For taxpayers who pay estimated tax, the credit elect is generally a good way to handle an overpayment on the taxpayer’s Form 1040 tax return.
A taxpayer can elect to have an overpayment refunded to himself or applied to his subsequent year’s estimated taxes (credit elect). This election is generally irrevocable (IRC Sec. 6513(d); Regs. Sec. 301.6402-3(d); Rev. Rul. 55-448).
Warning: Credit elects can be are forfeited to the U.S. Treasury if the subsequent year’s tax return is filed, received or processed more than three years late (or more than two years after the credit elect was done in some circumstances) see RSED here.
- An unofficial method to bypass these credit elect restrictions, and in effect make an overpayment revocable, would be to request a refund check and then hold the uncashed check. In the future, the check can be voided and sent back to the IRS to be applied as the taxpayer directs (basically the same as a credit elect would do). Any interest included in the check amount is generally forfeited when doing this procedure. A stale-dated refund check can be replaced upon request and cashed if desired.
- An unofficial trick is to combine your April 15th estimated tax payment with your Form 4868 extension payment and then when filing your Form 1040, using credit elect to cover the April 15th estimated tax payment. This way you can cover any unforeseen shortfall that otherwise would appear on the Form 1040 when it is completed. The resulting shortfall in the following year’s estimated taxes can be cured with catch-up payments or with increased withholding tax.
Withholding tax is generally deemed to be paid ratably throughout the year, even if the withholding actually was done later in the year.
Dollar for dollar, the underpayment of taxes due on April 15th for the prior year generally results in a larger penalty than an underpayment of estimated tax for the following year (in 2016 this is generally about double or 6% vs. 3% for being up to five months late with payment).
- Exception: unless the taxpayer is a delinquent filer and has gotten so far behind that prior year penalties have been maxed out. In such a case, paying more current obligations sooner, might minimize penalties.
Applying an overpayment to the following year’s estimated taxes, a credit elect, may be done with the filing of Form 1040. Applying an overpayment to any subsequent year’s estimated taxes may be done with the filing of Form 1040X.
Warning: When using Form 1040X overpayments to pay the current year’s estimated tax payments, the IRS is required to review the refund claim before allowing the overpayment. If the amended return is selected for audit or is delayed, the subsequent year’s return may be due and the overpayment from the prior year will not be there to pay the current year’s taxes.
But if the taxpayer is filing a carryback claim on Form 1045, Application for Tentative Refund, the overpayment can be applied more timely. Unlike Form 1040X, the carryback claim on Form 1045 is generally processed within 90 days of filing. This is because the IRS allows the overpayment before performing a detailed review or examination. see 1045 or 1040X here.
Once the credit elect is applied the IRS will reverse this payment back to the prior year only if:
- the IRS applied the overpayment as a credit elect due to an error in processing,
- an individual taxpayer requests the reversal within a certain time period, or
- the taxpayer provides proof of hardship (Internal Revenue Manual, IRM 18.104.22.168.6).
If the IRS erroneously applies an overpayment that the taxpayer requested to be refunded, the taxpayer can contact the IRS and request the overpayment be reversed back to the prior year and a refund issued. Conversely, if the IRS erroneously refunds an overpayment that was supposed to be applied, the IRS will correct this if the taxpayer returns the IRS refund check and requests the IRS properly apply the overpayment to the next year’s estimated tax payments (IRM 22.214.171.124.5).
An individual taxpayer must make the request before the subsequent year’s return is filed and before March 1 of the year following the year to which the credit was applied. To illustrate this, the IRM gives the following example:
A request to reverse a credit elect from a 2013 account back to the 2012 account must be received before the 2013 return has posted and by March 1, 2014. [IRM 126.96.36.199.6.1] see Deadline for retroactively changing Form 1040 credit elect
IRM 188.8.131.52.6.1 does not have any other requirements. However, IRM 184.108.40.206.6 allows a taxpayer to file a balance due superseding return and request a credit elect reversal to satisfy the balance due. The IRS will honor only requests for reversals due to a verified IRS processing error after the March 1 deadline.
