Foreign Account Reporting in a Nutshell

When I first started preparing tax returns in the late 90’s, foreign account reporting was not really a concern. Rarely was there a need to check yes to the question on Schedule B (Interest and Dividend Income) of Form 1040, to indicate the taxpayer had an interest in or signature authority over a foreign account. No more. The times, as they say, are a’changing.

In the last decade the IRS has started a real push to identify U.S. taxpayers who are hiding assets offshore. Just read some of the IRS’ press releases  regarding foreign accounts (see here, here and here) and it is easy to see that the IRS believes its efforts are bearing fruit. The IRS is not alone in this. The Financial Crimes Enforcement Network is also part of the enforcement effort. Combined both agencies are putting a lot of pressure on taxpayers to come clean. The two major programs dealing with foreign asset reporting are FBAR and FATCA, which stand for “Report of Foreign Bank and Financial Accounts”, and “Foreign Account Tax Compliance Act”, respectively. Taxpayers who run afoul of either reporting requirement can face severe penalties (at a minimum) or criminal prosecution (at worst), so I thought it worth a quick explanation. Not that many of my clients are of the wealthy jet-set who fly their private jets to the Caymens for sun, sin and financial shenanigans…yet.

FBAR

If you possess an interest in or have signature authority over a financial account located in a foreign country then you may need to file a FinCen114 report through the Financial Crimes Enforcement Network (link is here). FinCen114 is due April 15th of each year and which is filed electronically. If you cannot meet this deadline then you can get an extension up to October 15th. The FBAR applies to both individuals and businesses (unlike FATCA, which applies only to individuals).

You are required to file under FBAR if you have an ownership interest in or signature authority over a foreign account, with an aggregate value of all such foreign accounts exceeding $10,000 US dollars, at any point, on a given day during the calendar year.

A foreign financial account is defined rather broadly and includes bank accounts, brokerage accounts, mutual funds, and trusts which are located in a foreign country. It doesn’t have to be a foreign bank to be considered located in a foreign country. So long as the branch, where the account is opened and held, is located in a foreign country it has to be reported, regardless if the branch is of a US or foreign company.

Aggregate value means the total value of all accounts over which a taxpayer has an interest in or signature account over during the year. If, on any given day, the aggregate balance of the accounts exceeds $10,000 (in terms of U.S. dollars) then a FinCen114 report needs to be filed. The taxpayer computes the aggregate amount based on 100% of the value of the account, whether or not the taxpayer’s actual ownership equal 100% of the account or not. If the account has a value denominated in a foreign currency, the taxpayer will use the conversion rates promulgated by the US Treasury to determine the value in U.S. dollars. You can find the link here for the Treasury Reporting Rates for FBAR.

Penalties for failure to file a FinCen114 or to prepare the return correctly are as follows. The IRS may assess a penalty, indexed for inflation, not to exceed $12,459 per violation for non-willful violations (meaning unintentional); if the violation is willful then this penalty increases to the greater of $124,588 or 50 percent of the balance in the account at the time of the violation, for each violation. Beyond the financial penalties, there is the potential for criminal prosecution for tax evasion, depending on the egregious nature of the violation.

FATCA

FATCA or the Foreign Account Tax Compliance Act is designed to prevent tax evasion by identifying individuals who possess an interest in certain foreign financial assets. To comply with FATCA, the taxpayer submits Form 8938, Statement of Specified Foreign Financial Assets, along with his or her tax return, which is due on April 15th of each calendar year (which can be extended to October 15th). FATCA has some very complicated filing requirement, making explanation in a short blog post difficult but I will try to distill it down as best I can.

FATCA applies to certain specified U.S. taxpayers holding specified foreign financial assets outside the United States (I know that sounds redundant but that’s the IRS’ formulation and not mine). If the aggregate value of these foreign financial assets exceeds a certain dollar threshold then the taxpayer must report such assets on IRS Form 8938, as stated above.

First, FATCA applies only to specified individual, such as US citizens; resident aliens who live in the United States for any part of the tax year; nonresident aliens who elect to be treated as resident alien for purposes of filing a joint income tax return; and nonresident aliens who are bona fide residents of American Samoa or Puerto Rico. So FATCA applies to US citizens, at home and abroad, and to certain foreign citizens residing in the US, American Samoa or Puerto Rico.

Second, the specified individual must possess an interest in specified foreign financial assets. These assets are divided into two categories: either a financial account maintained by a foreign financial institution (unless it is a US Bank or the institution has a US presence) or other foreign financial assets held for investment (that are not held in an account maintained by a US or foreign financial institution). Good examples of the second category of assets are: stock or securities issued by a foreign company; an interest a foreign entity (akin to a partnership or other non-corporate interest); and a financial instrument or contract which has a foreign individual or entity as the other party or issuer.

The final requirement is that the aggregate value of the specified foreign financial assets exceeds certain thresholds established under the law. For unmarried taxpayers living in the US, the aggregate value has to exceed $50,000 on the last day of the tax year or more than $75,000 at any time during the tax year. Married taxpayers living in the US (who file a joint return) must file a report if the aggregate value exceeds $100,000 on the last day of the tax year or more than $150,000 at any time during the tax year (married taxpayers filing separately have to use the lower unmarried taxpayer threshold of $50,000 on the last day of the tax year or more than $75,000 at any time during the tax year). If the taxpayer lives abroad (so US citizens only) then the thresholds increases considerably (the rules regarding taxpayers abroad can complicated so I won’t go into any detail).

Valuing foreign financial assets can be complicated and so taxpayers are allowed some leeway. For brevity purposes, I will not go into detail of how to value specified foreign financial assets; generally taxpayers are allowed to make reasonable estimates regarding an assets worth when determining whether he or she needs to make a report under FATCA.

Failure to file Form 8938 carries with it certain penalties. You can be penalized up to $10,000 for failure to file the report plus an addition $50,000 if you continue to properly file a report after the IRS notifies you. If that wasn’t enough, the IRS can assess an additional 40 percent penalty on an understatement of tax attributable to non-disclosed assets. Like the FBAR, the same threat of criminal prosecution applies depending on the circumstances.

In Conclusion

As you can probably guess, there are areas where both FBAR and FATCA reporting requirements can apply to a single foreign financial asset. Based on what I discussed above, you can well imagine that the cost of complying with both reporting requirements can be expensive but there is no exception for a taxpayer who meets the filing requirements of both.

I suspect that most of you who are reading (this probably all of you) will never own a secret Swiss bank account or hide assets in a Cayman trust but the rules are worth reviewing. I hope you found it interesting (even if probably a bit overwhelming). You never know when that nice Nigerian prince will finally get his money out of the country. He keeps emailing me to let me know that one more check should do it… Bahamas, here I come!

What to Know if the IRS Levies Your Assets.

If you owe money to the IRS, you face possible seizure of your assets such as wage garnishment or a bank levy. In some rare cases, the IRS can even foreclose on your home. This post is intended to give you some basic knowledge of what an IRS levy is and what you can do if your are the target of an IRS levy. To keep things simple, I will confine my discussion to wage garnishments and bank levies. Just be aware that the IRS can levy on almost every asset imaginable.

What is a levy?

A levy is simply a seizure of a taxpayer’s assets to pay a tax debt. It should not be confused with a tax lien, which is a claim placed on real estate or personal property. Liens are passive collection measures; the IRS will place the lien on your property and then wait for you to sell it, at which point the IRS will be paid. Levies, on the other hand, are an active collection measure; the IRS can take action immediately to seize property to satisfy your tax debt. Often levies are intended to be a wake-up call to delinquent taxpayers, the idea is to encourage the taxpayer to take immediate steps to address their tax liability. I can tell you from personal experience that a levy does indeed get a client’s attention.

Under what circumstances can the IRS levy my assets?

As I said earlier, the IRS uses tax levies to either get assets to pay any taxes due or to force the taxpayer to enter into some payment arrangement to address the delinquency. So in deciding whether or not to levy a taxpayer’s assets the IRS will consider the following circumstances:

  • The taxpayer’s financial condition, including whether the levy will create an economic hardship for the taxpayer
  • The taxpayer’s responsiveness to attempts at contact and collection
  • The taxpayer’s filing and paying compliance history
  • The taxpayer’s effort to pay the tax
  • Whether current taxes are being paid

As you can see, you are more likely to face a levy if you have not been reactive to prior attempts to settle your tax debt. Even more so if you are in the habit of not being compliant with filing your tax returns and paying any taxes due.

