US Federal taxes question

[Do_Not_Taunt]

Let’s say I make an error in my favor on my 2010 taxes: I calculate in good faith that I am owed a refund of $1000, but actually I’m entitled to a refund of $500. Instead of requesting the IRS to send a check / deposit it in my bank account, I request the IRS to apply the refund to next year’s taxes. Now, later in 2011, I’m audited, and the error is found. Other than reducing what I get to apply to taxes next year, for what am I liable? Penalties? Interest? Does it change if I discover the error myself and correct it in an amended return rather than it being found in an audit?

Don’t need answer fast.

[Nothar]

CPA checking in. I have run into this situation many times. Most likely either the IRS catches the error after the return has been filed and sends you a letter notifying you of the error and the change to the amount of the refund they are applying to the subsequent year’s taxes or the taxpayer or accountant catches it and they file an amended return.
If the error is found during an audit it will usually affect multiple years returns due to the lag on audits and each year will be adjusted that the refund carryover effected. Practically speaking you will usually not get audited for 2010 until after the 2011 return is filed. There will not be any penalties or interest applied unless a subsequent year would have resulted in tax being owed that was not paid due to the error. For example, if a 2008 return showed a $1000 refund applied to 2009 that should have been $500 and the 2009 return as a result showed a $300 refund that was collected, the IRS are owed the $300 collected plus an additional $200 plus late payment penalties and interest on the $200 that accrued from April 15th 2010 until the date paid. If the $300 was also applied the 2010 carryover would be zeroed out and the same situation regarding penalties and interest would apply to the other $200. Depending on the amounts owed and other factors there could also be an additional penalty for underpayment of estimated taxes.
If no subsequent year would have resulted in taxes being owed even with the error then no interest or penalties would be owed.
There could also be a fraud penalty if the IRS can prove that the taxpayer willfully and knowingly underreported income or overstated deductions/credits that resulted in the error. Practically, from my experience the IRS usually does not pursue fraud unless it was blatant or the amounts were much higher than in the example.
Hope that helped.

[Do_Not_Taunt]

That’s exactly how I suspected it worked. Thanks so much for the confirmation!

[ok11]

@Nothar

There will not be any penalties or interest applied unless a subsequent year would have resulted in tax being owed that was not paid due to the error. For example, if a 2008 return showed a $1000 refund applied to 2009 that should have been $500 and the 2009 return as a result showed a $300 refund that was collected, the IRS are owed the $300 collected plus an additional $200 plus late payment penalties and interest on the $200 that accrued from April 15th 2010 until the date paid.

I don’t think that’s how it works. Using your example, if the statute of limitations is still open on the 2008 tax return, the adjustment would be made to whatever created the error in 2008. Balance due would be $500, plus interest (computed from the due date of the 2008 return), and penalties. If the 2008 tax return was filed timely (and, in some cases, even if it was filed late), then failure to pay penalty would not apply. The auditor might not even assess the accuracy penalty (e.g. if there are no indicators of negligence and the understatement is not substantial). Changes would not be made to the $1,000 reported on the 2009 return as the amount applied from 2008.

What you’re describing might happen to carryovers (such as charitable contributions, net operating loss deductions, etc). But I don’t think this approach makes sense for an amount applied from prior year. Conceptually, applying a refund from one year to another is almost like receiving a refund check, and immediately making an estimated tax payment for the same amount. The amount of the 2009 “estimated tax payment” does not change regardless of what the refund amount should have been in 2008. (Of course, if the IRS catches the error before the refund is processed, they’d apply a smaller amount to 2009, and send a notice about this change.)

[Nothar]

You are correct that in the example the adjustments made affect the 2008 return and only the incorrect refund applied to the subsequent year. However, in this case the IRS cannot charge you any late payment penalties or interest with regard to the 2008 return. There is no late payment penalty because there was no tax due after the change. There is no interest charged because the taxpayer did not receive any of the funds due to the error for that year but applied them instead. The interest and penalties could only come into play starting with the 2009 return if the taxpayer collected an incorrect refund or underpaid tax due that resulted from the 2008 error on the 2009 return. The date the interest would start accruing from in those cases would be the 2010 date stated above. I did misspeak above in the example for 2009 i gave where $300 was incorrectly refunded and collected instead of $200 tax paid. I meant to say no late payment penalties would apply to the $300 collected but only possibly for the $200 tax due not paid. However, interest could be charged on the entire $500 error since in the example the $300 was collected and not applied.
Hopefully that is a bit clearer.

[ok11]

@Nothar

[…] the taxpayer did not receive any of the funds due to the error for that year but applied them instead.

But the taxpayer actually received funds. Once received, the refund was applied to the next year. IRS released the funds, and it doesn’t matter whether they were directly deposited into taxpayer’s bank account, applied to the next year, applied to the prior year to offset a balance that was outstanding, etc.

Maybe we’re thinking of different hypotheticals, so let’s use a concrete example.

@Do Not Taunt

Let’s say I make an error in my favor on my 2010 taxes: I calculate in good faith that I am owed a refund of $1000, but actually I’m entitled to a refund of $500.

Let’s say that a credit was accidentally overstated by $500, and the mistake was not corrected by the IRS during processing. Taxpayer should have received a refund of $500, but instead received $1,000, which was applied to 2011. In 2013, the 2010 tax return gets selected for audit. The auditor re-computes the credit, and proposes an adjustment of $500. Revenue Agent Report (RAR) would show a balance due of $500, and interest computed from the due date of the 2010 tax return. Computations on the RAR don’t take into account how large the refund was, or what you chose to do with it. It compares tax reported on the tax return to the recomputed tax (in this case, these numbers would be the same) and adds in any decreases to credits (in this case, $500 decrease).

