Tips to Mitigate Tax Extension Liabilities and Risks

Tax season can be a stressful time for accountants and CPAs, especially when clients are scrambling at the last minute to gather the necessary paperwork. Fortunately, if you’re running behind or still waiting on documentation, filing a tax extension can be a simple way to alleviate this stress and earn some extra time. Unfortunately, tax extension liabilities can potentially increase the risks for accountants—and penalties for their tax-paying clients—if they’re not properly prepared.

Here’s what you need to know about navigating tax extension liabilities as an accountant, and how you can mitigate these risks with your clients.

Why file for a tax extension?

Even with diligent bookkeeping practices, federal filing deadlines can sneak up on taxpayers. Whether you’re facing an illness, divorce, family emergency, natural disaster, or major business transition, sometimes you just need more time to collect and organize all the required financial documentation. This year, the federal tax filing deadline is:

  • March 15 for partnerships, multiple-member LLCs, and S-corporations.
  • April 18 for individuals, sole proprietors, single-member LLCs, and C-corporations
  • April 19 for individuals, sole proprietors, single-member LLCs, and C-corps in Maine and Massachusetts, where the 18th is a state holiday.

If a client isn’t quite ready to file their tax returns for any reason, you can request an extension. This extends the tax filing deadline, granting an extra six months to prepare all the paperwork without any late-filing penalties. This moves the deadline to September 15 for partnerships and S-corps, or October 17 for individuals, sole proprietors, C-corps, and single-owner LLCs.

Extension requests must be filed by the regular spring deadlines. The IRS automatically grants these requests, without requiring an explanation of why you’re seeking an extension. If any of your clients are falling behind, filing for an extension is preferable to missing the deadline or rushing their returns, as we’ll explain below.

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What’s the catch?

Extensions only extend the deadline for filing taxes—NOT for paying them! This is the biggest misconception people have about tax extensions. Many clients don’t realize that they still need to pay any estimated tax liabilities by the regular deadline to avoid penalties from the IRS, even if they get an extension to file their returns later.

If the estimated taxes aren’t paid by the regular deadline, the IRS will start charging late fees. Penalties and interest apply to any balances exceeding 10% of the total tax due. In other words, the estimated payment must put the taxpayer within 90% of their federal tax liability to avoid underpayment penalties. This puts the onus on accountants to accurately estimate a client’s tax liability when filing for extensions, as underestimation can be costly.

Comparatively, if you miss the tax deadline altogether without requesting an extension, you could face a late-filing penalty of up to 5% of the unpaid balance each month up to 25% PLUS a monthly failure-to-pay penalty, which is 0.5% of the unpaid balance. That means the late-filing penalty is 10 times higher than the late-payment fee, so it is critically important to file tax returns on time—or at least request an extension if you can’t.

How to file a tax extension

Individual taxpayers can request an extension with IRS Form 4868, or by simply selecting the “extension” option when paying estimated taxes online through the IRS payment gateway before the payment deadline. During the process, you must maintain transparency and good communication with your client—keep them informed about details such as whether the extension will be filed manually or electronically.

Corporations can similarly file for a business tax extension using IRS Form 7004. Certain situations may require different paperwork; access all the IRS tax extension liability forms here. It’s important to note that all states have their own filing procedures, and extension rules may vary depending on the state you file in.

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Reducing tax extension liabilities

As beneficial as tax extensions can be when clients need more time to file, the process presents challenges for accountants and CPAs. Here are a few common examples of obstacles that financial professionals may encounter when it comes to tax extension liabilities.

Underpayment penalties
Estimating potential tax liabilities within 10% accuracy can be a challenge, especially if you’re several months away from completing all the necessary paperwork. This is the first and often the largest obstacle that accountants face when filing tax extensions for clients.

In some cases, the client may not have all of the documentation needed to accurately determine their taxes by the initial deadline. However, if they’re going to owe anything, they have to pay something, so the CPA must estimate these liabilities based on the information that’s available at the time.

Hopefully, the actual tax liabilities come close to the CPA’s initial tax estimates, and the client can simply pay the balance when filing their returns. But what if the client ends up owing significantly more than the early estimates suggested? The IRS could invalidate the extension altogether, hitting the client with late payment penalties on top of failure-to-file fees, accumulating every month since the initial deadline passed. Depending on the client’s tax balance, these penalties can quickly amount to significant bills.

This is a classic example of a potential tax extension liability claim against accountants who underestimate their clients’ payments. To prevent these liability claims, accountants should clearly communicate the extension process and potential risks. This can be done with a “hold harmless disclaimer,” stating that the CPA uses the information provided to estimate a payment amount, which may or may not reflect the amount of the final return based on complete and accurate information. Through this disclaimer, the client agrees to hold the firm harmless from any damages that result if the extension is invalidated.

Assumed extension
In another common example of tax extension liabilities, imagine an accountant who has been working with the same client-company for over a decade. Due to internal auditing and accounting processes, the company consistently files for tax extensions every year, taking advantage of the extra time to verify their numbers before filing.

But for some reason, the accountant hasn’t heard from this long-term client yet about filing 2021 tax returns—or even requesting an extension to file later. Maybe the client is going through an acquisition or divorce that’s complicating their financial matters; maybe they’re in the armed forces and they’ve been deployed. Should the accountant automatically assume that the client wants an extension, just because they’ve done it before?

Assumptions can be risky in this situation, and can even cause costly accountant liability claims. To prevent these claims, accountants should always require affirmation from clients to authorize an extension. In a detailed engagement letter sent prior to tax season, inform your clients that your firm won’t file an extension unless they specifically request it.

Missed deadline
Perhaps the worst case scenario happens when accountants fail or forget to apply for a tax extension, causing a client to miss the deadline altogether. In fact, we saw several examples of liability claims last year that resulted from accountants simply forgetting to put clients on extension. After all, tax season can be a frantic time for financial professionals, and unfortunately, mistakes may happen.

In recent years, liability insurers have reported a rising number of claims resulting from various tax extension liabilities. Although clear client communications and detailed engagement letters can help prevent many of the liability claims triggered by tax extensions, accountants can’t always prevent every possible situation. When mistakes inevitably happen, accountants and CPAs need the protection of professional liability insurance to mitigate the risks surrounding tax extensions.

Although tax extension liability claims can’t be entirely eradicated, they can be drastically reduced with solid risk management practices, proper tax planning, and the peace-of-mind that liability insurance provides.

To learn more about protecting your practice from the potentially devastating cost of tax extension liabilities, contact the professional liability experts at McGowanPRO.