The complexities associated with return preparation, tax law, and the April 15 deadline have required practitioners to devote more time to preparing returns. As a consequence, more extensions of time to file are being filed.
The IRS has indicated that taxpayers should file a Form 4868, Application for Automatic Extension of Time to File U.S. Individual Income Tax Return. The instructions for filing a Form 4868 require taxpayers to:
- Properly estimate their tax liability using the information available to them;
- Enter their total tax liability on line 4 of Form 4868; and
- File Form 4868 by the regular due date of their return.
Normally, filing this form results in an automatic six-month extension of time to file without any late-filing penalty. However, filing the form does not extend time to pay any income tax liability due. The estimated taxes due should be paid with the extension application. Interest is charged on a material underpayment of tax from the original due date of the return until the tax is paid, and a late payment penalty may also be due. The interest rate varies quarterly with the federal short-term interest rate.
Regulations provide relief from penalties only if the balance due on Form 1040 is less than 10% of the total tax shown on that form and is remitted with the return. If the balance due is more than 10% or is not remitted with the return, the penalty may apply to the total of the balance due from the original due date of Form 1040 to the date of payment, unless the taxpayer establishes reasonable cause (Regs. Sec. 301.6651-1(c)(3)).
In addition to these concerns with the federal extension, applicable state extensions and the rules and regulations associated with them require the same careful consideration. The requirement to electronically file some state extensions raises the due diligence required by practitioners.
Increased monitoring by the states and the IRS of both practitioners and tax returns may cause many practitioners to rethink their office procedures in dealing with clients who desire to extend their individual income tax returns.
First, there is the need to accurately estimate a client’s tax liability when an extension is filed. Second, the practitioner should advise clients that if an extension is filed on their behalf, it is an extension of time to file only and not an extension of time to pay. Some clients have the misconception that the filed extension extends not only the time for filing but the time for paying the tax due. Clients should also know that penalty and interest apply to any balances due in excess of 10% of the total tax shown on the tax return. This could be done in the engagement letter with the client. Sample language can be found in the engagement letters included in the AICPA Tax Practice Guides and Checklists:
If an extension of time to file is required, any tax due with this return must be paid with the extension. Any amounts not paid by the filing deadline may be subject to interest and penalties.
information on sample engagement letters is available here.
Third, the practitioner may want to have an affirmative indication from the client authorizing the filing of an extension, including the amount of federal and state withholding and estimated tax payments. This should contain language indicating that the taxpayer understands he or she may also be required to make estimated tax payments for the current tax year.
These office procedures would be consistent with IRS rules in Circular 230, particularly Sections 10.22 (Diligence as to Accuracy) and 10.33 (Best Practices). In addition, the IRS has indicated its desire for more oversight of all income tax preparers. Kip Dellinger argues that courts—and in particular the IRS—are increasing what constitutes return preparer due diligence (see Dellinger, “Return Preparer Due Diligence and the IRS: The Looming Battle,” 128 Tax Notes 889 (August 23, 2010)). It is not inconceivable that the IRS could develop computer criteria in the future to invalidate extensions if the requirements of Sec. 6651 are not met. State revenue departments could also do this.
Reasons for Additional Office Procedures
Liability insurers have noted an increased number of claims resulting from extensions (Lee, “Frequent Tax Claims Against CPAs,” AZ CPA (February 2007)). In addition, there have been some court cases that merit consideration of additional office procedures in the preparation of extensions.
In Crocker, 92 T.C. 899 (1989), the Tax Court held that the IRS could void the automatic extension because the taxpayers “did not make a bona fide and reasonable estimate of their tax liabilities nor did they make a bona fide and reasonable attempt to secure the information necessary to make such an estimate.”
In Haddad Motor Group, Inc. v. Karp, Ackerman, Skabowski & Hogan, P.C., 603 F.3d 1 (1st Cir. 2010), accountants were held liable in a civil suit brought by the client for the client’s nonpayment of estimated quarterly taxes and estimated tax due with the extension of time to file the return. The court found the accountants liable for deceiving the client as to its tax liability related to the closeout of a margin-against-the-box transaction and conversion to an S corporation.
The client closed out the transaction in February 1999, thus incurring a built-in gains tax liability on the transaction. The accountants failed to have the client make any estimated payments based on the liability from the transaction. In December 1999, the accountants advised the client of the built-in gains tax liability and for other reasons recommended that the client file an extension of time to file taxes (Form 7004, Application for Automatic Extension of Time to File Certain Business Income Tax, Information, and Other Returns). However, the accounting firm did not consider the large built-in-gains tax in the estimated tax liability shown on Form 7004. Therefore, the IRS assessed penalties against the client for underpayment of estimated taxes and assessed interest for failing to pay tax from the original due date of the return through the extended due date.
In the client’s suit against the accountants, the jury awarded damages for federal and state interest and penalties incurred (only) from the original due date through the extended due date. The judge also awarded damages for the interest and penalties on the failure to make adequate quarterly estimated tax payments, plus treble damages and attorneys’ fees and court costs under MA Gen. Law, ch. 93A. Although the total amount the client was charged in interest and penalties attributable to the transaction was about $12,350, the firm ended up paying over $250,000 to the client as a result of the litigation.
Practitioners should consider including language on extensions in their engagement letters, regardless of whether positive or negative letters are used. The client should provide written confirmation of authorization to file the extension with withholding and estimated tax payments included. The extension authorization letter should include a notation that the client may be required to make estimated tax payments for the current year. In addition, documentation of any estimates and calculations should be retained in the client file for future reference. It takes only one engagement that goes astray to cause many sleepless nights for a practitioner. These ideas are a means of preventing this from this happening.
Valrie Chambers is a professor of accounting at Texas A&M University–Corpus Christi in Corpus Christi, TX. Gerard Schreiber is with Schreiber and Schreiber in Metairie, LA. They are both members of the AICPA Tax Division’s IRS Practice and Procedures Committee. For more information about this column, contact Prof. Chambers at firstname.lastname@example.org.