YOUR TAX RETURN - 2011 EDITION

For those yet blissfully unaware, it is my unpleasant duty to focus your attention once again to the dreaded and tedious task of gathering together your tax information. The “tax filing season,” as tagged by tax professionals, who, from it earn a living, culminates for most with the filing of a tax return some time before April 15 and for some not until October 15. You should now have received most of your tax information and hopefully are already engaged in organizing that information for filing your 2010 Form 1040.

This year, with many last-minute tax law changes, and uncertainty about the future structure of the tax law, one must wonder if the process should be listed as a disorder in the standard psychiatric diagnostic manual DSM V. For, often, it feels wholly irrational to be spending as much time pondering and fretting about a chameleon-like tax law and the largely misunderstood act of filing one’s tax return. Anton Chekov in his novel “Ward Number 6” ruminates on the definition of sanity and who gets to decide who is sane and who is not. Are we insane to subscribe our names to inscrutable documents; or, is the fear of being unfairly punished for one’s ignorance, merely paranoid? One might justifiably feel that the government is setting you up. In making the tax code incomprehensible to all but the highest level of specialized tax professionals (which excludes even most tax preparers) you are perhaps intentionally induced to err in the execution. I suspect that few comprehend how most of the many entries on their tax return are determined. Many who carefully examine a restaurant check before paying, scantly peruse their tax return before signing and filing

SELF ASSESSMENT MADNESS

The self assessment tax system is an odd concept. Your real estate tax bill is determined by the county assessor and millage rate. The sales tax you pay is derived from what you spend. How your income tax liability is determined, however, is akin to a customer being allowed to set the price when buying a car subject only to an occasional adjustment by a fair price commission choosing to review one percent of purchases. The taxpayer determines his tax by the income and deductions he reports subject to audit. Matching Forms 1099, K-1s and W-2s has taken away some of the liberty; but, it is still a self determined tax in the first instance. This power of self determination, or annual income confession, can unfortunately become delusional and grandiose leading to the major headaches of an audit, court dispute, or even, criminal tax investigation and draconian civil and criminal financial penalties, and/or prison time.

KEEPING OUT OF TROUBLE

I prepare tax returns as a tax lawyer because I have found it easier to keep my clients out of trouble than to get the clients of others out of trouble. Yet, many tax preparers are quite cavalier about how serious a document is the ordinary tax return. When I mention criminal tax matters, the stock response is: “I’ve never had a client who was investigated for or charged with a tax crime.” This anecdotal assessment, on one level, is true; only the very few unfortunates are subjected to the honor. The rub is that those targeted for investigation are put on the rack and subjected to a very expensive and painful experience, even if not ultimately indicted. Even the more ordinary civil tax audit is expensive and emotionally fretful to endure. The response is not wholly irrational of those, who, upon receiving an envelope in the mail from IRS, mentally transpose “IRS” into “I’m Really Scared!” A criminal tax investigation is sort of like a Hurricane, not likely to happen but very destructive when it does. A civil tax audit is more likely but still hits you with tropical storm force. Thus, I am once again admonishing all to respect the tax return and attend thoughtfully and cautiously to its filing.

WHY BE CONCERNED ABOUT SIGNING YOUR TAX RETURN?

This obtuse document, this complex and vexing tax return, this intimidating Form 1040 - we sign under the following declaration:

“Under penalties of perjury, I declare that I have examined this return, including accompanying schedules and statements, and to the best of my knowledge and belief, it is true, correct and complete.”

Your tax return is one of the rarest of documents, one calling for a signature and expressly stating that a knowingly false statement will be treated as perjury. The information in your tax return is akin to providing testimony under oath. Your tax return is a disclosure and reporting document. Some behave like it is a document filed in an adversarial proceeding but that is an inaccurate expression. Filing your tax return may lead to an adversarial proceeding but it is not in and of itself an adversarial filing. Thus, your return preparer is not merely an advocate but has a parallel duty not to frustrate or subvert the integrity of the tax system. The filer is bound by the above declaration and other civil and criminal sanctions for abusing the system by negligently or willfully under-reporting income or overstating deductions and credits.

