The Internal Revenue Service (IRS) is increasing audits (also called examinations) to close the “Tax Gap.” The Tax Gap equals the difference between the amount of tax that should be owed by taxpayers and the amounts actually paid by taxpayers. The Internal Revenue Service (IRS) is hiring new IRS revenue agents (auditors) and increasing the number of audits of tax returns. Thus, increased IRS audits (also called examinations) are coming, especially for businesses like partnerships and S corporations.

No one wants to receive an IRS initial audit letter (often an IRS Letter 6323). However, a taxpayer can limit the damage of an IRS audit by filing a “qualified amended return.” If you are concerned that your tax return was not filed correctly, now is the time to correct it (subject to the important risks discussed below). 

IRS Penalties Can Be Expensive

In an IRS audit, the IRS can determine that a taxpayer owes additional tax (called a “tax deficiency” or “underpayment”). The IRS also can impose penalties on top of the tax. These penalties are calculated as a percentage of the additional tax owed at a rate of 20%, 40%, or even 75%.

For example, assume that the IRS determines a taxpayer owes $100,000 in additional tax. The IRS could then determine that a 20% “accuracy-related” penalty applies on top of the tax. This 20% penalty equals $20,000 (20% of $100,000). In addition, interest accrues on both the tax and penalty until it is paid in full.

In certain contexts, the IRS can apply a 40% penalty, which would equal $40,000 on top of the tax in the above example. 

A Qualified Amended Return May Reduce or Eliminate Penalties

A “qualified amended return” could completely eliminate these penalties. A qualified amended return is defined in the Treasury Regulations at 26 C.F.R. (Treas. Reg.) § 1.6664-2(c)(3).

Basically, a qualified amended return is an amended return that is filed before the IRS first contacts someone about a taxpayer’s tax return. These “first contacts” could include:

  • An IRS initial audit (or examination) letter (for example, IRS Letter 6323);
  • An IRS initial audit letter for a partnership or S corporation of which the taxpayer is a partner, member, or shareholder;
  • An IRS examination of a promoter or return preparer under 26 U.S.C. (I.R.C.) § 6700;
  • An IRS “John Doe summons” related to an item on the taxpayer’s tax return; or
  • The IRS established a settlement initiative regarding a particular “listed transaction” reflected on the tax return.

To be a qualified amended return, a taxpayer must file an amended return (for example, Form 1040X for individuals or Form 1120X for C corporations) before any of the above events occur.

If the taxpayer files a qualified amended return and reports additional tax due, then the IRS generally cannot impose penalties on that additional tax. The taxpayer would still owe the tax and interest, but the taxpayer could avoid substantial penalties.

A Caution on Qualified Amended Returns: Criminal Activity or Fraudulent Returns

However, the qualified amended return rules are not without risks or limitations.

The IRS and courts have established a rule that an amended return cannot “scrub” an original tax return that was fraudulent. Thus, if the IRS considers a taxpayer’s original return to be fraudulent, the qualified amended returns will not work. Instead, the IRS could still impose penalties on the full amount from the original tax return.

In addition, if a taxpayer has potential exposure to tax crimes or criminal penalties, a taxpayer should exercise great care in deciding whether to file an amended return. After all, the IRS could use that amended return as additional evidence of criminal intent and to calculate the government’s tax loss.

Do your income tax returns have errors that need to be corrected? Are you concerned that the IRS might consider your original tax return to be fraudulent? Do you have potential criminal exposure? The Former IRS Attorneys of Holtz, Slavett & Drabkin, APLC can review your situation from an IRS perspective and advise on how to fix these tax problems before the IRS contacts you.

Have you already been contacted by an IRS revenue agent about an audit? The Former IRS Attorneys of Holtz, Slavett & Drabkin, APLC represent clients in sensitive domestic and international tax examinations, litigation, criminal tax investigations, and difficult tax collection matters.

David J. Warner is a former IRS senior trial attorney. While at the IRS, David advised IRS revenue agents (auditors) on complex international and domestic audits and litigated over 500 cases in U.S. Tax Court. David also taught tax practice and procedure, as well as tax courses on partnership and S corporation taxation, to IRS attorneys and to law students at Loyola Law School, UCI School of Law, and Chapman University Fowler School of Law. Please contact David at (949) 999-6606 to schedule a consultation.