Tax Procedure 101
Nothing scares a taxpayer more than receiving a notice from the IRS that their tax return(s) have been chosen for audit. Audits can be conducted in a variety of ways such as through correspondence or through a visit with the taxpayer. For example, if the IRS receives a 1099 or W-2 and the numbers on the taxpayer's tax return do not match or not put on the return, the IRS will usually send a letter advising the taxpayer they received information that does not correspond with what was reported. In these cases, the taxpayer generally pays the asserted tax due (plus interest) and that is the end of it. In more extreme cases, the taxpayer and the IRS may disagree on the amount of taxes owed and the IRS will send what is known as a "30 day letter" to the taxpayer. A taxpayer has several options once he receives a "30 day letter." First, the taxpayer can agree with the report issued by the Revenue Agent that conducted the audit, and submit payment to the IRS for the taxes owed plus interest. If the taxpayer signs a Form 870 (that usually accompanies the 30 day letter), the taxpayer will never receive a 90 day letter (and thus loses his or her ticket to Tax Court). The Form 870 permits the IRS to assess immediately and a taxpayer needs to ensure, before signing the Form 870, that this is the correct path the taxpayer wishes to take. As stressed before, if the taxpayer does sign a Form 870, they will not be permitted to go to Tax Court, but they still have the option of paying the amount of taxes and then filing for a refund claim. Additionally, the taxpayer may ignore the "30 day letter" - in which case, the taxpayer will receive a "90 day letter" discussed below. A third option is for the taxpayer to disagree with the IRS agent's report and request a conference to discuss why the taxpayer believes the tax liability is incorrect. Finally, a taxpayer may file an appeal with the IRS Appeals Division.
If the taxpayer fails to appeal the decision or simply ignores the "30 day letter," the taxpayer will receive what is known as a "90 day letter." It is imperative that the taxpayer weigh their options upon receipt of the 90 day letter. Under the Internal Revenue Code, a taxpayer has 90 days after the notice date of the 90 day letter to file a petition in Tax Court to dispute the amount of taxes owed. If the taxpayer fails to file a petition in Tax Court within this time period, the taxpayer is barred from filing in Tax Court. There are two other avenues, the Court of Federal Claims and a federal district court. However, in order to file in either of these courts, the taxpayer must pay all amounts the IRS has asserted is owed. Thus, it is important for the taxpayer to file in Tax Court within the 90 day period if they wish to contest the amounts shown by the IRS without paying the taxes first. For more information on audits, court options, etc., see Publication 556.
Example: Mary receives a 90 day letter from the IRS asserting she underpaid her taxes by $20,000. Mary disagrees with the IRS's determination of tax liability, but decides to wait until the 91st day to file a petition in Tax Court. Mary's petition in Tax Court will be dismissed because she filed after the 90th day, and Mary will have to pay the $20,000 first before going to a federal district court or the court of federal claims.
Taxpayers routinely move from year to year. As a result of the move, the IRS may send a 90 day letter to the taxpayer's last known address (the address on file with the IRS when the taxpayer files their last return). If the taxpayer has not notified the IRS of the move, the 90 day letter will be valid despite the fact the taxpayer never received it. However, if the taxpayer files a return with their new address, the IRS is given notice of the taxpayer's last known address. See Rev. Proc. 2010-16. The IRS must be given clear and concise notice of the change of address, and the taxpayer can do this by filing Form 8822.
Example: Angie filed her 2010 tax return with her correct address of "123 ABC Drive, New York, New York 10012." Angie moves on October 2011 to "456 DEF Drive, Shreveport, LA 71105" and does not notify the IRS of her move. Angie doesn't file a tax return for the 2012 tax return year. In 2012, the IRS sends a letter to the New York address providing they received information that she failed to report $10,000 in income. Angie never receives the letter. When the IRS does not receive any information from Angie, they issue a 90 day letter on December 1, 2012 and again mail this to the New York address. Angie finally finds out about the 90 day letter in August 2012 when the IRS attempts to levy on her home. The 90 day letter, though sent to Angie's New York address, is still a valid 90 day letter. Angie may not file a petition in Tax Court. Angie may pay the taxes associated with the $10,000 of income, and then file a petition for refund in a federal district court or the court of federal claims.
