Falling behind on taxes can happen surprisingly quickly when you are self-employed.
You may have had a difficult year, incomplete bookkeeping or an unexpected business setback. Perhaps you filed your returns but could not afford to pay the balances. Or maybe one missing return turned into several years because the problem became too overwhelming to confront.
Eventually, you may no longer know which returns need to be filed, how much the IRS believes you owe or whether you can resolve the debt without paying everything immediately.
The good news is that years of back taxes can often be addressed. However, the solution requires more than simply filing returns or calling the IRS and agreeing to the first payment it requests.
You need a plan that addresses three separate problems:
- Filing the required returns
- Paying current taxes as they become due
- Resolving the accumulated IRS debt
Here is how that process normally begins.
Step 1: Find Out What the IRS Already Knows
Before preparing several years of tax returns, it is important to review the information already in the IRS system.
IRS wage and income transcripts may contain Forms 1099 submitted by customers, payment processors, banks, brokerage firms and other third parties. Account transcripts can help identify:
- Which returns have or have not been filed
- Balances already assessed
- Payments and credits applied to your account
- Penalties and interest charged
- IRS collection activity
- Returns the IRS may have prepared for you
This information provides a starting point, but it may not tell the complete story.
A Form 1099 may report gross payments without accounting for refunds, fees or business expenses. Your own records may also contain income that was not reported on a Form 1099. The objective is to reconcile the IRS information with the actual activity of your business.
Preparing returns without first completing this review can result in missed income, overlooked deductions or unnecessary work on returns the IRS may not currently require.
Step 2: Determine Whether the IRS Filed Substitute Returns
When a taxpayer repeatedly fails to file, the IRS may prepare what is known as a Substitute for Return.
This does not mean the IRS has accurately prepared the return on your behalf.
A Substitute for Return is generally based on income information available to the IRS. It may not include all the legitimate business expenses, deductions, exemptions or credits the taxpayer could have claimed.
This can be especially damaging to a self-employed taxpayer. If the IRS sees payments reported by customers but does not have a complete record of the expenses required to earn that income, the resulting assessment could be substantially higher than the correct tax liability.
According to the IRS, taxpayers may still benefit from filing their own accurate past-due returns after substitute returns have been prepared. The IRS will generally adjust the accounts to reflect the correct figures.
However, the proper procedure can depend on where the assessment stands and what notices have already been issued. A taxpayer who has received a Notice of Deficiency should pay particular attention to the response deadline.
Learn more about IRS Substitute for Return procedures.
Step 3: Reconstruct Your Business Records
Many self-employed taxpayers remain unfiled because their records are incomplete.
Incomplete records do not necessarily make it impossible to prepare accurate returns. Depending on the business, useful records may include:
- Bank and credit-card statements
- Customer invoices
- Forms 1099-NEC and 1099-K
- Payment-processor reports
- Canceled checks
- Receipts
- Accounting records
- Mileage logs and calendars
- Prior-year tax returns
- Loan and equipment-purchase documents
The goal is to create a reasonable and supportable reconstruction of the business’s income and expenses. It is not appropriate to invent expenses or automatically deduct an estimated percentage of income.
At the same time, reporting all the gross income while overlooking valid business expenses can cause serious harm. It may unnecessarily increase both income tax and self-employment tax.
For many self-employed taxpayers, reconstructing the business activity is the most time-consuming—but also one of the most valuable—parts of becoming compliant.
Step 4: Identify Which Returns Must Be Filed
Some taxpayers assume that every missing return from the past 10, 15 or 20 years must immediately be prepared. Others assume that older returns can simply be ignored.
Neither assumption should be made without reviewing the specific account.
The IRS will commonly require a number of recent returns before it will consider a long-term collection resolution. However, the precise filing requirements can depend on:
- The number of unfiled years
- Whether the IRS has requested particular returns
- Whether substitute returns were assessed
- The type of returns involved
- Prior filing history
- Existing collection activity
- Whether a refund or credit may still be available
The filing strategy should be established before spending money preparing returns that may not be required—or overlooking returns that are necessary to resolve the case.
Most importantly, filing a tax return and paying the resulting balance are separate issues. Being unable to pay everything immediately is generally not a reason to continue avoiding required returns.
Step 5: Stop Creating New Tax Debt
This is where many IRS resolution plans for self-employed taxpayers fail.
Employees generally have income tax, Social Security tax and Medicare tax withheld from every paycheck. Self-employed taxpayers ordinarily must create their own system for paying these taxes.
The IRS generally requires self-employed individuals to file annual returns and, when applicable, make estimated tax payments during the year. Those estimated payments are used to cover both income tax and self-employment tax.
Before approving many resolution options, the IRS will expect the taxpayer to demonstrate current compliance. For example, taxpayers generally must have filed all required returns and made all required estimated payments before submitting an Offer in Compromise.
A taxpayer who resolves an old IRS balance but owes again when the next return is filed has not fixed the underlying problem.
