Have you heard that you can turn your tax debt into a refund? This might sound like a fairy tale, but it is true. When you file your outstanding tax returns, you can save a lot of money. In some situations, you might even find that you receive a refund instead of having to pay any money to the IRS. Wondering how this works? Let’s find out.
Substitute for Return
When you do not file your federal income tax return when you were supposed to do so, the IRS will file it for you using what is known as a Substitute for Return (SFR). To do this, they use the information they have on file for you. Generally, this is your income from your employers. Even if you are an independent contractor, the IRS will have information about what your clients paid to you from 1099-MISC forms. The IRS also has information about other sources of income through 1099 and W2 forms, among others.
Once they have this income information, they put it on the computers to calculate what you owe, giving you the standard deduction. They do not have any other information on you, so you do not receive any exemptions, credits, or deductions for which you would normally qualify. In many cases, this means that you end up with a tax liability higher than what you would owe.
Filing Back Taxes to Save
You have the ability to file an outstanding return even after the IRS files a Substitute for Return. When you file a return including your deductions and credits, you most likely save a lot of money on your tax bill. This also reduces the amount of money owed due to penalty fees and interest, since your original tax debt is lower.
How does this work? Well, when you fill out a tax return, you have the ability to reduce your income through certain deductions, such as educator expenses, certain business expenses, IRA deduction, student loan interest deduction, tuition and fees, moving expenses, and health savings account deduction. This has the potential to lower your adjusted gross income. Then, you also have itemized deductions that might be higher than the standard deduction that further reduces your taxable income. There are also credits such as the child tax credit, earned income credit, and retirement savings contributions credit that further reduce the amount of tax you owe. Basically, deductions reduce your taxable income, while credits reduce the tax you owe.
For example, let’s say you gross $30,000 per year and are a single filer with no dependents. When the IRS calculates your tax using an SFR, they will take your 30,000 and subtract the standard deduction for the tax year, which in 2016 was $6,300. You will be taxed on $23,700, which amounted to $3,095 in 2016. Now let’s say you are paying off student loans, so you get to apply the $1,000 interest you paid as a deduction. You also put in money to your IRA and can deduct up to $5,500. So, you can subtract another $6,500 off your income for a taxable income of $17,200, since you also still get the standard deduction. Your new tax is $2,120, based on the 2016 tax tables. You have already saved almost $1,000. Now, let’s say you also have a tax credit of $1,000. This leaves you owing just $1,120. That is a difference of almost $2,000. That could make a huge difference!
Depending on your situation, you could greatly reduce your adjusted gross income, taxable income, and tax owed through your deductions, credits, and exemptions. The majority of people who file their old returns in place of an SFR find their tax liability reduced.
In some cases, once you have input your credits, deductions, and exemptions for your tax return, you end up with a refund rather than a tax bill. With a refund, you do not owe any interest or penalty fees, so you get the full amount back!
The one caveat? You have a three-year time limit for filing a return to receive the refund. After the three years, you still can avoid paying your tax debt, including any penalties or interest, through filing the return. However, any money owed to you goes to the US Treasury instead of to you, any outstanding debt, or future estimated taxes.
Filing your outstanding returns has the power to save you a lot of money. Not only might it stop penalty fees for not filing, but it also allows you to reduce your original tax liability. In some situations, you might find that the IRS owes you money, not the other way around. Filing your taxes is one of the easiest ways to start the process of solving your federal tax debt.
At Fidelity Tax Relief, we help our clients save money and resolve their tax debt. We review your case to determine if filing your back taxes or applying for a tax relief option such as an Installment Agreement or Offer in Compromise is the right solution for your situation. Call us today to discuss your options.