Correcting Errors on Prior Year Tax Returns
By: Gary Porter, CPA
The two significant issues here are: (1) must the association amend a previously filed return if an error is subsequently discovered?; and (2) if the prior tax return is not amended, how is the association's tax reporting position determined for the current and subsequent tax years?
Virtually all community associations that file Form 1120 will have either an IRC Sec. 277 excess membership deduction carryover, or a Rev. Rul. 70-604 (see July, 1990 issue of Ledger Quarterly) excess membership income carryover. The two cannot co-exist. The only other possibilities are that (1) the association failed to make a Rev. Rul. 70-604 election, and paid tax on its net membership income, or (2) had a net membership income of $0. These two events are highly unlikely to occur.
Carryovers, therefore, exist in most associations, yet are rarely documented in the tax returns. Consequently, carryovers are often overlooked by the CPA when preparing the return, which can have disastrous results for the association if they are later discovered.
The issue of the obligation to correct prior year returns is particularly important to associations because of the IRC Sec. 277 excess membership deductions carryovers, the Rev. Rul. 70-604 excess membership income carryovers, and less frequently, a net operating loss carryover, (see October, 1989 and January, 1990 issues of Ledger Quarterly for a full discussion of these carryovers). It is unfortunate that associations frequently change CPAs, generally as a result of the annual (normally) bid process for audit and tax services. Because of the frequent changes, the lack of understanding by some tax preparers of the extreme complexity of community association tax law, and the inadequate documentation generally accompanying tax returns, the carryover status of the above named items is many times lost, and sometimes cannot even be deciphered from the tax returns. For these reasons, our firm always requests copies of three years prior tax returns on any new association client before we will prepare the current year tax return.
MUST THE PRIOR YEAR RETURN BE AMENDED?
Section 1.451-1(a) of the Regulations to the Internal Revenue Code provides the following:
"If a taxpayer ascertains that an item should have been included in gross income in a prior taxable year, he should, if within the period of limitation, file an amended return and pay any additional tax due. Similarly, if a taxpayer ascertains than an item was improperly included in gross income in a prior taxable year, he should, if within the period of limitation, file claim for credit or refund of any overpayment of tax arising therefrom."
Section 1.461-1(a)(3)(i) of the Regulations to the Internal Revenue Code provides the following:
"Each year's return should be complete in itself, and taxpayers shall ascertain the facts necessary to make a correct return. The expenses, liabilities or loss of one year cannot be used to reduce the income of a subsequent year. A taxpayer may not take advantage in a return for a subsequent year of his failure to claim deductions in a prior taxable year in which such deductions should have been properly taken under his method of accounting. If a taxpayer ascertains that a deduction should have been claimed in a prior taxable year, he should, if within the period of limitation, file a claim for credit or refund of any overpayment of tax arising therefrom. Similarly, if a taxpayer ascertains that a deduction was improperly claimed in a prior taxable year, he should if within the period of limitation, file an amended return and pay any additional tax due. However, in a going business, there are certain overlapping deductions. If these overlapping items do not materially distort income, they may be included in the years in which the taxpayer consistently takes them into account."
The use of the word "should", rather than "shall", is generally interpreted to mean that while it is correct and advisable for the association to file an amended return, it is not mandatory.
The CPA is required to advise the association of the error in the prior return, as indicated by Section 10.21 of Circular No. 230, which prescribes the rules applicable to practice before the Internal Revenue Service:
"Each attorney, certified public accountant or enrolled agent who, having been retained by a client with respect to a matter administered by the Internal Revenue Service, knows that the client has not complied with the revenue laws of the United States or has made an error in or omission from any return, document, affidavit or other paper which the client is required by law to execute in connection with such matter, shall advise the client promptly of the fact of such noncompliance, error or omission."
The CPA, however, should not tell the association that there is any duty to amend the original return, nor may the CPA inform the IRS of the prior year error without the association's permission (Statement on Responsibility in Tax Practice No. 6 Knowledge of Error: Return Preparation, August 1970, AIPCA). Further, the CPA has no duty to withdraw from the engagement simply because the association fails to file an amended return.
PREPARING THE CURRENT YEAR RETURN
If the prior return(s) are amended, the current year returns should be prepared based on the corrected prior year information.
If, however, the prior returns are not amended, the correction of erroneous information is still required. Section 1.441-1T(a) of the Regulations to the Internal
Revenue Code provide that "Taxable income shall be computed and a return shall be made for a period known as the `taxable year'". (also see Rev. Rul. 80-59). The current year return must, therefore, reflect the correct income and expense for the current accounting period, including accurate carryover information.
Carryovers must be recalculated as if the prior year tax returns had been properly filed or corrected by amendment. This calculation has been extended by case law (Phoenix Coal Company, Inc. 231 F2d 420 (CA-2, 1956) to include "closed" years. The association is further required by Regulation Sec. 1.172-1(c) to disclose the calculations that use items from erroneous prior returns. Disclosure of NOL (net operating loss) calculations is required. Failure by the association to make the correct calculations, or to make "hidden" calculations with no disclosure, or an attempt to make a "cumulative adjustment" in the current year, may be viewed by IRS as an attempt to conceal the previous erroneous returns.
Tax preparers are subject to penalties under IRC Sec. 6701 if they "know that such portion [of the return] (if so used) would result in an understatement of the liability for tax...". This penalty may be applied where a CPA knowingly ignores prior year carryover errors in computing current year membership income.
Where a CPA discovers errors made in good faith in prior year returns, he must notify his client, the association. The association should file an amended return, but is not required to do so. Filing the amended return is the most conservative approach to solving this problem. If no amended returns are filed, the CPA must disclose on the current year returns, the nature, reason, and amount of the corrections to the carryovers coming into the current year. Failure by the CPA to make the appropriate calculations and disclosures exposes the CPA to the application of the IRC Sec. 6701 penalties.