What Makes A Tax Extension Valid?

 

You file an extension on April 15th for your personal tax return.

Is the extension valid if you wind up owing money but entered zero (-0-) on line 6?

What if you entered a balance due on line 6 but entered zero (-0-) on line 7?

A couple of things come immediately to mind:

(1)  There are clients – numerous clients – who have no intention of fully paying their taxes by April 15^th. The best the CPA can do is get them to pay something - anything - to take the pressure off the tax due (plus interest and penalties) when they finally file. I have heard the scold many times over the decades: the tax should be fully paid-in by April 15; the extension is for time to file not time to pay; yada yada. This is not a classroom, folks. This is real life, and I cannot control people. I think that I do some good just by nudging clients closer to compliance with the tax law.

(2)  Are you trying to get me sued? What if I (i) enter a number on line 4 but (ii) file the extension with no payment due (line 6)? Will the IRS bounce the extension? This is where procedural consistency is critical. I need high confidence in how the IRS will process this extension.

Let’s look at Karp.

The Karps wanted the IRS to apply a 2016 tax overpayment (of $336,558) to a later tax year.

Problem: The Karps were not diligent about filing tax returns on time. They were counting on that huge overpayment/carryover to keep them out of trouble. While true, there are ways this can blow up.

The IRS told the Karps that the 2016 overpayment could not be applied to 2017 because they filed the 2016 return in April 2021.

COMMENT: That’s how it blows up: you have to get that return in within 3 years (plus the extension, if you obtained one). The 2016 return was due April 15, 2017. Three more years is April 15, 2020. The IRS did not receive the return until April 2021 - a year late.

The Karps responded with proof that the IRS received their 2016 return on October 15, 2020.

COMMENT: Good! That is why practitioners recommend certified mail (which is becoming a dinosaur as we move to electronic filing) with proof of mailing.

FURTHER: We are not told whether the Karps actually waited until the last day for filing or were instead impacted by IRS closures during COVID.

The IRS backed down when presented proof. The IRS refunded $154,720 and credited the remaining 2016 overpayment to 2022.

The IRS then changed its mind.

Huh?

The IRS argued that the 2016 extension was invalid.

Because it was invalid, there was no extension until October 15, 2017.

Which means that the 2016 return filed October 15, 2020 was outside the three-year window (without the extension, that date was now April 15, 2020). The IRS wanted its $154,720 back. Oh, the IRS also reversed the portion of the overpayment that was credited to 2022.

“No soup for you” snarled the IRS.

Let’s catch our breath.

First, what was the IRS’ reasoning to blow up the 2016 extension?

The IRS looked at Form 4868 and saw zero (-0-) on both lines 5 and 6.

Mind you, the Karps had a sizeable overpayment from 2015 to 2016 (in fact, the Karps had reported sizeable overpayments for years). There was enough there to pay a subsequent year’s tax and send the Karps a refund check for 2016.

The IRS was relying on a Tax Court case (Crocker) where the taxpayer did not appear to even try to estimate the tax due on the extension. When finally filed, the return showed significant additional income and tax (because: of course). The Court agreed with the IRS that the extension was void. The return was late. Penalties. Interest. Brussels sprouts and lima beans. It was catastrophic.

Second, how was the IRS to know?

The 2015 return had not been received or processed by the time the 2016 extension arrived. Maybe - if the Karps ever got around to filing a tax return on time - the IRS might have had a clue of knowing what they intended for 2016.

While I disagree, I do have some sympathy for the IRS.

First, the Court noted that the Karps had a track record of (a) huge overpayments that (b) they repetitively applied to the following tax year.

COMMENT: I personally think this was THE factor that saved the Karps here.

The Karps looked at that overpayment and said: we do not owe anything for 2016. They then put zeros all over that Form 4868. Technically, they should have put (1) estimated gross tax on line 4; (2) the overpayment on line 5: and the (resulting) negative amount on line 6. The Karps did not do that, explaining that they mistakenly thought that the tax estimate was the amount they would be required to pay upon filing. The Court considered it a ministerial error, and they had conflated gross tax with net tax.

The Court also pointed out – devastatingly, I think – that the IRS initially accepted the 2016 return, including the extension as filed. That is why the IRS now wanted the refund check back.

Second, the Court noted that the IRS was put in a tough spot, as it did not have a 2015 return when processing the 2016 extension.

While it was easy for the Court to point out that the Karps had applied their prior overpayments, the IRS could not automatically predict that they would do so again. This dance was getting close to: heads you win, tails I lose for the IRS.

The Court pointed out that the Karps were still within procedural guardrails. They pushed it, but they got it done within three years.

Technically correct, but not an optimal real-world approach to tax filing.

The Court ordered summary judgement for the Karps and instructed both sides to sort the dollars involved and report the results back to for judgement.

I point out that this was not a Tax Court case. It was heard in the Court of Federal Claims, which hears civil claims against the federal government. While specialized (cases against the U.S. government), it is not the same specialization as the Tax Court (which hears only tax cases).

The cynical part of me wonders if the verdict would have been the same had the case gone to Tax Court. The Karps had an advantage: many cases go to Tax Court because one does not need to pay the tax before bring suit in Tax Court. Here, the Karps had already paid the tax (hence the huge overpayment), so filing outside the Tax Court was an option.

Our case this time was Karp v United States, U.S. Court of Federal Claims, No. 23-926, filed May 21, 2026.

Lawsuits, Attorney Fees and What Is A “Relator” Anyway?

I have a friend who was considering employment litigation earlier this year. His job has sufficient visibility that it attracts people – some unpleasant and others unhinged. Couple that with a political-correctness-terrified employer and you have a combustible mix.

The taxation of litigation damages leaves room for improvement. Certain types of litigation – say personal injury or employment – are commonly done on a contingency basis. This means that the attorney does not receive fees unless the case is successful or settled. A common contingency fee is one-third. A rational tax system would recognize that the litigant received 67 cents on the dollar and assess tax accordingly. Our system does not do that.

Our tax Code wants to tax the litigant on the full proceeds, although one-third or more went to the attorney. The Code does allow one to deduct that one-third as a miscellaneous itemized deduction. It sounds great but many – if not most – times it amounts to nothing. Why? 

·        Miscellaneous itemized deductions are deductible only to the extent that they exceed 2% of your adjusted gross income (AGI). Swell that AGI to unrepresentative levels - say by the receipt of damages – and that 2% can amount to a high hurdle.

·        Even that result can be overridden by the alternative minimum tax (AMT). The AMT does not allow miscellaneous deductions at all. Forget about deducting that contingency fee if you are an AMT taxpayer, which you likely will be.

·        Then you have states, such as Ohio, which do not allow itemized deductions. The damages are sitting in your AGI, though. It stinks to be you.

How did we get to this place?

We know that the tax Code allows one to deduct business expenses against related business income. There may be restrictions – entertainment expenses, for example, or limitations on depreciation – but overall the concept holds. The result of this accounting exercise enters one’s tax return as net profit or loss.

But not always.

For example, I am in the trade or business of being an employee of my accounting firm. My salary enters my individual tax return as gross income. What if I have business expenses relating to the practice?  The IRS allows me to deduct those, but not directly against my salary. The IRS instead wants me first to itemize and then claim my accounting-practice expenses therein as a miscellaneous deduction. Miscellaneous deductions are the redheaded stepchild of itemized deductions. They are never deductible in full, and depending on one’s situation, they may not be deductible at all.

Extrapolate this discussion to the recipient of a legal settlement and you have the issue I have with accounting-practice expenses – but greatly magnified, as the dollars are likely more substantive.

So I was pleased to review the case of Bagley v United States.

