This article proposes a framework for deciding whether to fix a mistake found on a previously filed tax return. Rather than treating mistakes on previously filed tax returns as isolated events to be managed on an ad hoc basis—the usual and less effective approach—the proposed framework views the discovery of mistakes, and the decisions about whether to fix them, as part of an overall strategy for ensuring tax compliance. Viewed through the lens of overall tax compliance, taxpayers can most successfully resolve mistakes found on their tax returns by focusing on two actions:
- contemporaneously documenting the standard of care and diligence used in preparing the tax return; and
- ensuring that decisions about whether to fix the mistake for past years comport with that established standard of care and diligence.
An initial focus on these two inquiries, rather than getting bogged down in weighing the pros and cons of various procedures for fixing old tax returns, will help define a clear and optimal strategy for resolving the mistake. And a well-defined strategy will then help identify the appropriate procedure to use in effectively resolving the issue with the Internal Revenue Service.
The Usual Approach
Taxpayers tend to think about mistakes on their tax returns only after they have been discovered—typically months, if not years, after filing. In this context, a mistake does not refer to some intentional omission or known rough spot in completing the return. It refers to errors on the return that the taxpayer truly does not know about, the errors that come as a complete surprise when someone, for whatever reason, has to go back and review the previously filed return. In addition, this article assumes that the person identifying the mistake works for the taxpayer and not the IRS, such that the taxpayer has full discretion to decide how to manage the mistake.
In the most typical scenario, the immediate instinct upon finding a mistake is to launch a lengthy inquiry into how it happened. This inquiry can quickly devolve into an exercise in email archaeology, with the tax team randomly digging through old emails hoping that someone just happened to retain the one message that will unlock the mystery of how the mistake occurred. If the team is lucky enough to dredge up a handful of emails on the issue, it then begins the delicate work of patching them together into a narrative history of how the mistake occurred despite everyone’s having acted with the utmost care and diligence.
In addition to the scramble to develop facts, finding a mistake on a tax return typically initiates a deep dive into the various procedural opportunities the IRS provides for handling the mistake. The discussion can quickly become consumed with weighing the pros and cons of amended returns, superseding returns, Revenue Procedure 94-69, Section 9100 relief, and a host of other procedures. These findings often get summarized in a tidy chart, with rows for the procedures and columns for the pros and cons.
In the worst of all worlds, the patchwork of facts and the chart of procedures are developed in parallel rather than together. The chart of procedures makes no effort to address the still-developing facts, and the search for facts proceeds with no sense of the available procedures. The result is that the mitigation efforts only add to the stress, concern, and unexpected work associated with discovering a mistake on a tax return.
Documenting Care and Diligence
Rather than this reactive approach to handling mistakes on a tax return, a more effective approach is to prepare in advance by establishing and documenting the standard of care used in preparing the tax return, then acting consistently with that standard of care in deciding how to fix the mistake. Proactively preparing for mistakes on your return makes sense because, put simply, there will always be mistakes on your tax return. You don’t need this article to tell you that, and I don’t need to review your return to say it. It cannot possibly be otherwise given the difficulty of the tax laws, the complexity of your business, the scope of information required to complete a return, and the everyday pressures all of this places on tax professionals.
Because tax-return mistakes are inevitable, taxpayers should document the diligence and care used to prepare the return. Contemporaneously documenting the return preparation process differs from documenting technical positions and is intended to answer two key questions:
- What level of care and diligence should be reasonably expected of the taxpayer in preparing the tax return, given the specific facts and circumstances?
- Did the taxpayer meet that level of care and diligence?
Unlike documentation of technical positions, which is intended to show that the taxpayer is technically correct, documenting the standard of care and diligence becomes relevant when the taxpayer is technically wrong. The documentation shows that, despite the mistake, the taxpayer acted with reasonable care and diligence in preparing and filing the tax return, which substantially mitigates the most difficult aspects of discovering a mistake on a return, including the risk of tax penalties.
