Tom Talks Taxes - November 24, 2021

Filing valid extensions for clients plus an update on PPP loan tax issues

Thank you for being a member of the Tom Talks Taxes community! I’m grateful that you are here, and have a wonderful Thanksgiving holiday. -Tom

Filing (Valid) Extensions for Clients

After the last two terrible tax seasons, you are likely considering shifts in your business model for the upcoming year. When preparing your tax preparation engagement letters for the upcoming season, I encourage you to add language making it clear that the onus is on the taxpayer to ensure an extension is filed if needed.

This sentence is directly from my engagement letter:

We do not file tax return extensions automatically for clients; as such, please notify us in writing if you request us to file an extension.

I often hear of tax practitioners gratuitously filing extensions for either all of their clients or prior clients who have not been in communication for the tax season. I believe there are three important reasons why you should not file an extension without authorization and good cause:

  1. You are providing additional services for no compensation,

  2. There can be unintended negative effects to the taxpayer, and

  3. The extension may be later deemed invalid if reviewed.

Free services. If a taxpayer is not engaged for services — why would you provide services for the client? If there is no engagement to provide tax preparation services, then you do not have responsibility to ensure that taxpayer’s tax returns are timely filed. On the other hand, if a taxpayer is engaged for services - why would (or should) they pay for an extension many of them would not use or need? Why spend the time preparing a valid extension for a taxpayer who never needed it?

Negative impact. The filing of an extension does not extend the assessment statute of limitations as it is generally three years from the date the tax return is filed (not the due date). However, under 11 U.S.C §507, an extension could delay the dischargeability of a tax debt in a bankruptcy for six months. While this is not a common occurrence, for taxpayers facing a potential bankruptcy, it could lead to either a debt not being discharged, or having to wait six additional months to file for bankruptcy.

Invalid extension. Treas. Reg. §1.6081-4(b)(4) states an extension request must show the full amount properly estimated as tax for the tax year. At the same time, the IRS, as reflected in IRM 3.11.212.9.5.1 (01-01-2010), approves a Form 4868, Application for Automatic Extension of Time to File U.S. Individual Income Tax Return, as long as it is submitted timely.

Treas. Reg. §1.6081-4(d) allows the IRS to terminate an extension at any time as long as it mails to the individual a notice of termination at least 10 days prior to the termination date. Therefore, even if the IRS accepts an extension initially, it can later be terminated if found to be 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, although there was ample evidence available to the taxpayer that there would be an income tax liability, was invalid.

Crocker v. Comm., 92 T.C. 899 (1989), a case in which the Tax Court held the extension invalid because the taxpayers severely underestimated their tax liability and made no effort to provide a reasonable estimate, had several important holdings related to extensions:

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…

Where a taxpayer does not make a bona fide or reasonable estimate of his tax liability (based on the information available to him) or does not make a bona fide or reasonable attempt to locate or secure the information necessary to a proper estimate of his tax liability, the doctrine of estoppel does not prevent respondent from voiding a previously allowed extension…

Reliance on a voided automatic extension does not constitute reasonable cause for a taxpayer's failure to file his return in a timely manner where the taxpayer fails to properly estimate his tax in obtaining such extension…

If a taxpayer’s prior tax professional electronically files an extension that is invalid, and it is accepted by the IRS, it prevents the taxpayer or his or her current tax professional from electronically filing a valid extension.

In summary, it is a best practice, in my opinion, to only file extensions for clients who are currently engaged for tax preparation services and actually need additional time to file, as the preparation of a valid extension requires due diligence as to the estimate provided on the extension itself.

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PPP Loans: New Tax Planning Options

Here is the current federal tax treatment of PPP loan forgiveness:

  • The cancellation of debt is excluded from income,

  • Expenses paid for with forgiven PPP funds are deductible, and

  • PPP loan forgiveness is treated as tax-exempt income for partnership and S corporation basis purposes, thus increasing basis.

There has been ongoing uncertainty as to when a taxpayer recognizes the basis increase from PPP loan forgiveness. This is important as a delay in the basis increase compared to when the deductible expenses are incurred may lead to either distributions in excess of basis, which are taxable gain, or losses in excess of basis, which are suspended and carried forward until basis is restored.

In Rev. Proc. 2021-48, the IRS did not opine on the correct timing, but instead allowed pass-through entities to choose one of three times to pass-through the tax-exempt income (and the corresponding basis increase):

  1. As the taxpayer pays or incurs eligible PPP loan expenses,

  2. When the taxpayer files a PPP loan forgiveness application, or

  3. When the PPP loan forgiveness is granted.

A pass-through entity may report tax-exempt income based on the above on an original or amended return. Rev. Proc. 2021-50 allows BBA partnerships to file amended returns for this purpose without filing an administrative adjustment request (AAR); however, the partnership amended return must be filed by December 31, 2021.

If the above events are in different tax years, then there are planning opportunities. For example, let’s assume a taxpayer’s 100% owned S corporation received a PPP loan in tax year 2020 that was forgiven in tax year 2021 and that the S corporation passed through a large tax year 2020 ordinary loss that would otherwise be suspended due to lack of basis. The taxpayer can either:

  • Increase basis in tax year 2020, allowing the loss to either offset other tax year 2020 income or generate a net operating loss that can be carried back to tax year 2015, or

  • Increase basis in tax year 2021, allowing the loss to either offset other tax year 2021 income or generate a net operating loss that can be carried forward to tax year 2022.

There are many factors to consider in this decision, including marginal tax rates and potential distributions in excess of basis.

I’ll be discussing PPP loan tax issues in depth in my 2021 Tax Update: Businesses webinar on December 16. You can register here for this 3 CE/CPE webinar, or here for the 2021 Tax Update bundle for 6 CE/CPE which covers individuals and businesses.

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