TAX PERJURY

The federal criminal statues embody that concept. Specifically, as to the tax return declaration, 26 USC Section 7206, provides, in part:

Any person who –

(1) willfully makes and subscribes any return … which contains or is verified by a written declaration that it is made under penalties of perjury, and which he does not believe to be true and correct as to every material matter…shall be guilty of a felony and, upon conviction thereof, shall be fined not more than $100,000…, or imprisoned not more than 3 years, or both, together with the costs of prosecution.

EXTENSION FORMS

One may be convicted of the crime of filing a false return, even if no tax is due as a result of the falsity. Extension forms are not verified and hence are not covered by the tax perjury law. But, there is a separate offense contained in 26 USC 7207 which makes knowingly presenting a materially false document to IRS a misdemeanor punishable by up to one year in prison and a fine of up to $100,000 or both. In addition, filing a false extension, such as one reporting zero income and tax when it is known that the taxpayer will owe tax, when considered with other actions, may help the government support the more serious tax offense of a willful attempt to evade or defeat any tax. The later is a felony carrying a 5 year maximum sentence and a fine of up to a $250,000. Despite these severe sanctions, author Herman Wouk wrote: “income tax returns are the most imaginative fiction being written today.” Here in South Florida, the genre seems popular. Other tax crimes raise even higher the price one may pay for attempting to illegally best the IRS.

With mounting government budget deficits, some suggest that we are heading towards a simple two line tax return:

1. How much did you earn? __________.

2. Pay the amount shown on line one.

Even then, I suspect, that human nature being what it is some, perhaps having the Kingfish (Amos n’ Andy) or Ralph Kramden (The Honeymooners) in their blood, would devise schemes to avoid the taxman. To those who would scoff, Ralph Kramden would chide: “Har, har, hardee, har, har!” When Ralph’s latest scheme inevitably fell through, however, his friend Ed Norton would console: “Tough luck Ralphie boy.” My advice is not to emulate Ralph Kramden or the Kingfish regarding your tax return.

YOUR TAX RETURN PREPARER

Almost anyone can prepare a tax return for hire although all tax return preparers are now required to register with IRS and obtain an identification number (PTIN). Non-regulated preparers (not an attorney, CPA or enrolled agent) will be required to pass and examination and take continuing education courses. The levels of education and competency of preparers varies considerably and from bottom level to top level are:

1. Yourself using Turbo Tax or some other product. Self deluding as to correctness of return for all but most basic returns.

2. Unaffiliated store front tax preparer. Most often cited in fraudulent tax preparation schemes.

3. Store front franchise tax Preparation Company like H&R Block or Liberty. Minimally trained preparers following a template for preparation – adequate for very simple individual returns).

4. Bookkeeper or unlicensed accountant (quality varies widely but definitely not tax experts. Oddly enough, those in categories 2, 3 and 4 will be designated by IRS as “Registered Tax Return Preparers.” Many feel the public will be misled by this term applied to minimally qualified person who will be tabbed “Registered” a phrase not employed for the more qualified preparers below.

5. Enrolled Agent. Pass a written IRS examination but requires no minimum educational requirement; or, former IRS agent with minimum required experience. Subject to Treasury Department standards in Circular 230 – alright for most individual returns.

6. Certified Public Accountant. General practitioners in smaller firms perform accounting, auditing and tax services; larger local and national firms have dedicated tax personnel. Qualify very high in national firms and varies considerably in local firms. Generally capable for most returns although skills higher on computational tax matters. Governed by Circular 230 but no useful client communication privilege is possessed.

7. Tax lawyer or tax lawyer-CPA. Few tax lawyers prepare personal tax returns. Generally, more conceptual and thoughtful in approach to returns. If experienced in tax controversies, knows how to identify and control evidence, perfect appeal options, avoid strategic mistakes that may limit defense or tax collection options, and preserve privileges. Communication of information not going into tax return should be privileged and confidentiality rules may protect non-legal business or investment communications. Documents created may have work product protection. Your personal papers in lawyer hands will have 5th Amendment protection.