Once the IRS has identified a taxpayer who is fit for a levy, the IRS will take certain steps to encourage the taxpayer to get compliant and avoid the levy. First, the IRS will ensure that were sent CP 501, a Notice and Demand for Payment regarding you tax liability. Second, the IRS will confirm that you either failed or refused to pay the tax due. Finally, the IRS sent you CP 90, a Final Notice of Intent to Levy and Notice of Your Right to A Hearing (levy notice) at least 30 days before the levy.

TIP – Often taxpayer will tell me that they had no idea the IRS intended to levy their assets. It is a very rare circumstance that the IRS levies on a taxpayer without prior notice. So don’t ignore any IRS notices! Attempt to resolve your tax debts and make sure to do your taxes on time and pay any amounts due. This will significantly reduce the likelihood of a levy. You can see a sample notice here.

What happens after the IRS determines my assets should be levied?

After the IRS determines a levy is appropriate and it confirms that it has followed all the required steps, the IRS will send paperwork to your employer or bank informing them that there is a levy in place.

Where the IRS garnishes your wages, the IRS will take a portion of your wages each pay period until you make arrangements with the IRS, the taxes are paid in full or the levy is otherwise released. Your employer will receive information on how much should be withheld from your paycheck and forwarded to the IRS.

To properly determine the amount to withhold, your employer is required to provide you with a Statement of Exemptions and Filing Status to complete and return within three days. Failure to return the statement within the required time frame means the employer is required to withhold the maximum amount possible. You also need to be aware that if you are to receive a bonus then 100% of the bonus may be payable to the IRS! This depends on whether or not you were paid in the same pay period as the bonus payment.

In the case of a bank levy, your bank will receive a levy notice from the IRS, requiring it to hold the balance of your account for 21 days. The reason for the hold is to allow you, the taxpayer, time to make payment arrangements or contest the levy. After the 21 days have passed the bank will pay the funds seized, as of the date of the levy, to the IRS. Funds subsequently deposited into your account, after the date of the levy, are not seized and so you can use the funds as you did before the levy. For example, if you have $1,000 in your account on the date of the levy, with another $1,000 deposited the following day, then the bank will hold the first $1,000 for 20 days; the remaining $1,000 is free to use by you.

What can I do to have the levy released?

The IRS will release the levy under the following circumstances:

  • You pay what you owe
  • The time period for collection ends
  • You enter into a payment arrangement with the IRS
  • The levy creates an economic hardship
  • The value of the seized asset is sufficient to cover any tax due and releasing the levy will not hinder the collection of the tax due

Economic hardship requires some explanation. It does not mean you are inconvenienced by the levy or that you can’t pay all your bills. Instead, economic hardship means the IRS has determined the levy prevents you from meeting basic, reasonable living expenses. Emphasis on the IRS determination. You will need to provide proof that you qualify for economic hardship before the levy will be released.

The best way to have a levy released is to not allow the levy in the first instance. The notice of intent to levy provides appeal rights, which means you have an opportunity to work something out with the IRS or challenge the IRS’ determination to levy your assets. The key is to be proactive before the levy is filed.

Is there anything else I can do?

Yes, call a tax professional immediately. If you owe taxes and the IRS has filed a levy against your wages or bank account you are at risk of future levies. Quick action is demanded to obtain the return of your money or to stop any wage garnishments. You should not take a levy action lightly!

Tax Tips for Year-End Charitable Giving

Give and you shall receive, as the saying goes. If you are considering a year-end gift of money or property to a worthy charity, here are some tips on maximizing your charitable tax deduction:

  1. Keep good records! Regardless of the amount of money given, meaning from dollar $1 up, the taxpayer must maintain a record of the donation made at or near the time of the donation. You can meet this requirement with a bank statement, a cancelled check, a credit card statement or a statement from the charity. Regardless of the form of the record, such record needs to show the name of the charity, the date of the donation, and the amount of the donation.
  2. If you make a single donation, of money or property, and it is worth more than $250 then you must get a written acknowledgement from the charity to deduct this donation. The written acknowledgement needs to contain the name of organization; the amount of cash contribution, if applicable; a description of any non-cash contributions, if applicable; a statement that no quid pro quo goods or services were provided in return for the contribution or, if goods or services were provided, a description and good faith estimate of the value of goods or services provided to the donor.
  3. If you make a gift using a credit card before midnight on the 31st than it is deductible in 2016 even if you do not pay your credit card until 2017. Similarly, if you properly mail a check on the 31st than it will also count as deductible in 2016 even if the check clears in 2017.
  4. If you are 70 ½ or older and you hold an IRA account, you may be required to take what are called required minimum distributions from a traditional IRA account. You can make a donation, up to $100,000, directly from your IRA to an eligible charity tax free. While you will not get a tax deduction for the contribution, the distribution is not taxable to you and qualifies as a required minimum distribution.
  5. If you are going to make a gift of household goods or clothing than such items must be in good used or better condition to be deductible. Damaged or stained goods and clothing will not be acceptable and hence deductible. Household goods includes such things as furniture, furnishings, electronics, appliances and linens. Items worth over $500 do not have to meet this “good used or better condition” if a qualified appraisal is done.
  6. If you are making a gift of property with substantial worth than you may need to have an appraisal to provide a proper value to use for your charitable donation. There are some complicated rules in this area so I won’t go into detail but if you intend to donate artwork, antiques or collectibles than you may need to meet other requirements to get full advantage of your deduction.

