THE RETURN OF THE UNFILED RETURN

In fact, it may have taken several years before we were ready to acknowledge that we were actually running a business and several more years to realize that we just might be making a profit! At that point, some of us started filing tax returns each year and ignored the earlier years. Hardly anyone went back and reconstructed earlier tax returns. But, some of us felt the enormity of the situation and became paralyzed. We didn't know anything about how the tax laws apply to such small businesses and felt totally unable to pull together accurate financial information from which to prepare a tax return. (After all, people don't usually start keeping business records until they realize they have a business.)

I personally think more tax returns go unfiled for these reasons than because people are refusing to pay their taxes. For a great many people, dealing with the tax system is just too overwhelming and threatening for their current state of reality.

I helped a client file 10 years of tax returns a while ago. He had recently become sober and he wanted to clean up that part of his past. He had no paperwork to go by. He had no W-2 forms and couldn't even remember who he worked for. All he knew was that he had been doing construction work on a nuclear power plant! We wrote to IRS for copies of his W-2's and 1099 Forms, telling them that we were preparing the returns now. The IRS sent the copies and did not hassle him once. We didn't sweat the small stuff. We had no information about itemized deductions or employee business expenses, so we just let them go. That was a small cost. It turned out that he had overpayments in some years and owed a little in the other years. Since he was having taxes withheld by his employers, there weren't too many surprises.

Most of us are aware that there is an IRS "statute of limitations" that keeps IRS from auditing our returns after 3 years have passed (in most cases). This is true, but it only applies if we have filed the return! If we haven't filed a return or if there is any indication of fraud in a return that was filed, the IRS can investigate at any time. That's actually a good incentive to get the returns filed, even if we can't get them done 100% right! At least they will be "dead and buried" three years after we filed them! There can be an end to our worries about these years!

If we did file tax returns for every year, but just left out our craft business activity, we may be experiencing what I call a "KLONG". The definition of a Klong is "a sudden rush of sh.. to the heart". It’s the same feeling we get when we’ve been on the road for a couple of hours and remember we had invited our brother-in-law to come along to this show! It’s kind of a sinking feeling that we might be in trouble. Actually, we just have a tough decision to make. We have to decide whether or not to go back and amend the tax returns for the early years of our business to report the income. There are a few considerations. First, IRS won’t allow you to amend any returns that were filed more than 3 years ago. If you haven’t heard from the IRS about them, you can forget about them.

For returns that were filed within the 3-year period, you should estimate the tax consequences of the corrections. This means estimating what the taxable profit might be and calculating the additional income and self-employment taxes on that profit. You might then decide it’s not worth preparing the amended returns; that you’ll take the risk that IRS will question you before the 3-year statute is up. On the other hand, you might decide the peace-of-mind (that would come from knowing all is correct) is worth the small tax cost and the hassle of preparing the amended returns.

If the tax cost is higher, I would have to recommend that you do prepare the amended returns and ask for an installment payment plan if you need one. I say this because the risk may just be too high. If the missing income is substantial, then the statute of limitations may be 6 years... or forever, as I mentioned above. I wouldn’t want that fear hanging over me. Also, if there is what they call "substantial understatement of income", IRS can impose hefty penalties. If there is fraud, they can also make a criminal case. It just wouldn’t be worth it, in my book.

To amend a tax return, we use a relatively simple Form 1040X. On it we just show each line of the Form 1040 as it was originally reported and then again as it should have been. We attach explanations and any affected back-up forms, such as a missing Schedule C.