Failing to file returns is not a reasonable response to the inability to pay the tax liability associated with the returns. If in doubt, file the returns and work out a payment arrangement with the IRS. Also, know that the civil “failure to file” penalty accrues at 5.0%/month (up to 25% of the tax deficiency). The civil “failure to pay” penalty accrues at the rate of 0.5%/month (up to 25% of the tax deficiency). When you do the math and factor in the numerous other risk factors associated with the failure to file a tax return, the decision to file becomes somewhat obvious in most cases.
Before contacting a non-filer, the IRS will often attempt to identify the non-filer’s occupation, location of bank/savings accounts, sources of income, age, current address, last file returned, adjusted gross income of last file returned, taxes paid on last file returned – amounts and methods of payment (withholding, estimated tax, pre-payments), number of years delinquent, and the non-filer’s standard of living.
Tax Evasion and Fraud? If a non-filer is contacted by the government, the examiner will determine the cause (does the non-filer lack records, ability to pay, lack of education, etc.) and may offer necessary information or assistance (preparation of returns, payment arrangement information, etc.) to secure full cooperation. If the non-filer is not cooperative (won’t respond or refuses to cooperate), third party contacts may be made to determine the non-filer’s income and make an assessment.
IRS Inquiries. On the initial screening of a non-filer case, the IRS will attempt to determine if the facts indicate potential fraud. Indicators of fraud for consideration set forth in the IRS Internal Revenue Manual (IRM) include:
- History of non-filing or late filing, and an apparent ability to pay;
- Repeated contacts by the IRS;
- Knowledge of the filing requirements (i.e., advanced education, business (especially tax) experience, record of previous filing etc.);
- Experience of the taxpayer in tax matters such as a law professor, CPA or tax attorney;
- Failure to reveal or attempts to conceal assets;
- Age, health, and occupation of the taxpayer;
- Substantial tax liability after withholding credits and estimated tax payments;
- Large number of cash transactions, i.e., purchases by cash and large cash deposits evidenced by documented cash transactions, payment of personal and business expenses in cash when cash payment is unusual and/or the cashing (as opposed to the deposit) of business receipts;
- Indications of significant income per Information Return Processing (IRP) documents (i.e., substantial interest and dividends earned, investments in IRA accounts, stock and bond transactions, high mortgage interest paid);
- Refusal or inability to explain the failure to file; and
- Prior history of criminal tax prosecutions for Title 26 violations.
If the IRS believes the possibility of fraud exists, the IRM instructs the IRS examiner to not solicit returns. If returns are submitted, they should be accepted but not processed, and clearly documented in the case history. Agents are not to discuss tax liabilities, penalties, fraud, or criminal referral possibilities with the taxpayer.
Non-Filer Examinations. During non-filer examinations, the IRS examiner will determine if related returns (corporate, partnership, employment tax, and excise tax returns) have been filed as required. They will also search for spin-off cases involving relatives, employees, employers, subcontractors, partners, and even return preparers! If a non-filer is involved in a family business, the examiner will determine if all family members have filed returns. If the non-filer is involved in a partnership, the IRS will determine if partnership returns have been filed and determine if all partners have filed returns. For delinquent corporate returns, they will attempt to determine if all shareholders have filed returns. Penalties are not typically be easily waived in non-filer cases without reasonable cause.
During the non-filer examination, the IRM suggests that the examiner:
- Interview the taxpayer to determine the reason or the intent of the taxpayer’s noncompliance.
- Ask sufficient questions to determine the extent of the delinquency, including the periods and tax due.
- Document verbatim, if possible, the questions asked and the taxpayer’s response or lack of response.
- Identify any personal reasons that could affect the taxpayer’s ability to comply. If the information is not provided by the taxpayer, attempt to secure the information from third party sources.
- Attempt to get a definitive statement from the taxpayer regarding additional expenses not listed in the books and records. These expenses could include, but are not limited to, expenses paid in cash or “under-the-table” payments to employees.
- Attempt to establish year-end cash on hand for each year under investigation.
If the IRS receives sufficient information (often utilizing bank deposits plus some specific income items from payments diverted to or for the benefit of the taxpayer) it can prepare substitutes for returns under Internal Revenue Code (26 U.S.C.) § 6020(b). Bank deposits can be prima facie evidence of income. Proof of gross receipts in the amounts shown by a bank deposits analysis is often sufficient to satisfy the Governments burden of showing that a taxpayer had an obligation to file returns.
Fraudulent Failure to File Penalty. Code § 6651(f) provides a penalty of 75% of the amount required to be shown as tax on unfiled returns if the failure to file the returns is fraudulent. The civil fraud penalty is a sanction provided primarily as a safeguard for the protection of the revenue and to reimburse the Government for the heavy expense of investigation and the loss resulting from the taxpayer’s fraud. The Government has the burden of proving fraud by clear and convincing evidence.
Fraud may be proved by circumstantial evidence, and the taxpayer’s entire course of conduct may establish the requisite fraudulent intent. Circumstantial evidence of fraud includes “badges of fraud” such as those present here: a longtime pattern of failure to file returns, failure to report substantial amounts of income, failure to cooperate with taxing authorities in determining the taxpayer’s correct liability, implausible or inconsistent explanations of behavior, and concealment of assets.
In a recent decision by the U.S. Tax Court, the taxpayer contended that compensation for architectural services he performed in Hawaii was not subject to income tax and that therefore he was not required to file returns for the years in issue. Further, he apparently asserted that “his earnings for architectural services rendered in Hawaii are not taxable because he is a U.S. citizen and has no foreign earned income taxable under section 911 and related regulations. His argument is based on inapplicable statutes and circular reasoning. He denies that “worldwide income” includes domestic income, substituting his own reading of statutory and regulatory materials for those of every court that has spoken on the subject in innumerable cases decided over decades. He takes items out of context, treats “includes” as a term of limitation, and contends that references to certain categories within a statute or regulation exclude all others. He has not presented any reason to reject respondent’s recalculated deficiencies and additions to tax or penalties. He has refused to produce evidence of nontaxable bank deposits or deductible expenses.”
The Tax Court noted that “Petitioner’s interpretative arguments have been consistently rejected in strong terms, even in judicial opinions sustaining criminal convictions. See, e.g., United States v. Ward, 833 F.2d 1538, 1539 (11th Cir. 1987) (“utterly without merit”); United States v. Latham, 754 F.2d 747, 750 (7th Cir. 1985) (“inane” and “preposterous”); United States v. Rice, 659 F.2d 524, 528 (5th Cir. 1981) (“frivolous non-sequitur”). In Takaba v. Commissioner, 119 T.C. 285, 292 (2002), the taxpayer and his counsel, Paul Sulla (the attorney who assisted petitioner in establishing entities used to conceal income), were sanctioned under section 6673(a)(1) and (2), respectively, for arguing, among other things, that a U.S. citizen residing in Hawaii was not taxable on compensation earned in Hawaii. No further discussion of petitioner’s stale theories is warranted. See Crain v. Commissioner, 737 F.2d 1417 (5th Cir. 1984).”
In concluding that the taxpayer’s failure to file tax returns for the years at issue was due to fraud, the Tax Court rejected “any inference that petitioner’s persistence in his frivolous theories demonstrates sincerity or good faith or is otherwise a defense to the charge of fraud. . . . A person with his education and skills could be expected to abandon unsuccessful arguments if acting in good faith. We conclude that petitioner’s failure to file for each year in issue was due to fraud.”
Additional Penalty for Delay or Where Taxpayer’s Position is “Frivolous.” Finally, the Tax Court apparently warned the taxpayer about the “possibility of a penalty under Code section 6673 if he persisted in his contention that he was not required to file returns and pay tax on his income for architectural services performed in Hawaii.” The Tax Court noted that “section 6673(a)(1) provides for a penalty not in excess of $ 25,000 when proceedings have been instituted or maintained by the taxpayer primarily for delay or the taxpayer’s position is frivolous or groundless. It may seem that an additional $25,000 on top of the amounts petitioner already owes will not change his position. However, serious sanctions also serve to warn other taxpayers to avoid pursuing similar tactics. See Coleman v. Commissioner, 791 F.2d 68, 71-72 (7th Cir. 1986); Takaba v. Commissioner, 119 T.C. at 295. An award of $ 25,000 to the United States will be included in the decision to be entered here.” (emphasis added).
The Path Forward. Generally, people who come forward and file returns prior to being contacted by IRS will not be subjected to a penalty associated with a Code § 6651(f) fraudulent failure to file return penalty nor will they likely be pursued through a criminal investigation.
The “willful” failure to file a tax return, pay a tax that is due or supply information requested can be subject to a criminal prosecution under Code § 7203. The IRS Voluntary Disclosure Practice set forth in Internal Revenue Manual 18.104.22.168 indicates that a timely, truthful voluntary disclosure is a factor to consider in deciding upon a possible criminal prosecution referral by the IRS to the Department of Justice. although this Practice does not technically absolve a taxpayer of civil penalties, it is an important factor in civil penalty determinations as well. Also,Treas. Reg. 1.6664-2(c)(2) generally encourages voluntary disclosures by eliminating accuracy-related (but not civil fraud) penalties on amounts reflected on an amended return that is filed before any IRS contact.
For non-filers, opportunities exist to file returns before any IRS contact that could reduce or eliminate potential civil penalties and any potential criminal prosecution, and may be able to coordinate an effective installment payment arrangement (or Offer in Compromise) for any resulting deficiencies. Regardless, a non-filer should not wait since the “first knock on the door” might not be user friendly . . .
 See Tokarski v. Commissioner, 87 T.C. 74, 77 (1986); Estate of Mason v. Commissioner, 64 T.C. 651, 656-657 (1975), aff’d, 566 F.2d 2 (6th Cir. 1977).
 See Hamlet C. Bennett v. Commissioner, T.C. Memo. 2014-256 (December 22, 2014)
 Helvering v. Mitchell, 303 U.S. 391, 401 (1938).
 See Code section 7454(a); Tax Court Rule 142(b).
 Rowlee v. Commissioner, 80 T.C. 1111, 1123 (1983).
 See, e.g., Bradford v. Commissioner, 796 F.2d 303, 307-308 (9th Cir. 1986), aff’g T.C. Memo. 1984-601; Powell v. Granquist, 252 F.2d 56, 60 (9th Cir. 1958); Grosshandler v. Commissioner, 75 T.C. 1, 19-20 (1980); Gajewski v. Commissioner, 67 T.C. 181, 199-200 (1976), aff’d without published opinion, 578 F.2d 1383 (8th Cir. 1978).
See Hamlet C. Bennett v. Commissioner, T.C. Memo. 2014-256 (December 22, 2014)
 Id.; See also Miller v. Commissioner, 94 T.C. 316, 332-336 (1990); Chase v. Commissioner, T.C. Memo. 2004-142; Tonitis v. Commissioner, T.C. Memo. 2004-60; Madge v. Commissioner, T.C. Memo. 2000-370, aff’d, 23 Fed. Appx. 604 (8th Cir. 2001); Greenwood v. Commissioner, T.C. Memo. 1990-362.
 See Hamlet C. Bennett v. Commissioner, T.C. Memo. 2014-256 (December 22, 2014)