I hope you and yours have a wonderful New Year’s Eve and best of wishes in 2017!

Gifts Can Be Taxing: Tax Consequences of Making a Gift

Gifts are a part of everyday life. Birthdays, holidays and special occasions. Who doesn’t love getting gifts! This includes Uncle Sam. You may not be aware of this but when you make a gift you are engaging in a taxable transaction. This gift tax is an excise tax assessed on individuals who make a gift and it is based on the fair market value of the property transferred. Now just because you make a gift and it is taxable does not mean you will owe anything to Uncle Sam. I intend to give you the broad strokes of how the gift tax works so you know before you make a gift the potential tax consequences of your actions.

First things first. What is a gift? A gift is a transfer of property or an interest in property for less than fair market value. Simple enough. The gift tax applies to lifetime gifts, whereas the estate tax only applies to gifts made after death. While I am only discussing the gift tax today, it is important to point out that both types of gifts share what is called an applicable exclusion amount. The idea is that even though a gift may be subject to tax, the tax should only be paid if the total gifts, during life and post-mortem, exceed the exclusion amount, currently $5.45 million in 2016. If the total gifts exceed the applicable exclusion amount then it will be subject to tax. Right now the tax rates range from 18% to 40%, with the 40% bracket starting when taxable gifts made during life equal to or exceed $1 million dollars.

Before you start worrying that every gift you make is a hidden tax trap, not all gifts are treated as taxable gifts. For example, gifts to political organizations, gifts made directly to an education institution for tuition, gifts made to medical institutions on behalf of another and gifts that qualify for the annual exclusion are excluded from the IRS definition of gift and there is no requirement to report such gifts. Similarly, gifts to charity and gifts to spouses are allowed a deduction equal to the fair market value of the transfer (though there are some small exceptions) so while they are treated as taxable, in essence these gifts will not reduce the applicable exclusion amount.

Let me focus in a bit on the annual exclusion (this is different than the applicable exclusion) because it comes up quite frequently. When an individual makes a gift of a present interest, the gift will be treated as non-taxable up to the annual exclusion amount, currently $14,000 per recipient. Theoretically, this means an individual can gift an unlimited number of people $14,000 and he or she would never use a penny of their applicable exclusion. Now the rub here is that the gift must be of a present interest, which means the recipient has the right to use, possess and enjoy the property or income generated by the property without restriction (think gifts of cash or tangible property like a car or home).

Closely related to the annual exclusion is gift splitting. Married individuals can double up the annual exclusion by agreeing to treat a gift as being made by both individuals. So let’s use an example. Joan and her husband Earl are well off but Earl wasn’t as thrifty as Joan and as such most of the wealth is owned by her personally. Their son David has just graduated from school and they would like to give him a gift of some stocks Joan has bought over the years (worth $20,000). Now if the gift-splitting rules did not apply, if Joan makes a gift of the stock, her gift would be treated as part taxable and part non-taxable. The first $14,000 of the gift would be covered by the annual exclusion, leaving $6,000 to be treated as a taxable gift. Now if Earl consents to gift-splitting, the gift can be treated as if made equally by both parents (even though Joan owns 100% of the stock) which means that none of the gift will be taxable because the combined annual exclusion amount of $28,000 exceeds the fair market value of the stock. Used wisely, gift-splitting can be a very powerful tool in estate planning. Imagine if Joan and Earl want to move assets to their son over time; over the course of five years, the couple can gift David $140,000 worth of assets without incurring any gift tax consequences.

