Postscript March 20, 2013: To accommodate taxpayers in the last recession, the IRS allowed taxpayers to use “economic hardship” as a reason for granting relief from late-payment penalties. For 2011, taxpayers could file Form 1127-A (2011) “Application for Extension of Time for Payment of Income Tax Due to Economic Hardship” as explained in our blog below. As of this date, the IRS has not issued a Form 1127-A for 2012, so taxpayers need to qualify for penalty relief under the general Form 1127, “Application for Extension of Time for Payment of Tax Due to Undue Hardship.” Form 1127 instructions state ‘File Form 4868, Application for Automatic Extension of Time To File U.S. Individual Income Tax Return… and Do not file Form 1127 (instead).’
It’s getting too late to focus on complete tax return filings due by April 17. (April 17 is the tax deadline this year since April 15 is a Sunday and April 16 is a federal holiday in Washington D.C.) Instead, focus on filing an automatic extension to get an additional six months to file. While extensions are fairly basic one-page filings – listing estimated tax liability, taxes paid to date and balances due – you should be aware of several important strategies, pitfalls and relief from the IRS. Partnership tax extensions are also due April 17, 2012, granting you five more months to file by Sept. 17, 2012.
New for 2011 tax returns: Form 1127-A relief
Some business traders and other taxpayers may qualify for new relief from the IRS provided by filing new tax Form 1127-A, Application for Extension of Time for Payment of Income Tax for 2011 Due to Undue Hardship. If you qualify to use Form 1127-A rather than the automatic extension Form 4868, you will be exempt from nasty penalties associated with paying less than 90 percent of taxes owed by April 17, and related rules mentioned below.
An automatic extension is for filing later, but paying taxes owed by April 15. This new form allows a qualifying taxpayer to pay later without penalties. But, you still need to file Form 1127-A correctly and on time.
On Form 1127-A, “financial hardship” is defined as:
· wage earners (or spouse) who have been unemployed at least 30 consecutive days during 2011 or in 2012 up to the April 17 filing deadline, or
· self-employed individuals who experienced a 25% or greater reduction in business income in 2011 due to the economy.
Many traders may qualify for this financial hardship clause and the AGI income and tax liability thresholds. Leaving a job to pursue trading full time and losing money may be the ticket. Click here to learn more about Form 1127-A. Check with us if you have any questions.
Great year in 2011, but lost the money in 2012
Some traders can’t pay their taxes because they lost 2011 trading gains in Q1 2012 before April 17, 2012. That’s a different situation than “financial hardship” mentioned above. If you can’t pay your taxes, use one of the following strategies with a Form 4868 extension filing.
Securities traders need to file extensions
Due to the cost-basis reporting crisis on 2011 tax returns, we are advising securities traders to file for automatic extensions, rather than try to rush tax returns filings (with problems) by April 17. Securities traders need more time to request corrected 1099-Bs from their brokers and hopefully fully reconcile differences in trade-accounting reporting on Form 8949. We don’t want traders to be audited by the IRS or to receive tax notices caused by reconciliation differences with 1099-Bs.
File for an automatic extension
It’s important to file an automatic extension by April 17, whether you can pay the taxes owed or not. Paying what you owe is the safe way to avoid penalties. If you can’t pay 90 percent, according to Form 4868 instructions your extension can still be valid if you demonstrate reasonable cause and these conditions in the eyes of the IRS:
1. Properly estimate your 2011 tax liability using the information available to you
2. Enter your total tax liability on line 4 of Form 4868, and
3. File Form 4868 by the regular due date of your return.
No. 1 might be the most difficult condition to satisfy. Many traders are unsure of their 2011 trading gains, due to botched wash-sale loss reporting by brokers on 1099-Bs or other reasons. Many traders may underestimate their taxable income and pay too little with their extension. Will the IRS think that you “properly estimated your 2011 tax liability using the information available to you”? We suggest relying on TradeLog if you have it rather than conflicting and botched 1099-Bs.
No. 3 is the easier one. If you skip the extension, you will trigger both late-filing and late-payment penalties.
