Tom Talks Taxes - April 7, 2023

Best practices for Form 1040 extensions

The Form 1040 deadline is quickly approaching. Every Form 1040 under an active engagement letter for tax services should be electronically transmitted, postmarked, or extended as soon as possible.

Please consider the following best practices when doing extensions this tax season.

Electronically file all extensions at least one day in advance. All extensions should be electronically filed, not mailed, to confirm receipt by the IRS before the deadline. Completing all electronic filing of extensions at least one day in advance permits the timely mailing of an extension if the electronically-filed extension is rejected.

Ensure the extension is valid. As reflected in IRM 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. Acceptance of the extension does not mean it is a valid extension.

Treas. Reg. §1.6081-4(b)(4) states an extension request must show the total amount properly estimated as tax for the tax year. Treas. Reg. §1.6081-4(d) allows 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.

In Rev. Rul. 79-112, the IRS ruled that an extension that showed an estimated income tax liability of $0 was invalid because there was ample evidence available to the taxpayer that there would be an income tax liability.

While it is unusual for the IRS or the Tax Court to invalidate an extension, it remains a risk for an improperly prepared extension. In Crocker v. Comm., 92 T.C. 899 (1989), the Tax Court held the extension invalid because the taxpayers severely underestimated their tax liability and made no effort to provide a reasonable estimate.

Overestimate the extension payment amount. What type of estimate is sufficient for an extension? In Crocker, the Tax Court said:

For an extension to be valid, a taxpayer must make a bona fide and reasonable attempt to locate, gather, and consult information that will enable the taxpayer to make a proper estimate of his or her tax liability…

The other reason to overestimate the extension payment is to avoid interest and failure-to-pay penalty accruals on any unpaid amount. IRS statutory interest rates are currently 7%, the highest rate in the last decade. While failure-to-pay penalties can be abated with First Time Abate, interest can rarely be abated.

In the heat of tax season, there is rarely time to get an exact estimate; otherwise, the return can be prepared and filed. I recommend a four-step extension estimate process:

1. Use the prior year’s taxable income and withholding as a baseline,

2. Adjust the prior year’s income higher and the withholding lower to overestimate tax,

3. Adjust for known significant changes or estimated tax payments made, and

4. Round the payment as appropriate (e.g., $2,652 to $2,700 or $3,000).

Another option is to bundle the 1st quarter estimated tax payment with the extension payment since the taxpayer can credit any refund to the following year’s 1st quarter estimated tax payment. Any overpayment of the 1st quarter estimated tax payment can be corrected by reducing the other estimated tax payments in that tax year.

Don’t file extensions for non-clients. An extension is the client’s extension, not the tax practitioner’s! An extension should only be filed for clients for whom you are under an engagement letter for 2022 tax preparation. There is no legitimate 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,

2. The taxpayer’s electronically filed valid 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.

Don’t forget Form 8878. If the tax professional is filing an extension and authorizing an electronic funds withdrawal with the extension, Form 8878, IRS e-file Signature Authorization for Form 4868 or Form 2350, is generally required.

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

1. It avoids the preparation and signing of Form 8878,

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

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

Rely on disaster postponements when possible. Due to disaster declarations, the IRS has postponed the Form 1040 filing deadline for many taxpayers nationwide, including most of California. There is no reason to file an extension for taxpayers who live in the disaster zone, provided they plan to file the tax return by the postponed due date.

If the taxpayer plans to file after the postponed due date but before October 15, an extension should be electronically filed on or before April 18th; otherwise, the taxpayer will have to mail the extension to the IRS.

Extensions are not a free service. Preparing a valid extension provides value to the client by avoiding failure-to-file penalties, failure-to-pay penalties, and interest accruals. They also allow tax professionals to distribute the workload more widely, allowing a better client experience and work product by reducing tax professional stress and overwork.

Consider either bundling extension services with your base tax return package or charging separately for the extension service.

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