Richard Bagley had an MBA and a M.S. in accounting. He worked for TRW Inc, and from 1987 to 1992, he was the Chief Financial Manager for their space and technology group. TRW did a lot of work for the government, meaning they had to follow certain accounting procedures when requesting payment from the government. Remember that Bagley was in charge of the accounting, and you have a good idea of where the story is going.

Bagley became aware of bad accounting. He nonetheless signed certifications to the government, mostly because he needed the job. He did the good soldier thing and reported his concerns to his superiors. TRW in turn notified him that he was going to be laid off because of a corporate reorganization, rising tides, Punxsutawney Phil not seeing his shadow and the Chicago Cubs missing the World Series.

He was laid off in 1993.

In 1994 he brought a wrongful termination lawsuit against TRW.  He lost that lawsuit.

In that same year, he filed a False Claims Act (FCA) on behalf of the United States against TRW.

There is a peculiarity about a FCA lawsuit that we should discuss. Although Bagley brought the FCA lawsuit, the action was technically brought by the United States against TRW for fraud. Bagley stood-in as an agent for the United States, and his status was that of “relator.”

Bagley took this matter seriously.

During the 1994 to 2003 time period, Bagley exclusively worked on his FSA prosecution activity, and was not otherwise employed.”

He maintained a contemporaneous log of hours he worked on the litigation. He attended meetings with his attorney and government counsel. He spent a lot of time looking through TRW documents. He stayed involved because the attorneys

… weren’t accountants and hadn’t spent 25 years working with TRW and didn’t have an in-depth understanding of TRW’s accounting system or the people or the products or anything about the company which was  necessary to understand how the frauds occurred and where the evidence was.”

He logged approximately 5,963 hours working on the FCA. He put in those hours 

… in order to successfully prosecute the claims so that [he] would receive an award.”

In 2003 TRW paid the government, which in turn paid Bagley $27,244,000. He in turn paid his attorney $8,990,520. TRW also paid Bagley’s attorneys $9,407,295 and issued the Form 1099 to Bagley.

NOTE: This is standard treatment. The payment to the attorney is imputed to the litigant.

He filed his 2003 Form 1040. There was some complexity on how to handle the attorney fees paid directly by TRW, so he amended the return. He went the usual route of deducting the attorney fees as a miscellaneous deduction. He amended a second time, this time showing the relator litigation as Schedule C self-employment income. He was now deducting the attorney fees directly – and fully - against the litigation proceeds.

The IRS bounced the seconded amended return.

There really was only one issue: did Bagley’s litigation activity rise to the level of Bagley being self-employed?

The Court went through the analysis:

·        Pursuing the activity in a business-like manner

·        Expertise

·        Time and effort expended

·        Success in carrying on similar activities

·        History of income and losses with respect to the activity

·        Financial status while pursuing the activity

·        Elements of personal pleasure or recreation

·        Regularity and continuity

The IRS argued along different lines. They reminded the Court of the origin and character of the activity giving rise to the FCA claim. Bagley’s claim was that of an informant, according to the IRS, not that of a relator prosecuting the case. According to them, it was Bagley’s status as an informant, not his activities as a relator – that drive the tax consequence.

The Court decided that an action under the FCA was different from a tort action, as the “gravamen” of a FCA action was fraud against the government. The relator stands in the shoes of the government in order to prosecute the claim. This consequently was not a personal claim that Bagley had undertaken. He had no personal stake in the damages sought – all of which, by definition, were suffered by the government.

The Court decided that Bagley did have a trade or business, and that the second amended return was correct. The government was to refund him approximately $3,874,000 plus interest for his 2003 tax year.

Note the tax year involved: 2003. This case was decided just this summer. Sometimes these matters take a while to resolve, but this was an especially slow boat on a lazy river.

OBSERVATION: The facts are too unique for this case to provide much precedence, but I am pleased that Bagley won. Frankly, a minor change to the tax law would make this case obsolete and remove the tax nightmare from future litigation settlements. Simply allowing the litigant to recognize the net damages as income would solve this matter. It would also reflect the equity of the transaction. Do not hold your breath, though.