Statute of Limitations
If a taxpayer files his return and it is an official return, the IRS is prevented from auditing this return three years after the return is deemed filed. An official (or valid return) is one that (1) has sufficient data to calculate the tax liability; (2) is a document that purports to be a return; (3) is an honest and reasonable attempt to satisfy the requirements of the tax law; and (4) the taxpayer must sign the return under penalties of perjury. See Williams v. Comm'r (T.C. 2000) (holding that a the taxpayer's asterisk on a Form 1040 followed with a disclaimer of tax liability invalidated the return and thus was not a valid return). Thus, a taxpayer that puts all zeros on the tax return will generally be deemed to have not filed a valid return. This is significant because the statute of limitations only begins to run upon the proper filing of a valid return.
The date the return is deemed filed depends, naturally, on when the tax return is filed by the taxpayer. For purposes of filing the return, the "mailbox rule" applies. This rule states that whatever date the return is mailed is the date that will be considered for filing purposes. Thus, for example, if a taxpayer mails his return on April 15th, but the IRS receives it on April 25th, the return will be considered filed on April 15th. It is important to keep information that can prove you mailed the return on April 15th in case it is challenged by the IRS.
Aside from the "mailbox rule," a return is deemed filed on the latter of April 15th following the tax year or the date actually filed. Thus, if the taxpayer files his tax return for year 2011 on March 1, 2012, it will be deemed filed on April 15th for purposes of the statute of limitations period. If the taxpayer files his return on May 30th, 2012, the return is deemed filed on May 30th.
As mentioned above, the statute of limitations is generally 3 years from the date the return is deemed filed. There are some notable exceptions to this rule, however. First, as should be obvious, if the taxpayer never files a tax return or files a fraudulent return, there is no statute of limitations period. Under a 1984 Supreme Court decision, the statute of limitations never runs on a fraudulent return, even if the taxpayer later files an honest amended return. See Badaracco v. Comm'r (1984). Also, if the taxpayer omits from gross income an amount in excess of 25 % of the amount reported as gross income on the return, the IRS has an additional 3 years (for a total of 6 years) to audit. I.R.C. Sec. 6501(e).
Example: Lucy makes $35,000 in self-employment income for the tax year 2005. Lucy fails to file a Form 1040 tax return for that tax year. Later, in 2012, the IRS discovers Lucy's $35,000 in income and sends her a 90 day letter. Because Lucy never filed a tax return, the statute of limitations never runs and the IRS can assess the tax amount owed.
Example: On March 10, 2011, Michael reports on his Form 1040 $100,000 in self-employment income on Schedule C for tax year 2010. In reality, Michael made $175,000 in self-employment income for the year. The IRS, 5 years later, discovers the unreported income and mails to Michael a 90 day letter for the unpaid tax on the $75,000 Michael failed to claim. The statute of limitations is 6 years from when Michael was deemed to file the return (April 15, 2011) and thus the IRS may assess the unpaid taxes.
Example: Richard files a tax return on April 15, 2012 for the 2011 tax year. On it, he reports $35,000 in wages and $10,000 in self-employment income. Richard, non-fraudulently, fails to report $2000 in other income he earned in 2011. The IRS discovers the error and mails a 90 day letter on April 20, 2015 to Richard's last known address. The IRS may not assess the amount of unpaid taxes because it is beyond the three year statute of limitations period.
Also, keep in mind that the statute of limitations works both ways. That is, if you are paying taxes throughout the year (as most do, because they are employees), you have three years from the date the return is due to file a claim for refund with the Internal Revenue Service. If you do not, the U.S. Treasury is allowed to retain the payments made, despite the fact you may not owe that amount.
Example: Alice is an employee of XYZ Bank. Alice earns $30,000 throughout the 2010 tax year, and $5500 in federal income taxes are taken from her paychecks throughout the year. Alice files her 2010 tax return on October 10, 2014; showing a refund of the entire $5500. Alice will not be entitled to the refund of $5500 because she filed her return more than 3 years after the date the return was due (April 15, 2011). If Alice had filed before April 15, 2014, Alice would be entitled to a refund of $5500 (less any penalties for failure to file).
Liens and Levies
If the IRS sends a "90 day letter" to the taxpayer and receives no response after 90 days, they have several options available to them. First, they can levy a taxpayer's assets or they can place a lien on the taxpayer's assets. A levy is an actual taking of property, whereas a lien is placing a notice to others that the U.S. Treasury has a claim to that asset. In order to either, the IRS must meet certain procedural requirements.
Under the Internal Revenue Code, if the IRS intends to levy against the taxpayer's assets, it must first send notices to the taxpayer informing him or her of their intent to do so. Barring extreme circumstances (which are discussed later), the IRS must wait 30 days after the notice of intent to levy has been served on the taxpayer. A notice of the taxpayer's right to a Collection Due Process Hearing accompanies the notice of intent to levy. Under the Code, the taxpayer has 30 days to request this important hearing. If the taxpayer does request a CDP Hearing, the IRS is further prohibited from levying until the taxpayer has a chance to be heard.