In documenting the process used to prepare the tax return, the first question—what is the reasonable standard of care and diligence for this specific taxpayer?—is often more important than the second. The documentation process not only memorializes facts but also serves as a helpful impetus for the taxpayer to critically evaluate the standards in preparing the return. The first question forces a taxpayer to systemically consider things such as its return preparation costs, its return review processes, its materiality thresholds, and how such items contribute to its overall tax compliance. The tax laws recognize that what constitutes a reasonable level of diligence and care necessarily varies from one taxpayer to the next. For example, what constitutes “reasonable cause and good faith” in preparing a tax return for purposes of penalty protection will depend upon all the facts and circumstances, including the “experience, knowledge, and education of the taxpayer.”1 The documentation process helps define the taxpayer’s specific standard of care and diligence in light of these factors.
Having determined an appropriate standard of care, the next step is to memorialize your compliance with that standard. While this next step may seem obvious, the process is often turned on its head, with taxpayers attempting to memorialize what was done (often from old emails), then arguing that what was done must have met the appropriate standard of care. Having the discipline to prepare contemporaneous documentation helps ensure that the facts meet the relevant standard and avoids the temptation to lower the standard of care to meet the established facts.
In preparing the contemporaneous documentation, it is sufficient to demonstrate that the individuals preparing the tax return relied on proper information sources, conducted reasonable diligence on business operations, were properly overseen by qualified professionals, and followed established procedures for preparing and reviewing the tax return. This documentation should not be overly burdensome or time consuming. It is not a matter of maintaining lengthy and detailed minutes of each meeting related to the tax return, but rather establishing that 1) the tax department had an established cadence of meetings to prepare and review the return, and 2) the team followed that cadence in preparing this particular return.
By demonstrating that the taxpayer first established clear standards of care and diligence in preparing the return and then completed its return consistent with those standards, the contemporaneous documentation will generally mitigate the more worrisome potential implications of finding a mistake on a previously filed return, including with respect to tax penalties, financial statement implications, and professional responsibility. The documentation will leave a taxpayer well prepared to resolve the mistakes that will, inevitably, be found on previously filed returns.
Whether to Fix for Prior Years
Documenting the care and diligence initially used in preparing the tax return not only provides the factual foundation to resolve a mistake, but also provides a guide to deciding whether to fix the mistake on previously filed tax returns. Taxpayers must rely on their own particular compliance standards in deciding whether to fix a mistake on previously filed tax returns, because the Internal Revenue Code does not impose a duty to file an amended return. Without a specific duty imposed in the Internal Revenue Code, the decision about whether to fix a mistake on previously filed tax returns turns on whether doing so is necessary to maintain the overall standard of care and diligence the taxpayer has adopted in preparing the return.
By focusing on their established standards of care and diligence, taxpayers guard against the common error of allowing their decisions to be dictated by the availability and convenience of various IRS procedures. Taxpayers often start the decision on whether to fix a mistake with a laundry list of available procedural options, but the decision to fix a mistake rarely depends on the relative pros and cons of various procedures. The critical factors that must be weighed when considering whether to fix the return in prior years are not procedural, but rather are the same factors used to evaluate the level of diligence and care employed in initially preparing the return itself. Those factors include attributes such as materiality, complexity, compliance burden, financial statement implications, statutes of limitations, effects on other items on the return, and effects on other returns (including state and foreign returns).
These compliance factors do not provide a one-size-fits-all answer regarding whether to fix the mistake for prior years. The analysis necessarily depends on the particular facts and circumstances relevant to the issue and the particular taxpayer. In conducting this analysis, the contemporaneous documentation of the process for preparing the return once again provides substantial assistance. That documentation not only provides the factual basis for any penalty defense but also requires the taxpayer to think systematically about the standard of diligence and care it should employ in preparing the return. The mistake should be fixed on the previously filed return as necessary to maintain the previously established standards of diligence and care.