One of the big caveats of making a gift is that individuals need to consider the potential future income tax consequences of making a gift. The recipient receives the same basis in the gift as it had in the hands of the gift giver. So returning to our earlier example, if Janet gives her son, David, stock worth $20,000, which she purchased 15 years ago for $5,000, then if David later sells the stock his gain will be calculated using a basis of $5,000. Now if Janet had died, David’s basis would be $20,000 rather than $5,000 because assets received from an estate get a step up in basis. So with highly appreciated assets there may be a good reason to keep the asset in the estate rather than gifting it during life but that really depends on an individual’s circumstances.

So in summary, a gift tax is assessed on the fair market value of taxable gifts made during a person’s life. No tax will be due unless the taxable gifts, in total, exceed the applicable exclusion amount, currently $5.45 million. Not all gifts are taxable and so you need to check if certain exclusions apply, such as gifts that qualify for the annual exclusion. You also need to see if the gift qualifies for a deduction such as gifts to charity or to a spouse. Finally, remember that the applicable exclusion amount is shared with the estate tax and so taxable gifts will reduce the applicable exclusion amount available to the individual’s estate when he or she passes.

Whether or not planned gifting can benefit your estate depends on your particular circumstances, so if you have questions you should speak with an estate planning attorney or tax planner.

Getting Divorced? Here are Some Tax Traps to Avoid.

Divorce is tough. No doubt about it. So avoiding more bad news is probably a good idea. While I can’t make divorce any easier here are some tips on avoiding tax troubles in your divorce:

1. Filing a joint return in your final year of marriage.

The instinct that often prevails during divorce is to file as married filing jointly one last time. The reason is that most separating couples want to take advantage of the lower tax liability and the availability of certain credits one last time. There is a downside, however. Filing a joint return makes you liable, jointly and severally, with your soon-to-be ex-spouse. That means the IRS can come after you for the full amount of the tax liability shown on the return or if additional taxes are assessed after a later audit.

By filing a joint return, the IRS now has the right to collect all of the tax debt from both of you, even if the source of the liability was your ex-spouse. For example, you have a regular job but your husband is self-employed and he took deductions he shouldn’t have. The IRS later audits the return and assesses additional taxes. Now you are on the hook for those additional taxes. What’s worse is that even if the divorce judgment allocates a tax debt between you and your ex-spouse the IRS does not need to honor it because Federal law trumps state law. The better course of action may be to file married filing separately in certain cases. The takeaway here is don’t just assume that filing jointly is the way to go merely because it means you have to pay less taxes overall. Speak with your accountant first.

2. Alimony recapture.

The IRS has a quirky rule regarding alimony. If you are required to pay alimony to your ex-spouse and your payments decrease within the first three years following your divorce than you might run into some tax trouble. Normally, alimony payments are taxable to the recipient and deductible by the payer but where the alimony recapture rules apply than the payer may have to report some portion of those alimony payments as income in the third year.

The rules for alimony recapture are a bit complicated to explain in a blog post but watch out for the following situations which may indicate you have an alimony recapture problem: (1) there is a change in your divorce judgment, reducing payments; (2) you fail to make your alimony payments timely; (3) there is a reduction in either your ability to pay the alimony or in your ex-spouse’s need for alimony payments. If you find yourself in one of these situations you may want to talk with your accountant to determine if you may have to pay some unexpected taxes to Uncle Sam.

3. Dividing an individual retirement account.

Many marital estates contain a retirement plan that has to be divided, usually in the form of individual retirement accounts or IRAs. Unlike 401ks or a military pensions, IRAs do not require a special order from the court (called a qualified domestic relations order or QDRO) for the IRA to divided between the parties. This ease of transfer is, of course, a trap for the unwary. While no court order is required to divide your IRA it does not mean that you can simply write a check to your ex-spouse from your IRA and the matter is done. No, nothing is quite that easy in life or taxes. The IRS has specific guidance on how the IRA is to be divided.

To accomplish the transfer, the IRA must be divided among the divorcing couple under a divorce or separation instrument, which means the IRA should be divided in the divorce judgment or through a written agreement between the parties. Once that is done then the IRA must be transferred by a direct trustee-to-trustee transfer. If you take the money out of the account and transfer it then transfer is treated as a taxable distribution. Which means that the recipient spouse must set up his or her own IRA and provide instructions to the IRA trustee to make a proper transfer. If 100% of the IRA is going to be transferred than the owner merely needs to have the name changed.

Failure to follow these procedures may mean you may be facing additional income taxes and an early withdrawal penalties (10%) on the amount transferred.

