Tax Problem Fundamentals: Phase I Considerations

In the last blog I provided an overview on how to approach a tax problem. That overview broke the approach down into two phases. This installment considers Phase I: What do I owe?

Most income tax obligations arise through the filing of a tax return that reports a balance owed. This situation is typically referred to as a “self-assessment” since the taxpayer is volunteering, under penalties of perjury, what he or she believes to be his obligation. Once a self-assessment is made, the amount owed can still be changed by the taxpayer or by the IRS. The taxpayer can seek a change by filing an amended return. The IRS does so through an audit. As a general rule, any such change must occur within three years of when the return was filed.

In the case of an audit, if the taxpayer does not agree with the proposed audit adjustments there are both administrative and judicial appeal rights. The vast majority of administrative appeals are resolved without the need to go to court. The audit and appeal process can take months, sometimes years. But as long as this process is ongoing, the taxpayer is still dealing with Phase I issues. It is only after the taxpayer has foregone or exhausted all of these options to determine whether and how much is owed, does the tax problem move to Phase II of the process (the subject of my next installment.)

As a general rule, as long as Phase I is open no collection activity can be taken by the IRS under Phase II. But that is not always the case. For example, if no tax return is ever filed the IRS has the ability to file a return based upon information that has been reported by third parties (for example, W-2s and Forms 1099). When a tax liability arises as a result of this process, it is said to arise out of a “substitute for return.” If the IRS prepares a substitute for return, an amount owed has now been determined so collection activity (Phase II) will commence. And yet, when the IRS prepares a return for a taxpayer, usually the amount determined to be owed is significantly higher than what would have been owed had the taxpayer filed the return himself. Under these circumstances it is usually very beneficial to prepare the actual return for the year in question so the correct tax debt can be determined (Phase I).

Another instance when Phase II collection activity may occur before Phase I ends is when the IRS imposes penalties for the late filing of a return or the late payment of the tax owed. There may be no question that the underlying tax obligation is due but the circumstances that caused the late filing or late payment may serve as a basis to have penalties abated. Penalty abatement requests need to be submitted in writing and the written request must demonstrate reasonable cause and not willful collect. There is considerable guidance on what will constitute reasonable cause and things like serious medical issues or catastrophic events usually qualify.

Each of these Phase I examples — the substitute for return and penalty abatement request – muddy the Phase I and Phase II distinction I have made. In these situations, we clearly have Phase I issues to be addressed but IRS collection activity may also be well underway. Therefore, Phase II issues are also going to be in play.

In summary, any time the IRS asserts a liability, the possibility of there being what I call a “Phase I issue” should be considered. After it has been determined that Phase I is over, it is time to consider Phase II — the topic of my next installment.

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