Get the Most Out of Overpayments Applied to the Following Year’s Return

Editor:Valrie Chambers, Ph.D., CPA

Practice & Procedures

Many taxpayers have overpayments on their original return. A taxpayer can elect to have an overpayment refunded or applied to the subsequent year’s estimated tax payment. This election, once made, is generally irrevocable (Sec. 6513(d); Regs. Sec. 301.6402-3(d); Rev. Rul. 55-448). Applying overpayments to estimated tax payments is not limited to just the original return. Taxpayers can also apply overpayments from amended returns (Forms 1040X, Amended Individual Income Tax Return, and 1120X, Amended U.S. Corporation Income Tax Return) to a later year’s estimated tax payments.

Caution should be taken with using Form 1040X or 1120X overpayments to pay the current year’s estimated tax payments. The IRS is required to review all refund claims before allowing the overpayment. If the amended return is selected for audit or just held up in the IRS system, the subsequent year’s return may be due and the overpayment from the prior year will not be there to pay the current year’s taxes. This is especially true if the requested overpayment is more than the threshold of $2 million, above which refunds cannot be paid until 30 days after Treasury reports the refund to the Joint Committee on Taxation (Sec. 6405(a)); these overpayments should never be applied as an estimated tax payment for the current year, as it is highly unlikely that the examination of the amended return and joint committee process will be completed before the due date of the subsequent year’s return.

If the taxpayer is filing a carryback claim on Form 1045, Application for Tentative Refund, or 1139, Corporation Application for Tentative Refund, these overpayments can be applied to a current year’s estimated tax payments as well. Unlike the 1040X and 1120X procedures, the carryback claims on Forms 1045 and 1139 are generally processed within 90 days of filing. This is because the IRS allows the overpayment before any detailed review or examination. Accordingly, the IRS should allow taxpayers to request that these overpayments be applied to a current-year estimated tax payment before the current-year return is filed.

An overpayment applied to the subsequent year’s estimate is referred to by the IRS as a “credit elect.” Once the credit elect is applied to the next year’s account, it is a payment for the subsequent year’s return (Sec. 6513(d)). The IRS will reverse this payment back to the prior year only if (1) the IRS applied the overpayment as a credit elect due to an error in processing, (2) an individual taxpayer requests the reversal within a certain time period, or (3) the taxpayer provides proof of hardship (Internal Revenue Manual (IRM) §21.4.1.4.6).

If the IRS erroneously applies an overpayment that the taxpayer requested to be refunded, the taxpayer or the taxpayer’s representative can call the IRS and request the overpayment be reversed back to the prior year and a refund issued. Conversely, if the IRS erroneously refunds an overpayment that was supposed to be applied, the IRS will correct this if the taxpayer returns the IRS refund check and requests the IRS properly apply the overpayment to the next year’s estimated tax payments (IRM §21.4.3.4.5).

An individual taxpayer must make the request before the subsequent year’s return is filed and before March 1 of the year following the year to which the credit was applied. To illustrate this, the IRM gives the following example:

A request to reverse a credit elect from a 2009 account back to the 2008 account must be received before the 2009 return has posted and by March 1, 2010. [IRM §21.4.1.4.6.1]

IRM Section 21.4.1.4.6.1 does not have any other requirements. However, IRM Section 21.4.1.4.6 allows a taxpayer to file a balance due superseding return and request a credit elect reversal to satisfy the balance due. The IRS will honor only requests for reversals due to a verified IRS processing error after the March 1 deadline.

As noted above, the IRM states that the IRS can provide a reversal of a credit elect where the taxpayer presents proof of hardship. While FSA 200909042 says the relief is only available to individual taxpayers, corporate taxpayers suffering financial hardship should considering asking the IRS if they, too, need the refund rather than keeping the credit elect on the subsequent year. Exactly what will qualify as a hardship for these purposes is not spelled out in the IRM or elsewhere. To request the reversal of the credit elect, the taxpayer or representative can call or write the IRS. It is recommended to call, since the taxpayer will know immediately if the request will be honored. If the taxpayer makes a written request, it will take several weeks or months to know if the request is honored. While many taxpayers can get the IRS to act quickly, many of these requests will be referred to the Taxpayer Advocate Service and can take several months to resolve.

Taxpayers and their representatives must remember that once the credit elect is reversed, it is as if that payment was never in the account. If the other payments on that subsequent year’s return do not satisfy the required estimated tax payments, the taxpayer will be subject to the penalty for underpayment of estimated tax.