4. Not considering the tax consequences of a property division.

Property divided in a divorce does not trigger a taxable event and so property can be freely transferred between divorcing spouses. Again, while this all sounds good, this is a trap for the unwary. Just because you can transfer property among divorcing spouses tax free does not mean that it is without tax consequences.

Consider the following. A couple has two jointly assets to divide: stocks worth $100,000 (with a tax basis of $50,000) and $100,000 in cash. The husband wants the stocks while the wife wants the cash. After the divorce is finalized, the husband changes his mind about keeping the stock and sells the whole lot for $100,000. Come tax time the husband gets a surprise when he has to pay taxes on the gain from the sale of the stock ($100,000 less $50,000 basis equals a gain of $50,000). So while his wife got $100,000 in cash, he will only receive whatever is left over after paying taxes (which is certainly less than $100,000). Laughing all the way to the bank, the ex-wife owes no taxes on her $100,000 in cash because cash has a basis equal to its face value ($100,000) while other property may have a basis that is less than fair market value, especially where you purchase appreciating property like stocks and collectibles. Changing hands does not increase the basis to fair market value because it was a tax free transfer.

Now let’s say the couple gets cute and decides to have the wife “sell” her interest in the stock to her husband in exchange for cash. Sadly, that will not work either as transfers, to include sales, are not taxable between spouses for a period of time after the divorce (while this presumption doesn’t go on forever, it goes for a number of years after divorce). So pay attention to the potential tax consequences of dividing up your marital property, there may be hidden taxes due!

5. Marital status.

Finally, the issue of marital status comes up quite frequently. Many divorcing couples believe that if they are separated (but not divorced) at the end of the tax year than they can choose the tax status that provides the most benefit, usually head of household. The reason for this is obvious: married filing separately has restrictions on the credits that can be taken, such as the child care credit, education credits and earned income credit. All of which can have a big impact on your taxes.

Your tax status is determined by your married status as of December 31. If you are still married at year-end than you cannot file single and there are restrictions on filing head of household. For the most part, you must file married filing joint or married filing separate. To be able to claim head of household the taxpayer must meet the strict requirements of the statute. Again, if you are not divorced at year end, speak with your accountant to determine what filing status’ are available to you.

When is a Tax Return not a Tax Return?

In Re Giacchi, on appeal to the District Court E.D. of Pennsylvania

Good question. The answer can mean a great deal to a debtor trying to discharge a stale tax debt. Mr. Giacchi, hailing from Pennsylvania, sought out bankruptcy protection to try and discharge several years of unpaid tax returns, specifically 2000, 2001 and 2002. For reasons not explained, Giacchi did not file tax returns for those three years. It was only after the IRS examined those years and assessed taxes that Giacchi filed tax returns to report what he argued was the correct amount due. These returns were often filed several years after the original due date of the return; for example, Giacchi’s 2000 tax return was not filed until November 29, 2004 – more than three years after the original due date of April 15, 2001. Even though the returns were not filed on time, in each case, the IRS accepted Giacchi’s returns and adjusted the amount of taxes due to match the tax returns. In spite of this, Giacchi was still unable or unwilling to pay the amount due and in 2010, and again in 2012, he filed for bankruptcy protection.

While in bankruptcy, Giacchi attempted to get out from under his tax liabilities. He argued that while he did not file his return on time, each time he was notified that the IRS assessed a tax against him, he immediately filed a tax return; in fact, the IRS did not contest the returns as filed and adjusted his tax liability to match the returns. The problem for Giacchi, however, was that while he had prepared the correct tax form, with the necessary information to calculate his tax liability, mailed to the correct address and signed under penalty of perjury, what he filed was not, legally speaking, a tax return for bankruptcy purposes.

As a threshold matter, for a tax liability to be dischargeable, the debtor must file a tax return. Seems simple enough. Under the Bankruptcy Code, to meet the definition of a “tax return” a document must:

  • purport to be a tax return;
  • be signed by the taxpayer under penalty of perjury;
  • contain sufficient information to allow the IRS to determine if the proper amount of tax was calculated; and
  • represent an “honest and reasonable” attempt to satisfy the requirements of the tax code.

