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Nonfiling of federal income tax returns.

To tax professionals, the very idea of not filing a federal income tax return is heresy. Unfortunately, though many people do fail to file and CPAs should be ready to take action when a new or existing client comes to them with a confession.

It's hard to know exactly how many nonfilers exist. In 1989, the Internal Revenue Service identified 1.7 million nonfilers for 1988 returns and eventually assessed $2.5 billion in taxes, penalties and interest. Clearly, an important part of the $100 billion underground economy is made up of nonfiler's liabilities.

The IRS itself sometimes unwittingly conspires with nonfilers. Its matching program classifies potential nonfiling cases according to expected revenue, the higher the priority. And, despite computer matching, the IRS sometimes simply doesn't know who hasn't filed and it cannot fully police the reporting system. Still, the service claims a high matching rate for 1099s and W-2s.


Willful failure to file is a misdemeanor punishable by a maximum fine of $25,000 or one year in prison, or both, plus prosecution costs (Internal Revenue Code section 7203). Each year's failure is considered separately.

Willful failure to pay any tax is similarly punishable under section 7203, as is willful failure to supply any information the IRS requests.

Failure to file a return can, in theory, also rise to a felony--attempted evasion--which carries a maximum fine of $100,000, or five years in prison, or both (plus prosecution costs) (IRC section 7201). Most failures to file are prosecuted only under section 7203, but prosecutions for evasion based on failure to file are not unknown.

Despite these possible penalties, when the IRS catches a nonfiler, compliance usually is the most it seeks. Some nonfilers are prosecuted (fewer than 1,000 in 1989, according to IRS statistics), but nonfiling is "only" a misdemeanor. Federal prosecutors often have higher priorities, and prosecuting nonfilers is costly. Prosecutors usually are reluctant to proceed when there are fewer than three years of neglected returns at issue.


Experience teaches that nonfilers come in all ages, income groups and occupations. They are computer salespeople and corporate consultants, civil servnats and retired military. Indeed, they are lawyers and even accountants.

Some generalizations about nonfilers are possible.

* They are overwhelming male.

* Some traumatic event triggers the act--a divorce, a business disaster, a personal crisis (such as drugs, alcohol or other illness) or a combination of causes.

* They have an astounding capacity for denial, taking quick and easy refuge in self-deluding excuses. "I know I should have filed, but there's no harm--the government owes me money," I didn't have the money to pay" or "I'm getting my records together," are some of their claims. Excuses are limited only by the perso's imagination.

Sometimes nonfiler miss filing one year and promise themselves to make it up in the future. One year leads inexorably to another and then to a third. By that time they may be too scared to file or they may reason that if the IRS hasn't caught up with them by then, it never will do so. As a result, most nonfilers fear the IRS, but not enough to come forward.

At some time, however, many nonfilers do come forward. Again, it's an event that triggers the desire or tips the balance in favor of seeking help. The catalyst can be as ordinary as an inquiry from the IRS based on a W-2 or a 1099. Other times, the catalyst can be an informant or an information exchange between state and federal government. Audits of related returns (such as corporate returns) can alert the IRS. The trigger also can be a marriage or divorce or a good or bad business year. It can be an attractive business deal or a bank loan request the nonfiler believes will lead to discovery. In one case, a nonfiler's fiancee insisted he become current; in another, a man was about to be confronted by a government background check.


Every nonfiler needs a team: a CPA and a lawyer. The CPA must prepare the returns and the lawyer must review them and present them effectively to the IRS.

CPAs should hold only brief initial discussions with nonfilers. If they learn that more than two years are involved, they should stop the discussion and refer the client to a lawyer immediately. That's because prosecutors like to indict for a minimum of three years. If there are three years at issue, the criminal potential increases and the need for priviledged communications also escalates.

The client should engage the lawyer, whose privelege may (but will not always) shield the necessary discussions and thus prevent the CPA from becoming a witness against the client. For that reason, the CPA should not be present at the first meeting between lawyer and client. Subsequent meetings should be guided by the necessity of securing a privilege. There are ways to include the CPA in the lawyer's privilege, but at first it's best to err on the side of caution. In particular, the CPA shouldn't discuss the reasons for nonfiling with the client; anything revealed can and will be used against the client--and CPAs can be called as witnesses because they lack a client privilege.

