BY GREG MERMEL, C.P.A.
Each year, the Internal Revenue Service receives upwards of 130 million
individual income tax returns. The forty-three states (and District of
Columbia) which levy individual income taxes receive almost as many. Some
of them, inevitably, are wrong. Not fraudulent, just wrong: the sort of
stupid mistakes and omissions that humans do so well, sometimes with the
help of a computer.
These "oopses" often come to light when working on the next year’s taxes. You pull the previous year’s forms out (probably for the first and last time) and go, "Dang, that’s not right." Or maybe you were not confident you did it right last year, go to a professional this year, and he confirms your fear: You did it wrong.
Contrition or Confession?
When I tell a new client the previous year’s returns are wrong, their immediate response is always the same two questions: "Did I pay too much, or too little?" and "How much money is involved?" If the amounts are very small, correcting the error will be more trouble than it is worth. Otherwise, the client who paid too much tax invariably wants to correct it. The ones who paid too little tax? That’s a longer discussion.
A few—a very few—people are so scrupulously honest and ethical that they will insist on correcting the problem no matter what. Everyone else explores two other questions: How likely is it they will get caught, and what will happen if they do? Some mistakes will almost certainly get caught by the IRS’s computers, such as leaving out a W-2, or both the taxpayer and his ex-wife claiming the same child as a dependent. You may as well fix these errors when you find them, and save some money on penalty and interest. Others, though, are invisible without information that does not appear in the tax returns. Maybe you misunderstood what automobile use is deductible, or you copied a number incorrectly from an underlying document, or filed as single when you were newly married.
You may be disappointed that I am not going to say what you must do in those cases. The decision is yours, not mine. As a licensed professional, I have an ethical obligation to tell my clients about mistakes I identify in prior year returns and what is involved in correcting them, and to make sure the mistake is not repeated in the returns I prepare. But that’s all. Many people decide to let sleeping dogs lie, and do nothing—after asking about the consequences of getting caught.
The Worst That Can Happen Is Justice
Deliberately cheating on your taxes is a crime; making an honest mistake on a tax return is not. That means nobody goes to prison for an honest mistake (unless it is so outrageous as to look like fraud, and you are among the few fraud cases prosecuted each year, and you have a lousy defense attorney). All a mistake can do is cost you money. You will have to pay the additional taxes, of course. The IRS will want interest from the due date of the return to the day you pay them, and there is a late payment penalty which is calculated just like interest at a six percent per year rate. And that is usually all.
I hear somebody mutter, "usually?" The IRS does have a few more weapons. They can add a penalty of 20 percent of the additional tax if you were negligent in preparing the return, that is, you did not make a reasonable attempt to do it right or to exercise ordinary and reasonable care in preparing the return. Negligence is hard to prove, and I rarely see this penalty.
Another 20 percent penalty, the "accuracy-related" penalty, arises if the misstatement is more than $5,000 or 10 percent of the tax, whichever is greater. They will waive this one if you have reasonable cause for the error and acted in good faith. You are much more likely to convince them you acted in good faith if you voluntarily correct the error before being caught.
Doing It Right The Second Time
You correct mistakes by filing an amended return on a special form. The federal form has three columns of figures (as previously filed, amount of change, and as amended) and a large space on the back for your explanation. You attach both original and corrected copies of any schedule or form that changed, and sometimes copies of other documentation. Most of the time, you get a form letter in a few weeks saying they have accepted the change, and the amount you owe or the refund you have coming. You pay them, or vice versa, and that’s the end of it. Occasionally, you will get a letter from an actual person asking for clarification or better documentation.
What does not happen is what many people fear, and half expect, which is an exhaustive audit of your taxes for several years, along with those of your parents, siblings, cousins and third grade teacher. People who have filed amended returns do sometimes get audited, but no more frequently than those who have not.
Do not forget your state returns if you amend your federal return. Many changes to federal returns also change the calculation of your state taxes, and the Illinois Department of Revenue does compare notes with the IRS. Wait until you get the acceptance letter from the IRS before submitting an Illinois amended return; otherwise, Springfield will just send it back.
If you choose not to amend your return, you can forget about the mistake three years after the return was due (or after you filed it, if it was late). After that date, your tax figures for that year are final. The statute of limitations, and that sleeping dog, will both have expired.
You Can Still Get It
Call or write to me, and I will send you a free copy of my "Checklist of Potentially Deductible Items" for those in the arts.
Are there money or tax questions you would like to see discussed in this column? Let me know, at 2835 N. Sheffield, Suite 311, Chicago, IL 60657, or 773/525-1778 (888/525-1778 outside the Chicago area).
Greg Mermel is a certified public accountant whose clients in the arts range from individual performers to major theatre companies and suppliers. He also sometimes produces theatre.