The IRS Office of Appeals conducts the hearing (and it may be made heard by phone). At the hearing, the IRS Officer is told by statute to: (1) ensure the IRS has followed the requirements of any applicable law or administrative procedure; (2) allow the taxpayer an opportunity to raise any significant issues related to the unpaid tax or proposed levy (which includes spousal defenses; challenges to whether the collection actions are appropriate under the circumstances; and any offer by the taxpayer for alternative collection methods such as installment agreements or offers-in-compromise); and (3) allow the taxpayer the opportunity to raise a challenge to the underlying existence or amount of the tax liability but only if the taxpayer did not receive a statutory notice of deficiency (i.e., the 90 day letter) or did not otherwise have the chance to dispute the tax liability.
If the taxpayer fails to appeal the decision or simply ignores the "30 day letter," the taxpayer will receive what is known as a "90 day letter." It is imperative that the taxpayer weigh their options upon receipt of the 90 day letter. Under the Internal Revenue Code, a taxpayer has 90 days after the notice date of the 90 day letter to file a petition in Tax Court to dispute the amount of taxes owed. If the taxpayer fails to file a petition in Tax Court within this time period, the taxpayer is barred from filing in Tax Court. There are two other avenues, the Court of Federal Claims and a federal district court. However, in order to file in either of these courts, the taxpayer must pay all amounts the IRS has asserted is owed. Thus, it is important for the taxpayer to file in Tax Court within the 90 day period if they wish to contest the amounts shown by the IRS without paying the taxes first. For more information on audits, court options, etc., see Publication 556.
Example: Mary receives a 90 day letter from the IRS asserting she underpaid her taxes by $20,000. Mary disagrees with the IRS's determination of tax liability, but decides to wait until the 91st day to file a petition in Tax Court. Mary's petition in Tax Court will be dismissed because she filed after the 90th day, and Mary will have to pay the $20,000 first before going to a federal district court or the court of federal claims.
Taxpayers routinely move from year to year. As a result of the move, the IRS may send a 90 day letter to the taxpayer's last known address (the address on file with the IRS when the taxpayer files their last return). If the taxpayer has not notified the IRS of the move, the 90 day letter will be valid despite the fact the taxpayer never received it. However, if the taxpayer files a return with their new address, the IRS is given notice of the taxpayer's last known address. See Rev. Proc. 2010-16. The IRS must be given clear and concise notice of the change of address, and the taxpayer can do this by filing Form 8822.
Example: Angie filed her 2010 tax return with her correct address of "123 ABC Drive, New York, New York 10012." Angie moves on October 2011 to "456 DEF Drive, Shreveport, LA 71105" and does not notify the IRS of her move. Angie doesn't file a tax return for the 2012 tax return year. In 2012, the IRS sends a letter to the New York address providing they received information that she failed to report $10,000 in income. Angie never receives the letter. When the IRS does not receive any information from Angie, they issue a 90 day letter on December 1, 2012 and again mail this to the New York address. Angie finally finds out about the 90 day letter in August 2012 when the IRS attempts to levy on her home. The 90 day letter, though sent to Angie's New York address, is still a valid 90 day letter. Angie may not file a petition in Tax Court. Angie may pay the taxes associated with the $10,000 of income, and then file a petition for refund in a federal district court or the court of federal claims.
Statute of Limitations
If a taxpayer files his return and it is an official return, the IRS is prevented from auditing this return three years after the return is deemed filed. An official (or valid return) is one that (1) has sufficient data to calculate the tax liability; (2) is a document that purports to be a return; (3) is an honest and reasonable attempt to satisfy the requirements of the tax law; and (4) the taxpayer must sign the return under penalties of perjury. See Williams v. Comm'r (T.C. 2000) (holding that a the taxpayer's asterisk on a Form 1040 followed with a disclaimer of tax liability invalidated the return and thus was not a valid return). Thus, a taxpayer that puts all zeros on the tax return will generally be deemed to have not filed a valid return. This is significant because the statute of limitations only begins to run upon the proper filing of a valid return.
The date the return is deemed filed depends, naturally, on when the tax return is filed by the taxpayer. For purposes of filing the return, the "mailbox rule" applies. This rule states that whatever date the return is mailed is the date that will be considered for filing purposes. Thus, for example, if a taxpayer mails his return on April 15th, but the IRS receives it on April 25th, the return will be considered filed on April 15th. It is important to keep information that can prove you mailed the return on April 15th in case it is challenged by the IRS.