It is this last requirement that caused Giacchi’s ship to founder. A late filed return, filed post-assessment, is treated as being untimely by the courts; by not filing a return in a timely manner, Giacchi did not show that he was making an “honest and reasonable” attempt to satisfy the tax code, which meant that his tax debts were nondischargeable. The court did leave open the possibility that a debtor who has a good reason to file a late return, filed after an IRS assessment, might still receive a discharge of those taxes. Giacchi, however, failed to provide any excuse for the late filing, beyond stating that by filing his tax returns he reduced his tax liability, which the court rejected as not being a legitimate tax purpose. If, the court noted, the debtor only had to show that the IRS did not correctly calculate his or her tax liability then ” ‘the availability of a discharge would turn on the IRS’s accuracy in assessing taxes, rather than on [the debtor’s] sincerity and diligence in complying with the tax code.’ ”

So the question of whether a tax return is indeed a tax return can make a big difference for a debtor seeking to discharge an old tax debt. While the court did not address whether or not a merely filing a return late, without an IRS assessment, is dischargeable or not, it is clear that waiting to file a return until after the IRS comes a knockin’ can be detrimental to your financial health.

Can’t Pay Your Taxes? File Your Tax Return Anyway!

As a tax attorney I often hear the lament, “I can’t file my taxes because I don’t have the money!” Not having the money to pay your taxes is not great but IRS stormtroopers are not going to flood into your home to carry you off to some black site in Nebraska. At worst, you will get a love letter from the IRS asking you to please, with sugar on top, pay the outstanding balance. Now please do not misunderstand me, I am not saying there are no consequences for filing a return with a balance due. If you file your return on time but you owe taxes you will be assessed penalties and interest on the unpaid balance until it is paid (or the 10 year period for collection expires). I am saying that failure to file your taxes on time can make a bad situation much worse.

First, the “failure to pay penalty” is only one-half of one percent for each month the tax remains due, up to a maximum of 25% on the amount of tax owed. The “failure to file penalty” is five percent of the tax owed for each month the tax remains due, up to a maximum of 25% of the amount of tax owed. I do not think you have to be a MIT grad to know that there is a big difference between a 5% penalty versus .05%, especially where a substantial tax is due; it only takes 5 months to reach the maximum 25% penalty for the failure to file versus the 50 months to reach the maximum 25% penalty for failure to pay. As an aside, the failure to file penalty is reduced by .05%, if the failure to pay penalty is also assessed on the taxpayer. Not much of a consolation but it is something.

Second, the IRS has ten years from the date of assessment, usually the tax return filing date, to collect unpaid taxes. Failure to file the return means the clock does not start tick until you eventually file your tax return. Worse, if the IRS contacts you to file a return and you fail to do so it will prepare what is a called a substitute return. The ten year statute of limitation does not apply to this return and the IRS can continue collection efforts against you as long as it likes. Even worse than that, substitute returns are generally prepared with little effort to minimize the taxes due from the taxpayer resulting in a higher balance due than if the taxpayer prepared his or her own return.

Third, if you file for bankruptcy and you filed your taxes on time then you may be able to discharge certain income tax liabilities. Fail to file on time, however, precludes you from getting those same taxes discharged and you will have to wait out the ten year statute of limitation period. Right now I am working with a client who owes a substantial amount in income taxes. He might otherwise have been able to discharge his taxes in bankruptcy but for his failure to file his tax returns on time. Now he must do his best to pay his taxes until sometime in the 2020s. Not good.

Finally, the IRS offers certain programs to assist you if you cannot fully pay your taxes. The IRS offers installment agreements that allow you to pay your taxes over time, albeit with penalties and interest. It also offers the ability to make an offer in compromise to settle your unpaid taxes for less than the full amount. The IRS even offers an online application for an installment agreement so you do not have to leave the comfort of your home (nor spend hours on the phone waiting for an IRS representative). There is a limit on how much can owe to the IRS and use the online application which I believe is $50,000 for individuals and $25,000 for businesses. My experience thus far with the IRS has been good and I yet to meet an IRS employee who is out to destroy someone’s livelihood whether it be by garnishing a person’s wages or seizing property so there is no downside to being proactive about entering into a payment agreement with the IRS.

In summary, if you owe Uncle Sam it is foolish not to file your tax return on time, whether it be on April 15th or extended to October 15th. The IRS will eventually catch up to you and when it does the consequences will be much worse than if you faced your taxes head on in the first place. Hey, while you are at it why not talk to your local accountant or tax attorney (PLUG!) to get a second opinion. You may have missed a tax deduction or credit which would turn your balance due into a refund?!