The law governing the attorney-client privilege in tax investigations is vast and challenging, and a full discussion is beyond the scope of this article. CPAs should be aware that a privilege encompassing the CPA, his or her discussions with the client and his work product may exist but, if it does, it is fragile, narrow and easily waived. The IRS vigorously contests assertions of privilege by CPAs. (See, for example, United States v. Kovel, 296 F.2d 918 [2nd Cir. 1961]; United States v. Merrell, 303 F.2d Supp. 490 [N.D.N.Y. 1969]; United States v. Cote, 456 F.2d 142 [8th Cir. 1972].) Whether a privilege is available for data shown on a tax return is very much an open issue, and a careless remark by an attorney, CPA or a client to anyone at anytime outside the privilege, including the IRS, always has the potential for disaster.

For this reason, the lawyer should discuss the privilege issue with the CPA and the client as soon as possible. Written privilege agreements, modeled on guidelines set forth in the Kovel case cited above, can be useful in preparing for a counterattack.

At the initial interview, the attorney would explain the civil and criminal penalties to the client. The attorney also might point out that the chances of criminal prosecution are small if the returns are filed quickly. However, the likelihood of civil penalties for late filing and late payment (and sometimes fraud and estimated tax), are strong, unless there is reasonable cause for the late filing. The attorney should direct the client to his or her CPA, who would prepare proposed returns using al available information.


At this point, the client would be filing to avoid prosecution or to gain relief from civil penalties, so the returns must be accurate the first time and totally defensible if audited. CPAs should lean toward conservatism; they should take all lawful deductions they can prove but should consider carefully whether to take a deduction for which there is no or inadequate substantiation. The lawyer should always perform a bank deposits analysis and consider performing other income checks such as a net worth analysis. The IRS certainly will do so if the return is examined.

The CPA and attorney would then meet with the client again. Every gap in the numbers or documentation should be discussed, again taking a conservative approach. The lawyer should go over the returns in detail, probing, challenging and confirming everything just as an IRS special agent would do.

It's also important for the lawyer and CPA to address the collection issue, checking for statutes of limitations on refunds, credits, net operating loss carrybacks and so forth. Presentation of the collection aspects to the IRS often influences its judgment of the client's sincerity and commitment. That, in turn, may help limit civil penalties.

The CPA and attorney also would discuss the state returns, which normally follow and parallel the federal returns. The state liability can be large, so it must be included in the CPA's analysis.


Finally, the client and the attorney discuss the reasons returns weren't filed. Quite often the client starts off saying, "I just didn't think I had to," "I was just negligent" or words to the effect (never, "I just forgot"). In every case, careful questioning reveals much deeper, often compelling, business, personal, emotional or other reasons for the failure to file a tax return.

Whether the IRS will decide the client had reasonable cause is another issue, but often enough it does. For example, for a client taking care of sick parents, the service excused civil penalties because case law shows that illness in the family was reasonable cause. The service has even forgiven some penalties because severe business reversals caused emotional stress and a resulting failure to file.

What the client needs in every case is prompt and full disclosure to the lawyer, returns prepared quickly and accurately by a CPA, a full and powerfull statement prepared by a lawyer of the facts constituting reasonable cause, a plan to pay taxes owed and just plain luck.

Once this disclosure process is under way, it must be kept on track, which often is harder than it sounds. When clients first come to their CPAs or attorneys, they are scared and therefore motivated. Once into the process, they may begin to feel reassured about the consequences of their actions and may even begin to procrastinate again. Both the CPA and the attorney must be careful to ensure their efforts aren't delayed or sabotaged.



The final result? In most cases client stays out of jail and, in many cases, the IRS forgives some or all civil penalties. Sometimes, the service initially asserts the penalty, but an appeal is later successful. Even when penalties are sustained on appeal, the client's team of professionals can be help introduce reasonable doubt sufficient to prevent criminal prosecution and educate the client to the facts of tax life and his responsibilities as a citizen. Given the trouble and expense of failure to file, it's unlikely he'll repeat this mistake.
COPYRIGHT 1991 American Institute of CPA's
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 1991, Gale Group. All rights reserved. Gale Group is a Thomson Corporation Company.

Article Details
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Author:Nath, Robert G.
Publication:Journal of Accountancy
Date:Oct 1, 1991
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