Life can get busy, and occasionally, something happens that causes you to fall behind on your obligations. One of the things you fall behind on might be filing tax returns and paying your taxes.
Once you miss filing a return one year, it’s easy for the situation to snowball. After all, if dealing with one tax return feels difficult, filing two or more returns to get caught up can feel like an insurmountable hurdle.
Eventually, you’ll start getting Internal Revenue Service (IRS) notices about those unfiled tax returns. Ignoring those notices can lead to steep penalties, losing tax refunds you’re entitled to, and other serious issues. Read on to learn how to remedy the situation.
Why You Should File Back Taxes
Getting caught up on your back tax returns offers several financial and practical benefits.
1. You May be Able to Claim a Refund
If you haven’t filed back tax returns and you deserve a refund, you don’t have to worry about penalties and interest. However, you have a limited window of time to file your returns and claim your money.
Many taxpayers miss out on claiming those refunds. In April of 2021, the IRS announced that it had an estimated $1.3 billion in unclaimed tax refunds for people who hadn’t filed a 2017 federal income tax return.
In most cases, you have to file a refund within three years of your tax return’s original due date in order for the IRS to issue a refund. If you miss that window, the IRS will not send you a refund or apply any overpayments or tax credits to future tax years.
2. Stop Late Filing Penalties and Interest
If you don’t file a tax return and you owe the IRS money, the agency charges Failure to File and Failure to Pay penalties.
The Failure to File Penalty is 5% of the unpaid tax for each month (or partial month) that your return is late, but it’s capped at 25% of your unpaid balance. The Failure to Pay Penalty is 0.5% of your unpaid taxes each month (or partial month) that your tax payment is late, capped at 25% of your balance.
The IRS also charges interest on your underpayment and those penalties. The interest rate changes each quarter. For the fourth quarter of 2021, the interest rate on underpayments is 3% for most taxpayers or 5% for large corporate underpayments (underpayments greater than $10,000).
3. Start the Statute of Limitations
In most cases, the IRS can only audit tax returns filed within the last three years. This three-year limit is known as the federal tax statute of limitations.
However, the clock starts running on the date the return is due or is filed, whichever is later. There is no statute of limitations on a return that was never filed.
If you’re worried about dealing with an IRS audit, it’s best to file your return as soon as possible to get the clock started.
What to Do If You Owe Back Taxes to the IRS
Getting caught up on your tax filing obligations may not be as difficult as you think. Follow this three-step process to get it done.
Step 1: Gather Your Tax Documents
This step should be easy if you have all of your tax documents, receipts, and other paperwork handy. But what if your records were lost or destroyed or you just weren’t very good about record-keeping? In that case, you’ll need to reconstruct your records.
A good place to start is getting a copy of your Wage & Income Transcript from the IRS. This tax transcript provides data from information returns, such as W-2s and 1099s. You should also request a Tax Account Transcript from the IRS. This transcript shows any tax withheld, estimated payments, and overpayments from prior-year returns that the IRS applied to your account.
The Wage & Income Transcript is a good resource for reconstructing income and certain deductions that are reported to the IRS, but it may not include all the information you need to file a complete and accurate tax return. You may need to review bank account and credit card statements for the years in question to identify expenses and claim valuable tax deductions and credits.
The good news is, you typically only need to file the last six years of tax returns for the IRS to consider you to be in good standing.
Step 2: Complete and File Your Returns
Once you have all of the information you need to prepare your tax return, make sure you’re using the right tax forms. For example, you need to use the 2018 version of Form 1040 to file a 2018 tax return — you can’t file a 2018 tax return using the 2020 version.
Most DIY tax filing software allows you to file prior-year tax returns. However, you will need to print out and mail the forms, since e-filing prior-year returns is normally not an option.
If you’d rather not deal with preparing the returns on your own, work with a qualified tax professional, such as a CPA, Enrolled Agent, or tax attorney. These professionals help taxpayers get caught up on their tax filing obligations all the time.
Step 3: Pay the Tax You Owe
If you can afford to pay your back taxes with your late return, include a check payable to the U.S. Treasury with your return or make a payment online through IRS Direct Pay. It may take the IRS several weeks to process your return, but once they do, you’ll receive a notice with a bill for any interest and penalties you owe.
The IRS may be willing to waive those penalties if you didn’t file a return due to extenuating circumstances, such as a severe illness, natural disaster, or death of an immediate family member. However, the IRS rarely waives interest. Your tax preparer can send a letter requesting penalty abatement, or you can request penalty relief on your own by calling the toll-free number on the IRS notice.
What happens if you don’t have the money available to pay the balance due? You have several payment options.
The IRS offers several types of installment agreements, including:
- Short-term payment plans (for individuals). If you can pay the balance due in 120 days or less, the IRS won’t charge a fee to set up the installment agreement.
- Long-term payment plans (for individuals). If you need more than 120 days to pay your balance in full, the IRS charges a $31 setup fee if you agree to allow the IRS to automatically draft payments from your checking account or $149 if you pay via check, credit or debit card, or IRS Direct Pay.
- Long-term payment plans (for businesses). The IRS doesn’t offer short-term payment plans for businesses. For long-term payment plans, the setup fees are the same as those charged for individual plans. However, the IRS requires businesses that owe more than $10,000 to make payments via Direct Debit from a checking account.
When you apply for a payment plan, you tell the IRS how much you can afford to pay and the IRS either approves or denies your request.
Keep in mind, the IRS may still file a federal tax lien on your property, even if you’re on an installment plan. The tax lien lets other creditors know that the IRS has first dibs on your property if you try to sell it.
In an offer-in-compromise (OIC), you offer to pay the IRS a portion of the full amount of tax you owe. If the IRS accepts your offer, the agency agrees to let you off the hook for the balance. However, OICs aren’t available to every taxpayer. Generally, the IRS only accepts an OIC when it believes it can collect more from settling with you than it would by following its collection process.
To apply for an OIC, find a qualified tax professional who can walk you through the application process. You’ll need to provide a lot of information to prove your financial hardship to the IRS.
“Currently Not Collectible” Status
If your financial situation is really dire, the IRS may agree to place your account in “currently not collectible” (CNC) status. This means the IRS agrees not to levy your bank account, order wage garnishments, or pursue other collection activities.
In order to get on CNC status, you have to demonstrate that you can’t make monthly payments toward an installment agreement or OIC and cover reasonable living expenses at the same time.
The guidance above deals primarily with back federal income taxes. If you live in a state with its own income tax system, you will need to file state returns as well.
While you may be able to handle getting caught up on back taxes on your own, reconstructing tax records, preparing old tax returns, and navigating your federal and state tax liability can be tricky. No matter the situation, consider seeking the help of a tax professional. They can walk you through every step of the process, help lower your tax bill, and negotiate penalties.