In our recent article on the subject of non-filing, we wrote that "it is much better to initiate the contact with the IRS than to have them track you down, reconstruct your tax return from any and all data they can find including estimating your income based upon your lifestyle and then filing your returns for you with only their data". The focus of this article is the process the IRS uses to reconstruct and file a "substitute" tax return (herein referred to as SFR's) for a non-filer and the nightmare that this process can create for the non-filer and their family and friends.
The IRS becomes aware that an individual has failed to file a timely tax return for a given year either due to the fact that they filed in prior years or through the legislated reporting requirements that are in effect in this country. Wages are reported on the Form W-2's, gaming winnings are reported on the Form W-2G's and almost all other forms of income are reported on one of the many variations of the Form 1099. The versatile Form 1099 is also used to report the proceeds of a sale of property such as stocks, bonds, houses, buildings, etc., when a third party such as a broker is involved. Reports of cash transactions of $10.000.00 or greater are also required to be reported by most institutions in this county, not to mention the special reporting requirements on casinos. Once identified, the IRS mails a demand for a tax return to the last known address or "usual place of abode" of the individual. This process is repeated several times the last being sent by certified mail. If the IRS does not receive a response in the specified time or the individual refuses to accept the certified letter, it then proceeds to reconstruct your tax return.
The IRS usually uses one of two methods to reconstruct your tax return, the first by using reported income or sales proceeds as income and then applying the standard deduction and personal exemption to arrive at the amount of taxable income from which they compute the tax due. The other, known as the "lifestyle" method is much more complicated as it involves estimating the income by determining the amount of money you spent during the taxable year. This is accomplished utilizing the subpoena power granted by congress to obtain any and all financial records pertaining to you from banks, consumer reporting agencies, any company that issued you any type of credit card, investment companies, bookkeepers. Once the data is collected a SFR is prepared and then the fun begins.
Once prepared the SFR is subjected to an office audit. A summons to appear and produce all financial records and books is issued and mailed and here again, the process will proceed even if you do not show up. Should you respond to the summons, the IRS will present you with a form the shows the figures the IRS has, the resulting tax and the penalties and interest thereon. They should adjust the figures if your records indicate that you are entitled to itemize your deductions or for the cost of the property sold or any other legitimate deduction for which you have proof. Once the examination is completed and the appropriate income, tax, penalties and interest are recomputed, you will be asked to agree with these amounts and sign the form. If you do pay the amount due at this time or enter into an installment agreement, the collection process will begin. If you did sign, the IRS will first send you a "thirty-day" letter which informs you that you have thirty days to formally appeal the IRS's findings. If you do not pay or appeal within the time limit, you will next receive a "ninety-day" letter which gives you the option to pay or appeal to the Tax Court within ninety days. If you do neither, the Collection division then takes "enforceable action" which can include garnishment, levies, seizures and tax liens and you will find yourself in a real life nightmare. The IRS can inflate the amount you owe by imposing any and all of the civil penalties prescribed by law and even institute criminal proceedings in the U.S. District Court system. Criminal penalties can only be imposed after implementation of the constitutional criminal process, under which you are entitled to the same rights and privileges as are other criminal defendants.
Should the nightmare begin for you, seek professional assistance from a Tax Attorney, CPA or Enrolled Agent as soon as possible to give yourself a fighting chance.
IRS Civil and Criminal Penalties: