Failure to File Federal Income Tax Returns Legal Consequences and Solutions

A Tale of Woe

It all started innocently enough, many years ago, very late in the evening on a dark and stormy April 15th. In just its second year of existence, your landscaping business was on life support. Exhausted and with a hundred more pressing items on your to-do list, the last thing you wanted to do was stay up half the night to prepare and file an income tax return. To make matters worse, you hadn’t paid any estimated tax, and with hardly enough money left over each month to pay the rent and meet payroll, the last thing you needed was a bill from the IRS. But you hadn’t made much money anyway, so you weren’t too concerned. Assuring yourself that you’d deal with it in the fall after the busy season, you fell into bed and passed out.

Now here you are, a decade later. Your business has grown like Jack’s beanstalk and is profitable beyond your wildest dreams. Possessed of a beautiful family, an incredible home, and all the latest and greatest toys, you’re the envy of all your friends and the target of all your competitors. But unlike a decade earlier when the problem first started, with ten (10) years of unfiled returns you can’t sleep at night.

If it’s any consolation, you’re not alone. Your problem is a common one, and you’d be shocked to know just how common it is. But while misery loves company, you’d also like to understand where you stand legally and what you can do to get back on track. We’ll start with the bad news.

The Bad News

Potential Criminal Penalties

Failure to file is a crime punishable by up to one year in prison and a fine of up to $25,000 ($100,000 for a corporation) for each unfiled return, and that’s assuming the IRS doesn’t try to elevate the omission into an evasion charge, which carries much harsher penalties. The good news is that there is a 6-year statute of limitations on criminal prosecution, and criminal charges are the exception rather than the rule. But it does happen and is happening more and more frequently.

No Limitation on Civil Assessment

When the IRS records a tax liability on its books, it’s called an assessment. While there’s a 6-year statute of limitations on criminal prosecutions, for a civil assessment the statute of limitations is three (3) years after the later of the date a return is due or filed. But there are several important exceptions. In the case of fraud, a substantial understatement, or unfiled returns, there is no statute of limitations on the assessment.

So, in this situation, the IRS can go all the way back to when the problem started ten (10) years earlier and assess the tax. But the good news is that the IRS generally goes back only six (6) years.

Civil Penalties

There are also civil delinquency penalties for failure to file returns timely (i.e. 5.0% of the unpaid tax per month up to a maximum of 25.0%) and failure to pay tax in full and on time (0.50% to 1.00% on the unpaid tax per month up to a maximum of 25.0%). And if the IRS believes the failure to file is a fraudulent failure to file, the delinquent filing penalty increases to 15.0% of the unpaid tax per month up to a maximum of 75.0%.

Interest

Interest accrues on the unpaid estimated tax (referred to as an estimated tax penalty but equal to the applicable rate of interest) and unpaid tax at the applicable federal rate, adjusted monthly, plus 3.0% for individuals and 2.0% for corporations.

Collateral Consequences

There are also numerous collateral consequences arising from failure to file, some of which are unexpected. For example, if you are a lawyer or a CPA (yes, even professionals fail to file), a criminal conviction or even a filed notice of a tax lien can result in the suspension or revocation of your professional license. Government contractors can lose security clearances. Potential issues arise if you attempt to borrow money from a conventional lender. There are many other potential collateral consequences too numerous to catalog in this post.

Potential Solutions

Once you accept the fact that the problem needs to be addressed and doing nothing is not an acceptable approach, there are several viable strategies.

Prospective Filing

Although not recommended, one approach is to begin filing with the current year. For example, if it’s April of 2025 and you haven’t filed returns for the years 2014 through 2023, you could start filing in 2024 and continue filing every year thereafter. Assuming your returns are accurate, if the IRS doesn’t start a criminal investigation by April of 2030 your criminal exposure is eliminated. And as a practical matter, if the IRS doesn’t start a civil examination by April of 2030, your civil exposure for prior years is remote, but as noted above, the IRS can always assess a civil liability if a return is not filed.

If you get away with this approach, you avoid taxes, penalties, and interest for the unfiled years as well as professional fees. The downside is that you continue to have exposure to criminal prosecution for five (5) more years, and interest and penalties on the unfiled years continue to accrue.

Quiet Disclosure

A better approach is to file for the current year and six (6) preceding years. Although you will owe tax, penalty, interest, and incur professional fees, this does demonstrate good faith which may convince the IRS and the Department of Justice that you should not be criminally prosecuted.

Formal Voluntary Disclosure

If criminal prosecution is a serious concern, you may be able to make a formal disclosure under the IRS Voluntary Disclosure Practice (the “VDP”) and avoid criminal prosecution, while reducing civil penalties.

A formal voluntary disclosure is a two-step process. First, you complete and file Part I of Form 14457 seeking a preclearance determination that you are eligible to use VDP.

To be eligible to use the VDP:

• Your non-compliance must have been willful.

• Your unreported income cannot be from illegal sources.

• You must come forward before the IRS knows about your non-compliance (e.g., it has started a civil examination or criminal investigation or has received information from a third party).

• You must agree to cooperate fully if accepted into the VDP (i.e., file all returns, pay all delinquent taxes, and cooperate with the IRS investigation of your returns and any enablers).

If accepted, you must certify under oath that your non-compliance was willful, promptly file all returns, and pay all taxes.

While this program is not for everyone, there are definite advantages. First, you avoid criminal prosecution. Second, you avoid delinquency penalties except for an enhanced civil penalty of 75% of the tax delinquency for the largest year. For many clients with serious potential exposure, the peace of mind associated with this “certainty” is well worth the cost.

Conclusion

Tax non-compliance is a common but serious problem, and doing nothing is not an option. While the potential consequences are harsh, there are ways to get back on track while mitigating or avoiding some of the more serious criminal and civil penalties.