Best Practices for Form 1040 Extensions

Does an extension require a reasonable tax estimate to be valid?

The Form 1040 deadline is less than a month away, so tax professionals are likely considering which returns to complete and which to extend.

Below are the best practices regarding federal Form 1040 extensions. Because of their business structure, some firms may find them only partially achievable. I would challenge those firms to consider changes, as there would be considerable benefits to other areas of the firm, such as profitability and work-life balance.

File Extensions in Advance

Every Form 1040 under an active engagement letter for tax services should be electronically transmitted, postmarked, or extended by a few days before the April 15th deadline, to avoid last-minute problems. All extensions should be electronically filed, not mailed, to confirm receipt by the IRS before the deadline.

Completing all electronic extensions several days in advance allows mailing an extension if the electronically filed extension is rejected. Remember to retain proof of timely mailing with a method approved under §7502.

Only File Extensions for Current Clients

An extension belongs to the taxpayer not the tax professional! An extension should only be filed for clients for whom you are under an active engagement letter for tax services. There is no reason to do unpaid work for former or delinquent clients.

Here are four harms to the taxpayer from the filing of an unauthorized extension:

1. The extension is likely invalid without actual taxpayer information informing the estimated tax liability (more on that later),

2. The taxpayer’s authorized electronically filed extension may be rejected,

3. The taxpayer’s electronic funds withdrawal for payment may be rejected, leading to penalty and interest accruals, and

4. The taxpayer may believe they are a tax identity theft victim since they did not authorize the filing of an extension.

A Form 1040 extension extends by six months the date a tax debt for that year can be discharged in bankruptcy. While this only affects only a small subset of taxpayers, I have worked with some who had to delay filing a Chapter 7 bankruptcy because a former tax professional filed an unauthorized extension, thus causing financial harm.

Properly Estimate Tax on the Extension

As reflected in Internal Revenue Manual 3.11.212.9.5.1 (01-01-2010), the IRS approves Form 4868, Application for Automatic Extension of Time to File U.S. Individual Income Tax Return, as long as it is submitted timely. However, IRS acceptance of the extension does not mean it is a valid extension under federal tax law.

Treas. Reg. §1.6081-4(b)(4) requires that an extension request show the total amount properly estimated as tax for the tax year. In Rev. Rul. 79-113, the IRS held that an extension that showed an estimated income tax liability of zero was invalid because there was ample evidence available to the taxpayer that there would be an income tax liability.

Treas. Reg. §1.6081-4(d) authorizes the IRS to terminate an extension at any time as long as it mails the individual a notice of termination at least ten days before the termination date. Therefore, even if the IRS accepts an extension initially, it can later be terminated if found invalid, subjecting a taxpayer to late filing penalties on either a tax return balance due or a later examination assessment.

While it is unusual for the IRS or the Tax Court to invalidate an extension, it absolutely remains a risk if it is improperly prepared. In Crocker v. Comm., 92 T.C. 899 (1989), the Tax Court held the extension invalid because the taxpayers underestimated their tax liability and made no effort to provide a reasonable estimate, and that reliance on invalid extensions did not constitute reasonable cause for their failure to timely file.

In Graham v. Comm., T.C. Memo. 2005-68, the taxpayers attempted to save their extension by claiming the improper estimate was due to Mr. Lewellen, their CPA. They were not successful with that argument:

Petitioners contend that they estimated their tax with reasonable care on Form 4868 for 1998. Petitioners estimated that their tax liability for 1998 was $41,000, which they paid when they filed their Form 4868. This amount was less than one-half of their actual liability. They contend that their error in underreporting $135,422 on their extension request and their original 1998 return was attributable to Lewellen, not to petitioners.

We disagree. Lewellen credibly testified that he was unaware that petitioner had received client fees of $135,422 in 1998 until petitioner telephoned him shortly after the original 1998 return was filed. Lewellen did not know that petitioners improperly deducted $27,000 of personal expenses as business expenses on their 1998 return. Petitioners' failure to properly estimate their 1998 tax liability invalidates their extension.

In Clayton v. Comm., 102 T.C. 632 (1994), the taxpayer’s filing of an extension claiming zero tax liability when they knew there was a tax liability was a factor in the imposition of the §6651(f) fraudulent failure to file penalty:

On the Form 4868 which petitioners filed in this case on April 15, 1991, they estimated their total tax liability for 1990 to be zero. Section 1.6081-4(a)(4), Income Tax Regs., requires that the application show the full amount properly estimated as tax for the taxable year. Petitioners were well aware of the substantial 1990 income from wagering when they filed Form 4868…

To report zero estimated tax liability on Form 4868 was a blatant disregard by petitioners of the requirements for obtaining a valid extension of time, and invalidates the automatic extension otherwise available through Form 4868…

The same badges of fraud that existed in 1989 persisted throughout 1990. Furthermore, petitioners' failure to timely file their 1990 return itself appears to have been a flagrant effort at concealment on their part, since the Form 4868 that they filed reported zero estimated tax liability, a knowing misrepresentation of the true facts. We accordingly hold that petitioners' failure to timely file the 1990 return was fraudulent pursuant to section 6651(f)…

Other cases in which the Tax Court has held extensions to be invalid due to the lack of a proper estimate include Harrison v. Comm., T.C. Memo. 1998-417; Petrocine v. Comm., T.C. Memo. 1997-189; Hanna v. Comm., T.C. Memo. 1996-210; Clayton v. Comm., 102 T.C. 632 (1994); Risman v. Comm., 100 T.C. 191 (1993); Condor International, Inc. v. Commissioner, 98 T.C. 203, 224 (1992).

Another very important reason to properly estimate the tax is to avoid interest and failure-to-pay penalty accruals on any amounts not paid by April 15th. IRS statutory interest rates are currently 8%, the highest rate in the last decade. While failure-to-pay penalties can be abated with First Time Abate, interest can rarely be abated.

Last, but not least, Circular 230 §10.22(a)(1) applies due diligence requirements to extension requests:

A practitioner must exercise due diligence… In preparing or assisting in the preparation of, approving, and filing tax returns, documents, affidavits, and other papers relating to Internal Revenue Service matters…

Circular 230 §10.37(b)(2)(vi) also states that our evaluation of federal tax matters cannot not take into account the likelihood of IRS review:

The practitioner must… Not, in evaluating a Federal tax matter, take into account the possibility that a tax return will not be audited or that a matter will not be raised on audit.

Extension Payments

When an extension payment must be made, I generally instruct the taxpayer to pay the recommended amount using IRS Direct Pay for two reasons:

1. The taxpayer controls the payment timing and can ensure funds are available, and

2. The tax professional is not put in the middle of any withdrawal delays.

Extensions Are Not a Free Service

Thoughtfully completed extensions are not an administrative annoyance; they are an essential tool to help taxpayers project future cash needs and avoid penalty and interest accruals while allowing tax professionals to appropriately distribute work throughout the year. A tax professional who works with clients proactively should view the extension as an important tool in partnering with their clients.

Properly implemented extension services provide value to the taxpayer and should not be provided for free. Consider either bundling extension services with your base tax return package or charging separately for extension services.

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