Preventing new debt may require:
- Establishing a separate bank account for taxes
- Setting aside a percentage of every customer payment
- Updating bookkeeping monthly
- Reviewing business profitability regularly
- Making scheduled estimated tax payments
- Increasing withholding from a spouse’s wages when appropriate
- Adjusting estimated payments as income changes
This part of the plan may feel less urgent than dealing with IRS collection notices, but it is essential to achieving a lasting resolution.
Step 6: Calculate What You Can Actually Afford
Before contacting the IRS to request a payment arrangement, you should understand how the IRS is likely to evaluate your finances.
Depending on the proposed resolution, the IRS may examine:
- Household income
- Business income and expenses
- Necessary living expenses
- Bank and investment accounts
- Retirement accounts
- Vehicle equity
- Real-estate equity
- Other assets
- Future ability to pay
The amount you would prefer to pay is not necessarily the amount the IRS will accept. Conversely, the payment initially requested by the IRS is not always the only available option.
Agreeing to an unaffordable payment can create another problem. If the agreement later defaults, penalties and interest will have continued to accumulate, and the IRS may resume collection action.
The financial analysis should therefore be completed before selecting or negotiating a resolution.
Step 7: Choose the Appropriate IRS Resolution
Once the required returns are filed, the balances are established and current compliance has been addressed, the available resolution programs can be evaluated.
Depending on the taxpayer’s complete financial circumstances, possible options may include:
Installment Agreement
An installment agreement allows the balance to be paid through monthly payments. The terms and financial information required can depend on the amount owed, the remaining collection period and the type of taxes involved.
Partial-Payment Installment Agreement
A partial-payment installment agreement may be appropriate when the taxpayer can make monthly payments but is unlikely to pay the entire balance before the IRS collection period expires.
The IRS may periodically review the taxpayer’s financial condition and adjust the payment if the ability to pay improves.
Currently Not Collectible Status
Currently Not Collectible status may temporarily suspend active collection when making an IRS payment would prevent the taxpayer from paying necessary living expenses.
The debt does not disappear. Penalties and interest generally continue, and the IRS may review the taxpayer’s finances later.
Penalty Relief
Some taxpayers may qualify for penalty abatement based on their compliance history or reasonable cause. Penalty relief does not automatically eliminate the underlying tax or interest, but it can sometimes significantly reduce the balance.
Offer in Compromise
An Offer in Compromise may allow a qualifying taxpayer to settle IRS debt for less than the full amount owed.
However, owing a large balance does not automatically make someone eligible. The IRS evaluates the taxpayer’s ability to pay, income, allowable expenses and asset equity. An offer generally must represent what the IRS reasonably expects it could otherwise collect.
An Offer in Compromise is an important program, but it is not the correct resolution for everyone—and it should not be selected simply because it sounds like the most attractive option.
Review the IRS Offer in Compromise requirements.
What If You Owe More Than $50,000?
A self-employed taxpayer who owes more than $50,000 may face additional complications.
Larger balances can require more extensive financial disclosure and closer IRS review. The possibility of a federal tax lien, levy action or assignment to an IRS revenue officer may also become more significant, depending on the facts and collection status of the account.
At this level, it becomes particularly important to understand the complete situation before making financial commitments to the IRS.
The analysis should answer several questions:
- Are all the assessed balances correct?
- Have all required returns been filed?
- Are any substitute-return assessments overstated?
- Is the taxpayer current with estimated payments?
- How much time remains for the IRS to collect?
- What assets and equity will the IRS consider?
- What monthly payment can the taxpayer sustain?
- Is there a better option than a full-payment installment agreement?
A substantial IRS debt usually requires a customized strategy rather than a one-size-fits-all payment plan.
Take the First Step Before the IRS Takes the Next One
If you are self-employed and owe the IRS for several years, the solution is normally a process:
Review the IRS records, reconstruct the business activity, file the required returns, stop creating new tax debt and then negotiate the appropriate resolution.
The problem may be serious, especially if the IRS has begun sending levy notices or the balance exceeds $50,000. But continuing to wait usually increases penalties and interest while reducing the time available to develop a solution.
The first step is not promising the IRS a payment you cannot afford. It is determining exactly where you stand and developing a plan that addresses the entire problem.
Need Help Resolving Self-Employed Back Taxes?
I’m Bob Jablonsky, an Enrolled Agent and Certified Tax Resolution Specialist. I help self-employed individuals and business owners understand and resolve serious IRS problems, including multiple years of unfiled returns and substantial back-tax balances.
My process begins with reviewing the IRS records, identifying the filing requirements and analyzing the taxpayer’s financial situation before recommending a resolution.
If you owe a substantial amount to the IRS and would like professional help evaluating your options, use the link below to schedule a consultation.
[SCHEDULE A CONSULTATION] Tax Relief Consultation – Jablonsky Tax Relief
This article provides general educational information and is not individualized tax or legal advice.