Aside from the "mailbox rule," a return is deemed filed on the latter of April 15th following the tax year or the date actually filed. Thus, if the taxpayer files his tax return for year 2011 on March 1, 2012, it will be deemed filed on April 15th for purposes of the statute of limitations period. If the taxpayer files his return on May 30th, 2012, the return is deemed filed on May 30th.
As mentioned above, the statute of limitations is generally 3 years from the date the return is deemed filed. There are some notable exceptions to this rule, however. First, as should be obvious, if the taxpayer never files a tax return or files a fraudulent return, there is no statute of limitations period. Under a 1984 Supreme Court decision, the statute of limitations never runs on a fraudulent return, even if the taxpayer later files an honest amended return. See Badaracco v. Comm'r (1984). Also, if the taxpayer omits from gross income an amount in excess of 25 % of the amount reported as gross income on the return, the IRS has an additional 3 years (for a total of 6 years) to audit. I.R.C. Sec. 6501(e).
Example: Lucy makes $35,000 in self-employment income for the tax year 2005. Lucy fails to file a Form 1040 tax return for that tax year. Later, in 2012, the IRS discovers Lucy's $35,000 in income and sends her a 90 day letter. Because Lucy never filed a tax return, the statute of limitations never runs and the IRS can assess the tax amount owed.
Example: On March 10, 2011, Michael reports on his Form 1040 $100,000 in self-employment income on Schedule C for tax year 2010. In reality, Michael made $175,000 in self-employment income for the year. The IRS, 5 years later, discovers the unreported income and mails to Michael a 90 day letter for the unpaid tax on the $75,000 Michael failed to claim. The statute of limitations is 6 years from when Michael was deemed to file the return (April 15, 2011) and thus the IRS may assess the unpaid taxes.
Example: Richard files a tax return on April 15, 2012 for the 2011 tax year. On it, he reports $35,000 in wages and $10,000 in self-employment income. Richard, non-fraudulently, fails to report $2000 in other income he earned in 2011. The IRS discovers the error and mails a 90 day letter on April 20, 2015 to Richard's last known address. The IRS may not assess the amount of unpaid taxes because it is beyond the three year statute of limitations period.
Also, keep in mind that the statute of limitations works both ways. That is, if you are paying taxes throughout the year (as most do, because they are employees), you have three years from the date the return is due to file a claim for refund with the Internal Revenue Service. If you do not, the U.S. Treasury is allowed to retain the payments made, despite the fact you may not owe that amount.
Example: Alice is an employee of XYZ Bank. Alice earns $30,000 throughout the 2010 tax year, and $5500 in federal income taxes are taken from her paychecks throughout the year. Alice files her 2010 tax return on October 10, 2014; showing a refund of the entire $5500. Alice will not be entitled to the refund of $5500 because she filed her return more than 3 years after the date the return was due (April 15, 2011). If Alice had filed before April 15, 2014, Alice would be entitled to a refund of $5500 (less any penalties for failure to file).
Liens and Levies
If the IRS sends a "90 day letter" to the taxpayer and receives no response after 90 days, they have several options available to them. First, they can levy a taxpayer's assets or they can place a lien on the taxpayer's assets. A levy is an actual taking of property, whereas a lien is placing a notice to others that the U.S. Treasury has a claim to that asset. In order to either, the IRS must meet certain procedural requirements.
Under the Internal Revenue Code, if the IRS intends to levy against the taxpayer's assets, it must first send notices to the taxpayer informing him or her of their intent to do so. Barring extreme circumstances (which are discussed later), the IRS must wait 30 days after the notice of intent to levy has been served on the taxpayer. A notice of the taxpayer's right to a Collection Due Process Hearing accompanies the notice of intent to levy. Under the Code, the taxpayer has 30 days to request this important hearing. If the taxpayer does request a CDP Hearing, the IRS is further prohibited from levying until the taxpayer has a chance to be heard.
The IRS Office of Appeals conducts the hearing (and it may be made heard by phone). At the hearing, the IRS Officer is told by statute to: (1) ensure the IRS has followed the requirements of any applicable law or administrative procedure; (2) allow the taxpayer an opportunity to raise any significant issues related to the unpaid tax or proposed levy (which includes spousal defenses; challenges to whether the collection actions are appropriate under the circumstances; and any offer by the taxpayer for alternative collection methods such as installment agreements or offers-in-compromise); and (3) allow the taxpayer the opportunity to raise a challenge to the underlying existence or amount of the tax liability but only if the taxpayer did not receive a statutory notice of deficiency (i.e., the 90 day letter) or did not otherwise have the chance to dispute the tax liability.