Amending Prior Tax Returns

Most people amend their tax returns because they seek money that they are owed by the IRS. However, knowing when and when not to amend a return is crucial since you increase the risk of being audited.

You will need IRS Form 1040X, Amended Individual Tax Return. You can get free copies of Form 1040X by directly calling the IRS at 1-800-TAX-FORM.

A tax return generally must be amended within three years after it was filed. Therefore, a new filing can potentially provide you with up to four years of tax savings for this year and up to three years prior.

When to Amend Returns

The primary reason is to correct errors made in your original tax return. The majority of amended returns fall into this category.

Common errors made in personal tax returns:

• Failing to claim credit for duplicate Social Security taxes that you paid when you switched employers in the middle of the year.
• Mischaracterizing nondeductible child-support payments as deductible alimony.
• Missing deductions on Schedule C for small-business expenses, such as auto expenses or the cost of adding a call-waiting feature to your residence telephone.
• Reporting a full year’s worth of accrued interest for zero-coupon bonds purchased midyear, an overstatement found in many brokerage interest statements.
• Not claiming the child-care credit for private school tuition costs for children in preschool.
• Calculating depreciation incorrectly for home offices, computers, cars, or other business equipment.
• Conforming to a court case or revenue ruling that changed the law which was in effect when the original return was filed. Sometimes the tax code is liberalized retroactively, after you have filed your return. For example, the rule allowing self-employed business people to deduct 25% of medical insurance premiums from their gross income expired on June 30, 1992. The deduction was reinstated by the new tax law passed in August 1993. Business owners who deducted only 25% of one-half year’s worth of their insurance premiums were able to amend their1992 returns to claim 25% of the entire amount.
• Deducting this year’s casualty losses against last year’s income. The IRS allows people with losses from earthquakes, floods or other types of federally designated casualties to generate cash by carrying back the losses. For example, taxpayers with flood losses can use those losses to offset income and reduce the taxes they paid in the prior year.

Amendment Strategy

You can speed up your refund by filing a loss-carryback claim within one year of the year of the loss. So amendments based on business losses in the proper calendar year must be filed by December 31 of the current year. Otherwise, the amended return will be processed normally by the IRS. To qualify for the expedited refund, file the loss-carryback claim on Form 1045 instead of the usual Form 1040X.

To deduct certain investment losses against previous years’ investment gains, you can carry back what is called “section 1256” losses for three years and offset any section 1256 income that is not offset by other types of capital losses. What qualifies for Section 1256 losses includes index options, such as options on the S&P 500, commodity futures, currency and other types of commodity transactions.

An error on the original return that requires you to pay more tax will need to be corrected. The IRS matching program compares nearly all of the income reported on individual taxpayers’ returns with income reported by payers such as employers, banks, brokerage companies, and real estate brokers. For example, information matched by the IRS includes wages and other earned income, dividends, interest and proceeds from stock transactions, proceeds from house sales, and retirement plan distributions. If you make a mistake, you will be caught eventually, so you should amend the return voluntarily.

Why You Should Amend

When you correct an error in the IRS’s favor, you avoid the additional penalties and interest that would be assessed if the mistake had been found by the matching program of an audit.

Though you will still owe interest on the amount of tax paid late, the penalties you might avoid can be substantial. The IRS also assesses interest on the penalties.

If you have not reported all your income, normally the IRS has only three years to examine your return. However, there is no limitation if your return was prepared fraudulently, and IRS has six years if your return omitted 20% or more of your taxable income for a given year.

When Not to Amend

Income or expenses may have been reported in the incorrect year. If you reported your income or claimed an expense – even though it was in the wrong year- it may not be worth filing an amended return if you were in the same tax bracket in both years since the most the IRS will gain is interest for one year.

You may also elect not to amend when the amounts involved may be “insignificant.” This judgment must be made by each taxpayer. Consult your tax advisor for guidance.

Deadlines

You must file an amended return within three years of the date on which the original return was filed or two years from the time the tax was paid, whichever is later. The deadline is extended to seven years for deductions for bad debts or worthless securities and to 10 years for foreign tax credits.