How to Fix a Mistake
After determining whether to fix the mistake (based on the established standard of care and diligence), the taxpayer can then decide how to fix the mistake. A full taxonomy of the various ways of fixing mistakes on previously filed tax returns is beyond the scope of this short article. The IRS has put in place numerous rules, programs, and approaches to facilitate taxpayers’ efforts to fix their mistakes, each with its own pros and cons.
For taxpayers that can establish they acted reasonably in preparing their return, the decision regarding procedures is much less important because, as a general matter, no accuracy-related penalties should be imposed as a result of the mistake provided the taxpayer exercised reasonable diligence and care in preparing the tax return. This guideline generally holds true regardless of the procedure selected for fixing the mistake. Accordingly, for the taxpayer that acted reasonably, the choice of procedure for fixing the return generally boils down to one factor—what procedure imposes the least administrative burden. This single factor is typically not difficult to evaluate, which can make the choice of procedure an easy decision for taxpayers that acted reasonably.
For taxpayers unable to establish that they acted reasonably in preparing the return, the choice of procedure for fixing the mistake becomes more important, because certain procedures provide penalty protection regardless of the level of care exercised by the taxpayer (provided it did not rise to the level of fraud). In particular, Treasury regulations allow taxpayers to submit a “qualified” amended return prior to first being contacted about an IRS audit, and amounts shown on such a qualified amended return are treated as though they were reported on the original return for purposes of determining penalties.2 Because penalties generally are not an issue for taxpayers that acted with reasonable care and diligence in preparing their return, the qualified amended return provisions are most valuable to taxpayers that did not act reasonably in preparing their return, since they provide an additional incentive to disclose and correct the mistake that otherwise may never be subject to audit.
For large taxpayers under perpetual audit, Revenue Procedure 94-69 provides similar penalty protection for issues disclosed at the beginning of an audit. But the incentives are much different for these taxpayers, because they know their returns will be subject to audit, and therefore there is much more substantial risk that the IRS will detect any material mistake.3 Understanding that the IRS will fully audit and identify all material issues on a tax return substantially reduces the disclosure incentive provided by the penalty protection found in Revenue Procedure 94-69. For taxpayers under perpetual audit, the predominant benefit of Revenue Procedure 94-69 can be administrative efficiency, not penalty protection. It relieves large taxpayers from having to file a lengthy and complex amended return in each instance when they discover a mistake that must be fixed for prior years. They can instead disclose all such issues at the beginning of an audit, resolve them with the IRS audit team, and file a single set of amended returns at the conclusion of the audit.
The IRS has at times indicated that it may reevaluate the process established in Revenue Procedure 94-69. Fully revoking that revenue procedure would substantially increase the burden of fixing mistakes in prior years, since doing so would, again, generally require taxpayers to file large and complex amended returns. These additional procedural burdens, and not the penalty implications, will likely weigh significantly in a taxpayer’s decision about whether to fix a mistake on an old return. In that regard, if the IRS is seeking to reevaluate Revenue Procedure 94-69, those considerations should be guided much more by procedural efficiencies than by penalty implications.
Every large and complex tax return undoubtedly contains mistakes, and finding those mistakes after the return has been filed is never a pleasant experience. But by establishing and documenting an appropriate standard of diligence and care in preparing the return in the first place, then acting consistently with that established standard in deciding whether to fix the mistake for prior years, taxpayers can cut through many difficulties that arise when a mistake is found. They will then be best positioned to confidently select the most effective procedure for resolving the concern with the IRS.
Bryon Christensen is a principal, tax policy and controversy, at Ernst & Young.
- Treasury Regulations Section 1.6664-4(b)(1).
- Treasury Regulations Section 1.6664-2(c)(2).
- According to the 2018 IRS Data Book, only 0.1 percent of income tax returns were subject to a field audit. Assuming that the IRS’ chances of detecting a mistake during a field audit are the same for all taxpayers, this finding implies that the risk of detection is 1,000 times larger for a taxpayer under perpetual audit than for a taxpayer not under perpetual audit.