YOUR TAX RETURN AS A MICROCOSM OF YOUR LIFE

Line up all of your tax returns in a row and you will see before you a journal of your life, revealing such matters as:

1. Where you have resided (address).

2. Where you have worked (W-2s)

3. How much you’ve earned (wages)

4. When you were married (filing status)

5. When you were divorced (alimony)

6. When children were born (dependents)

7. When your children began college (Education credits)

8. When you moved (sale of residence, real estate taxes, mortgage interest)

9. How charitable you’ve been over the years (Schedule A)

10. Businesses you’ve owned (Schedule E and Schedule C)

11. Investment successes and disasters (Schedule D, capital gains).

NOT FILING A TAX RETURN

Some avoid the frustration altogether by simply not filing a tax return. This ostrich technique of sticking one’s head in the sand to avoid a problem does not work, however. Not washing the dishes right away leaves them sticky and harder to clean up later. Failing to file a return is a misdemeanor, not a felony like filing a false return. But, it can be elevated to the felony level of tax evasion if accompanied by other acts of deception such as using nominee entities to hide assets and income, etc. Moreover, IRS has become more skilled at locating non-filers. Thus, these individual are wise to come back into the system with the assistance of a capable tax lawyer. The IRS has just announced a Second Offshore Voluntary Disclosure Initiative offering the certainty of no criminal charges for those hiding unreported offshore financial accounts. One seeking admission into this program should engage an attorney to Sheppard the process (See Volume 5, No. 2). It is a risky enterprise for one to simply file delinquent tax returns, offshore bank account or not, using a trusted tax return preparer. The filing may not be viewed as a Voluntary Disclosure. The tax return preparer lacks attorney-client privilege and broader confidentiality protections that are granted to lawyers and which can protect communications and information not included in the returns. Also, a non-lawyer preparer is not trained to determine whether the facts and circumstances are such that returns may be safely filed without the filer being indicted for admitting his or her crime; or, whether other protective measures must be employed to bring the delinquent filer into compliance with the law. Not filing a tax return when due can have collateral consequences, as well, including:

1. Not being able to obtain a bank loan.

2. Missing out on valuable tax elections.

3. Leaving open indefinitely the time within which IRS may ask you to pay additional taxes for the year in question.

4. Not being able to recover taxes withheld from your wages in excess of what you rightfully owe.

5. Not being able to discharge taxes in bankruptcy.

6. Not being able to obtain other relief from IRS regarding tax liabilities for other years.

7. Not receiving notices mailed by IRS to an outdated address which, however, is treated as your “last known address” for procedural tax purposes.

If IRS discovers your non-filing and you fail to respond to requests to file, IRS will prepare a substitute return for you based on the information in its computer. This will often result in a higher tax assessment than you would owe on a return prepared from complete information because it will omit tax basis of assets sold and deductions and credits. A substitute return does not relieve one from the duty to file a return reporting income not included in the substitute return (e.g., income not reported on a Form 1099).

HOW LONG TO SAVE YOU TAX RETURN AND DATA

Keep your tax return forever. It is not that bulky in most cases and contains information that may become relevant to later tax issues. Your tax back up data, however, may generally be discarded after six years have elapsed following the filing of your return or the filing due date if later. Six years is generally the maximum period within which IRS can assess additional tax, although the usual period is within three years of the filing or due date, if later. Some documents should be kept longer. Examples are:

1. Documents relating to the tax basis of an asset: for six years following the year in which you sell the asset.

2. Documentation for expenses comprising a net operating loss carryover: for six years following the year in which you utilize the net operating loss.

CONCLUSION:

Treat your tax preparation and tax return filing as serious matters. Employ a competent and ethical return preparer. If your return preparer is a non-lawyer, make certain that he or she knows where tax accounting ends and tax law begins that he or she not end up as a government witness testifying against you in a criminal tax fraud trial or jeopardize legal rights about which CPAs are unfamiliar. Areas where one should involve a tax lawyer include when contacted by an IRS special agent, when filing delinquent or amended tax returns, when requesting Innocent Spouse relief or a Collection Due Process Hearing about an IRS tax collection matter or when deciding how to appeal an IRS audit result (i.e., filing a protest with IRS Appeals Division, petitioning the U.S. Tax Court or paying the tax and filing a refund claim) and when considering an item in a tax return to be filed that involves a controversial tax matter, requiring an analysis of tax law and litigated cases, and/or required or protective disclosures. These are some matters that have legal consequences on choice of forum, statute of limitations, avoidance of severe penalties or the ability to discharge a tax liability in bankruptcy, none of which are within the normal scope of a non-lawyer’s training or experience.