matters would be handled by the U.S. Department of Labor.  The legal citation is 15 U.S.C. 1674, and the IRS citation is Internal Revenue Manual 5.11.5.2.

But you want your job, and for the IRS to leave you alone, not a case with the Department of Labor.

If you have a threat of being terminated due to an IRS levy, I suggest the following steps to resolution:

  1. Communicate with the IRS.  In most every case, the IRS issues a wage levy because of poor communication from you.  The IRS has tried to contact you, has sent out letters requesting payment, and believes there has not been a satisfactory response.  All the IRS wants is for you to contact them and make payment arrangements.  When IRS doesn’t hear anything, they take action into their own hands.
  2. You probably can’t afford the levy taking your paycheck.  The IRS needs to know that. They want to know what you earn, your monthly bills and what you own.  In other words, how can you pay them back?  Or maybe you can’t pay them back.  Either way, the IRS needs to know.  The IRS accepts financial hardship, no pay cases – their terminology for it is currently uncollectible.
  3. We may need to complete an IRS collection information statement.  This tells the IRS how you can – or can’t – pay them back.  Remember, the IRS is levying because they want information, and have not received it.
  4. If you owe under $50,000, and can repay the amount you owe within 72 months, the IRS does not need a detailed financial disclosure from you, and the levy release can be expedited with payment terms over the 72 month time period.
  5. If you have any unfiled returns, those need to be completed and filed.  The IRS calls this compliance – they want you to be current on any unfiled returns.  If completing the returns quickly is too burdensome, and the levy is causing an economic hardship on you, the IRS does have rules that permit a levy release without the returns and only a financial statement.
  6. Get the levy released.  What you really want is to keep your job, not to sue your employer or contact the Department of Labor.  With communication, IRS financial arrangements and compliance, the IRS will let go, and release the levy.
  7. Provide your employer with a copy of the levy release.  I usually have the release expedited, with the IRS faxing a copy to me and your employer immediately, alleviating any delays by mail.  When your wages are levied, time is the most important factor.
An IRS wage levy is solvable situation.  It does not have to result in threats of being fired from your job.  All the IRS wants is communication, information, and compliance. With that, we can put the bear to rest, and get back to living.
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