Subsequent Deficiency Determination

If the IRS does not grant a credit elect reversal request, there are still options to minimize the negative impact on the taxpayer. If the IRS assesses a deficiency for the overpayment year after a taxpayer elects to apply the overpayment to the next year’s tax, taxpayers should consider Rev. Rul. 99-40. This revenue ruling states that when a taxpayer elects to apply an overpayment to a succeeding year’s estimated taxes, the overpayment will be applied to unpaid estimated tax installments due on or after the date of the overpayment, in the order required to avoid a penalty for the failure to pay estimated tax. When a taxpayer elects to have an overpayment applied to the following year’s tax, interest will be assessed on a subsequently determined deficiency for the overpayment return year that is less than or equal to the overpayment as of the date on which the overpayment is applied to the succeeding year’s estimated taxes.

For example, suppose the 2010 Form 1040, U.S. Individual Income Tax Return, was overpaid by $20,000, and the taxpayer elected to apply the overpayment to 2011. After the 2011 return is filed, it is determined a mistake was made on the 2010 return, and the individual owes $20,000. In this case, it is too late to request a reversal of the credit elect to pay the deficiency. However, with the application of Rev. Rul. 99-40, the interest assessed by the IRS may be reduced because interest on the deficiency, which would otherwise begin to accrue from the due date of the 2010 return, will instead only accrue after the credit elect amount has been fully applied to estimated payments for 2011.

To determine when the interest accrual starts, the taxpayer or representative must analyze when the credit elect was applied to avoid a penalty for failure to pay estimated tax for 2011. Under Rev. Rul. 99-40, when the credit elect is used depends on the amount (if any) of the taxpayer’s required estimated payments for 2011 and the amount and the timing of the estimated payments the taxpayer makes for 2011. If it is determined that the taxpayer made large enough estimated payments for each quarter of 2011 that the credit elect was not needed to satisfy the required estimated tax payment amount for any quarter, then the deficiency interest would begin to run from the due date of the 2011 return rather than the due date of the 2010 return.

While applying Rev. Rul. 99-40 will not eliminate interest in all cases, it will help many taxpayers. One common case in which the taxpayers will not be able to eliminate interest when they believe they should is if the overpayment rolls forward for several years. For example, the 2009 individual return shows a $20,000 overpayment, which is applied to 2010. This overpayment is not needed and is applied to 2011. In 2012, it is determined that the 2009 Form 1040 has a mistake, and an amended return is being filed to increase tax by $20,000. Many taxpayers feel that since the IRS has had their money since 2009, no interest should be owed on the 2009 underpayment. While Rev. Rul. 99-40 does apply the principle that no interest is due until the tax is both due and unpaid, the IRS will only allow an interest-free period for up to one year (FleetBoston Financial Corp., 483 F.3d 1345 (Fed. Cir. 2007)). So in this example, interest would accrue from April 15, 2011, the due date of the 2010 return, until it is paid. This will at least help to reduce the interest due to the IRS.

IRS computers are not equipped to compute interest using Rev. Rul. 99-40, so the taxpayer must request interest be computed using this revenue ruling. The request can be an informal claim or a formal claim (Form 843, Claim for Refund and Request for Abatement). If the annualized or seasonal installment method is used to determine the amount of the taxpayer’s required estimated tax payments for the subsequent year, the IRS requires that the taxpayer provide the Form 2210, Underpayment of Estimated Tax by Individuals, Estates, and Trusts, or 2220, Underpayment of Estimated Tax by Corporations, showing when the credit elect was used to satisfy the subsequent year’s estimated tax liability (IRM §20.2.5.7.2).

Quick Refunds and Early Filing

If the reason the reversal of the credit elect is sought is the need for cash, corporations that are not eligible for a reversal may be able to access the credit elect amount more quickly by filing Form 4466, Corporation Application for Quick Refund of Overpayment of Estimated Tax. A corporation can obtain a quick refund of estimated tax payments if the overpayment is at least 10% of the expected tax liability and at least $500. However, the taxpayer cannot file this form until the end of the tax year for which the estimated payments were made.

Individuals or corporations who are expecting a refund for the subsequent year but do not have all the information to file a final return for the subsequent year immediately can take advantage of the superseding return rules. If the taxpayer does not have all the information needed to file its final return, the IRS allows taxpayers to file a return claiming a refund based on the preliminary information and then file a second return (called the superseding return) with all the information before the extended due date. The superseding return is treated as a replacement of the originally filed return. However, taxpayers and representatives are cautioned that if they request too much of a refund on the original return and the superseding return shows a balance due, the taxpayer will be subject to interest and penalties.

Conclusion

In conclusion, a year 1 overpayment credit elect for year 2 is generally irrevocable, but there are certain circumstances that would allow for its reversal. When a reversal is not possible, there are procedures that can reduce the negative impact. A knowledgeable representative can bring value to clients if he or she is aware of these procedures.