The IRM states that the IRS can provide a reversal of a credit elect where the taxpayer presents proof of hardship, see FSA 200909042.
The Problem: A Subsequent Deficiency Determination
Assuming the taxpayer is not holding an uncashed refund check, and also assuming that the IRS does not grant a credit elect reversal request; then the taxpayer can have a cash flow issue with the credit elect being tied up until the next year’s tax return is filed and a refund is claimed, and interest and penalties are piling up while the deficiency remains unpaid.
But there is still an option to attempt to minimize the negative impact on the taxpayer. If the IRS assesses a deficiency for the overpayment year after a taxpayer elects to apply the overpayment to the next year’s tax, then the taxpayer should consider Rev. Rul. 99-40. This revenue ruling states that when a taxpayer elects to apply an overpayment to a succeeding year’s estimated taxes, the overpayment will be applied to unpaid estimated tax installments due on or after the date of the overpayment, in the order required to avoid a penalty for the failure to pay estimated tax. When a taxpayer elects to have an overpayment applied to the following year’s tax, interest will be assessed on a subsequently determined deficiency for the overpayment return year that is less than or equal to the overpayment as of the date on which the overpayment is applied to the succeeding year’s estimated taxes.
For example, suppose the 2010 Form 1040, U.S. Individual Income Tax Return , was overpaid by $20,000, and the taxpayer elected to apply the overpayment to 2011. After the 2011 return is filed, it is determined a mistake was made on the 2010 return, and the individual owes $20,000. In this case, it is too late to request a reversal of the credit elect to pay the deficiency. However, with the application of Rev. Rul. 99-40, the interest assessed by the IRS may be reduced because interest on the deficiency, which would otherwise begin to accrue from the due date of the 2010 return, will instead only accrue after the credit elect amount has been fully applied to estimated payments for 2011.
To determine when the interest accrual starts, the taxpayer must analyze when the credit elect was applied to avoid a penalty for failure to pay estimated tax for 2011. Under Rev. Rul. 99-40, when the credit elect is used depends on the amount (if any) of the taxpayer’s required estimated payments for 2011 and the amount and the timing of the estimated payments the taxpayer makes for 2011. If it is determined that the taxpayer made large enough estimated payments for each quarter of 2011 that the credit elect was not needed to satisfy the required estimated tax payment amount for any quarter, then the deficiency interest would begin to run from the due date of the 2011 return rather than the due date of the 2010 return.
While applying Rev. Rul. 99-40 will not eliminate interest in all cases, it will help many taxpayers. One common case in which the taxpayers will not be able to eliminate interest when they believe they should is if the overpayment rolls forward for several years. For example, the 2009 individual return shows a $20,000 overpayment, which is applied to 2010. This overpayment is not needed and is applied to 2011. In 2012, it is determined that the 2009 Form 1040 has a mistake, and an amended return is being filed to increase tax by $20,000. Many taxpayers feel that since the IRS has had their money since 2009, no interest should be owed on the 2009 underpayment. While Rev. Rul. 99-40 does apply the principle that no interest is due until the tax is both due and unpaid, the IRS will only allow an interest-free period for up to one year ( FleetBoston Financial Corp. , 483 F.3d 1345 (Fed. Cir. 2007)). So in this example, interest would accrue from April 15, 2011, the due date of the 2010 return, until it is paid. This will at least help to reduce the interest due to the IRS.
IRS computers are not equipped to compute interest using Rev. Rul. 99-40, so the taxpayer must request interest be computed using this revenue ruling. The request can be an informal claim or a formal claim (Form 843, Claim for Refund and Request for Abatement ). If the annualized or seasonal installment method is used to determine the amount of the taxpayer’s required estimated tax payments for the subsequent year, the IRS requires that the taxpayer provide the Form 2210, Underpayment of Estimated Tax by Individuals, Estates, and Trusts , or 2220, Underpayment of Estimated Tax by Corporations , showing when the credit elect was used to satisfy the subsequent year’s estimated tax liability (IRM 220.127.116.11.2).