[Do_Not_Taunt]

@ok11

But the taxpayer actually received funds. Once received, the refund was applied to the next year.

To my perspective, this is a very strange meaning for ‘received.’ Obviously I never actually received the funds; the federal government held onto them. Does the IRS really use a different, bizarre meaning here? Do they have a pub that covers this I can read (and possibly comprehend)?

[Nothar]

Ok11 - your experience may differ. But in 15 years as a CPA as a tax preparer at Big 4 and smaller firms i have dealt with this scenario i would estimate at least 100 times with the IRS. In all cases, if the error only changed the amount of refund applied to a subsequent year, the taxpayer was not charged penalties or interest for the tax year the error occurred in. All individual taxpayers are cash basis taxpayers. If they did not physically receive the refund in that tax year, the IRS cannot charge them interest on the portion that was applied in error. I would post cites but i am on an old cell phone that can barely access the internet, but irs.gov has the rules for when they are allowed to charge interest due to tax errors, and all the language used regarding overpayment of refunds and interest charged uses the word “received” which according to their dictionary is not the same as refunds applied.

[ok11]

Do Not Taunt, you received the refund in the sense that you were able to control what happened to it. When you apply a refund to the next year, you’re essentially getting the refund and turning it into an estimated tax payment.

I couldn’t find Revenue Ruling 77-339 online, but it’s cited in Georges v. U.S. Internal Revenue Service:

Rev.Rul. 77-339, 1977-2 C.B. 475 is also to the same effect. There, taxpayer’s 1976 return showed an overpayment of $3,000 and taxpayer elected to have the overpayment credited against estimated tax for 1977. Later, taxpayer filed an amended return for 1976 showing an increase of $300 in his tax liability and seeking to revoke the previous election to the extent of $300 in order to pay the additional $300 liability for 1976. It was held that once the elected amount is credited as a payment of estimated tax for the succeeding year, it loses its character as an overpayment for the year in which it arose and cannot be used to offset any subsequently determined increase in the tax for that year. See also Rev.Rul. 55-448, 1955-2 C.B. 595.

Nothar, when you say that the IRS cannot charge interest on the portion that was applied in error, are you referring to IRC Section 6404? I know that interest can be abated due to managerial or ministerial error/delay by the IRS, but here the mistake was made by the taxpayer.

[Do_Not_Taunt]

@ok11

Do Not Taunt, you received the refund in the sense that you were able to control what happened to it. When you apply a refund to the next year, you’re essentially getting the refund and turning it into an estimated tax payment.

While I can understand the logic, I still think that is a bizarre interpretation of what it means to ‘receive’ the refund, but that’s neither here nor there. I’m interested in what the IRS and any relevant case law says, and I thank you for that. Is it your experience that while this may be an established precedent, that Nothar is right that most of the time, the IRS would not assess interest and penalties in this case?

[ok11]

I haven’t been a CPA for as long as Nothar, so I don’t have as much experience. If someone has seen this exact scenario play out at least 100 times, then who am I to argue. My only concern is that it wasn’t the same scenario. As I’ve said in my first post, what Nothar describes happens when a carryover is overstated, but there is no tax impact in the year that the mistake was made.

Here’s an example. Let’s say that a mistake is made on the 2010 tax return. Charitable contributions were overstated, but the taxpayer wasn’t able to deduct the full amount in 2010, due to a limitation. Consequently, some of the contributions get carried over to 2011. Let’s also say that if the taxpayer reported the correct amount of contributions, he still would have had a carryover, but it would have been smaller.

When the 2010 return is audited, and the mistake is found, there is no tax impact in 2010. No additional tax is due, and interest and penalties don’t apply. The audit then gets expanded to 2011, and the change is made to the carryover.

For 2011, the amount reported as a carryover gets reduced. If the full carryover was not used in 2011, then the tax impact that year is smaller than if the full carryover is used. If by using the carryover in 2011 taxpayer received a tax benefit of $500, then this is how much additional tax he’d owe for 2011. Interest would be computed from the due date of the 2011 tax return, and penalties might be applied. That’s what Nothar describes, and I agree that this is what happens for carryovers.

This is not the same situation as the one described in the OP. Refund applied to the subsequent year is not a carryover. When the 2010 refund is applied to the next year, the IRS credits this amount to your 2011 account. Even before you file the 2011 return, this amount is already on your record for 2011. If you call the IRS and ask about your 2011 account balance, they’ll say you have a credit of whatever. They keep track of this number. When you put that amount on the next year’s return, it’s correct, because it matches what the IRS has in its system. During audit, this number should not be changed.

Here’s a .pdf of a Revenue Agent Report (RAR). This is what the IRS uses to compute additional tax liability. Lines 73 through 77 of the Form 1040 aren’t used on the RAR. This is why it’s irrelevant during the audit whether you chose to get a refund right away, or to apply it to 2011. The auditor would not expand the audit to the 2011 tax return. The mistake would be fixed at its source.

Based on the OP, the last number on the first page of the RAR would be $500. The second page of the RAR would show interest computed from the due date of the 2010 return. I’ve seen enough RARs to know that the auditor has to actively specify whether the penalty applies, but interest is added automatically. In my (limited) experience, the only time that interest gets removed is when IRC Section 6404 applies. If Nothar or someone else lets me know what other code section would apply in this case, I’d appreciate it.