How to Avoid Jail and Clean Up Tax Problems

If you have willfully failed to report income or claimed excessive deductions or failed to file your tax returns and pay the tax owed, you may be liable for civil penalties and possible jail time for criminal tax evasion.

Few tax professionals are aware of an Internal Revenue Service program that can help taxpayers clean up past troublesome tax issues without criminal liability.

The IRS has a longstanding program through which taxpayers can make voluntary disclosures of tax underreporting and tax criminal evasion. The latest voluntary disclosure program is known as the Voluntary Disclosure Practice (VDP).

A taxpayer seeking to make a voluntary disclosure must do so by first requesting preclearance on Form 14457, Voluntary Disclosure Practice Preclearance Request and Application, Part I.  The taxpayer must fax or mail the completed Form 14457, Part I. The IRS uses this information to verify that the taxpayer is not already under criminal investigation, which is a bar to entering into the VDP program.

If the IRS preclears a taxpayer, the taxpayer will use Part II of Form 14457, which seeks detailed information regarding the nature of the tax reporting failures and the associated unpaid tax liabilities. No returns or payments are required at this stage.

A critical requirement of Part II of Form 14457 is a Noncompliance Narrative Statement (Question 7 on Part II of the Form).  The Narrative Statement must give (a) the taxpayer’s personal and professional background, (b) professional advisors, and (c) non-compliance narrative.  The narrative must include a thorough discussion of all Title 26 and Title 31 willful failures to report income, pay tax, and submit all required information and reports.  So taxpayers and advisors should limit their narratives to avoid unnecessary disclosure of other irrelevant areas.

If the IRS ultimately accepts the voluntary disclosure, the taxpayer’s submission will be sent to the examination for review and examination. The taxpayer must cooperate with the IRS examiner or else the examiner can request that the IRS revoke its acceptance of the disclosure.  However, according to the memo if the taxpayer and examination cannot agree, “taxpayers retain the right to request an appeal with the Office of Appeals. ” Regardless, the case should generally remain in IRS civil (criminal) examination.

If the taxpayer is approved to participate in the VDP program, the taxpayer’s case is transferred to the appropriate IRS civil division for examination. Ultimately, the taxpayer must cooperate and must make arrangements to pay all unpaid liabilities. Typically, this will include the filing of corrected tax returns for six years; the payment of the correct tax and interest for those returns; and the payment of enhanced penalties for one tax year.

In April 2020, the IRS quietly updated Form 14457 and its instructions. The changes to the form and instructions answer some of the outstanding questions but also raise new questions.  For example, while the instructions clearly state that disclosure will not guarantee immunity from prosecution, they also state multiple times that the practice provides a way to “avoid potential criminal prosecution.”

Any taxpayer who is considering options for resolving tax problems should consult with an experienced tax attorney who is familiar with all options for resolving the noncompliance, including the IRS Voluntary Disclosure Program.