Penalties explained on Form 4868
Late Payment Penalty: The late payment penalty is usually ½ of 1% of any tax (other than estimated tax) not paid by April 17, 2012. It is charged for each month or part of a month the tax is unpaid. The maximum penalty is 25%. The late payment penalty will not be charged if you can show reasonable cause for not paying on time. Attach a statement to your return fully explaining the reason. Do not attach the statement to Form 4868. You are considered to have reasonable cause for the period covered by this automatic extension if at least 90% of your actual 2011 tax liability is paid before the regular due date of your return through withholding, estimated tax payments, or payments made with Form 4868.
Late Filing Penalty: A late filing penalty is usually charged if your return is filed after the due date (including extensions). The penalty is usually 5% of the amount due for each month or part of a month your return is late. The maximum penalty is 25%. If your return is more than 60 days late, the minimum penalty is $135 or the balance of the tax due on your return, whichever is smaller. You might not owe the penalty if you have a reasonable explanation for filing late. Attach a statement to your return fully explaining the reason. Do not attach the statement to Form 4868.
Be conservative and pay extra with the extension
We suggest being conservative with the extension payment — pay 100 percent of the estimated 2011 tax liability. That gives you a cushion if your estimates are wrong. If you aren’t sure about qualifying for trader tax status in 2011, then we suggest you prepare the extensions based on investor tax status. Or, consult with Robert Green, CPA as soon as possible.
Consider 2012 Q1 estimated taxes too
Taxpayers with material income in Q1 2012 — which is not subject to tax withholding — should consider paying closer to 125 percent of their 2011 extension balance due. When they file their actual 2011 income tax return, they can apply the 2011 tax overpayment credit toward 2012 estimated taxes. This strategy has served our firm well for decades. Rather than pay Q1 estimates separately, pay more with the 2011 extension instead. Be conservative with the tax cash paid to the IRS, but be aggressive and legal with the tax return filings, as that is where the real money is.
What to do if you can’t pay on time?
If you can’t pay 90 percent of your tax liability by April 17, first see if you qualify to use Form 1127-A (see above) for special relief on paying later without penalties. But, file this form on time. If you don’t qualify, file Form 4868 (Automatic Extension). If you are short cash, pay what you can, and try to impress the IRS with reasonable cause when you request penalty abatement after filing your tax return.
When you file your actual income tax return, the IRS will automatically send you a tax notice assessing the appropriate penalties, plus interest expense. After you receive that tax notice, send the IRS a “penalty abatement request” letter stating your reasonable cause and how you acted in good faith. Hopefully, you can get some or all penalties abated. Interest expense is statutory, so the IRS can’t abate it. The current IRS interest rate on late payments is 3% per annum.
Some states don’t require an automatic extension if you’re overpaid, as they accept federal extensions. Generally in all states, if you owe taxes, you need to file a state extension with 90 percent payment, too. Check the extension rules in your state. States tend to be less accommodating than the IRS in waiving penalties, so it’s usually wise to cover your state first if you are short on cash.
Don’t forget new Section 475 MTM elections are due by April 17
Making a Section 475 MTM election could be tricky based on using unreliable trading gain or loss tax information from the cost-basis reporting mess. This information can affect your decision to file or skip the Section 475 MTM election. Generally, we recommend Section 475 MTM on securities only, providing the business trader doesn’t have capital loss carryovers. Traders need capital gains to use up capital loss carryovers — not Section 475 MTM ordinary income. On the other hand, wash sales from 2011 can be converted into Section 475 MTM ordinary losses in 2012 with a MTM election. Consult a trader tax expert about this election. It’s beyond the scope of this article.
Section 475 MTM exempts traders from Form 8949 and wash sales. GreenTraderTax has recommended Section 475 MTM for securities business traders since Congress opened this door in 1997. All these years, it exempted business traders from wash sale rules – which have always been a pain to understand and apply – and that onerous capital loss limitation of $3,000 against ordinary income. Now, Section 475 MTM also exempts business traders from Form 8949, as Section 475 is reported on Form 4797 Part II ordinary gain or loss.
Note: You can’t attach a Section 475 MTM election to an e-filed automatic extension. You must paper-file the extension with a Section 475 MTM election statement attached.
Focus on what’s important now for April 17: filing a valid extension, seeing if you qualify for Form 1127-A relief and considering a Section 475 MTM election for 2012. Consider a consultation with our Robert A. Green, CPA to discuss these issues and more. Don’t bury your head in the tax quick sand — that’s always the worst choice.
Darren L. Neuschwander, CPA contributed to this article.