Editor: Mark G. Cook, CPA, MBA
Practice & Procedures
Recently, the Tax Court denied a taxpayer a deduction for a claimed theft loss because, even if he could prove that the loss had occurred, he had not filed a tax return for the year of loss and as a result did not make a proper election to itemize deductions (Murray, T.C. Memo. 2012-213). The Tax Court’s opinion illustrates that not filing a return on time can have results other than a nonfiling penalty.
In Murray, the taxpayer received a direct distribution from an inherited IRA in 2006. In 2010, the IRS prepared a substitute return for 2006 on the basis of information provided by third parties. The IRS issued Murray a notice of deficiency. Murray challenged the IRS’s determination in Tax Court, where among other things, he claimed he was entitled to a theft-loss deduction of $30,000. The IRS contended that even if the alleged theft loss occurred, Murray was not entitled to a theft-loss deduction because he had not filed a federal income tax return for 2006.
The Tax Court noted that under Sec. 165(c)(3), an itemized deduction is allowed for a theft loss, but under Sec. 63(e)(1), a taxpayer must elect to itemize deductions. Sec. 63(e)(2) requires a taxpayer to file a return to elect to itemize deductions. Citing its earlier decision in Jahn, T.C. Memo 2008-141, the Tax Court found that if the IRS prepares a substitute return because the taxpayer did not file one, then the taxpayer cannot claim itemized deductions.
Often, when there is no filing requirement, tax practitioners advise clients not to file a tax return. In light of these cases, one should consider advising clients to file a tax return for all tax years even if there is no filing requirement because, once an election is made to either itemize deductions or claim the standard deduction, a taxpayer may change the election on an amended return as prescribed under Regs. Sec. 1.63-1(a). If a return is not required but one is filed, the tax practitioner needs to make sure that it is a valid return. In Cabirac, 120 T.C. 163 (2003), aff’d, No. 03-3157 (3d Cir. 2004), the Tax Court held that the Forms 1040 and 1040A the taxpayer had filed showing only zeros for amounts to compute tax liability were not valid returns for federal income tax purposes under Sec. 6651(a)(1) because the taxpayer “did not make an honest and reasonable attempt to supply the information required by the Internal Revenue Code.” Hence, a return with simply the taxpayer’s name, address, and Social Security number may not be considered a valid return.
Further consideration needs to be given to the state-level effects of not filing a return. A failure to file a state return could cause a result at a state level similar to the one that occurred at the federal level in Murray. The issue is more complex when dealing with multistate taxpayers. For example, should a taxpayer file a return to claim a loss prior to the need to use it, to be able to carry forward state net operating losses?
When changing the election to claim the standard deduction or itemize deductions, taxpayers should be aware that the limitation of Sec. 6511 for claiming a credit or a refund is in effect. Thus, if the change results in a credit or refund, the amended return has to be filed within three years from when the return was filed or two years from when the tax was paid, whichever comes later.
Spouses filing separate returns must meet two conditions to change the election to itemize deductions (Regs. Sec. 1.63-1(c)). First, the change must be consistent between both spouses. Second, both spouses must file a consent in writing to the assessment of any deficiency of either spouse to the extent attributable to the change of treatment, even though the assessment of the deficiency would otherwise be prevented by the operation of any law or rule of law. Furthermore, no change of election is allowed if the liability of either spouse has been settled in compromise with the IRS (Regs. Sec. 1.63-1(d)).
While Murray discusses the availability of an itemized deduction election on a timely filed return, tax practitioners should also consider the broader implications of failing to file a timely return. For example, when the IRS prepares a substitute return, does this affect the availability of other elections or deductions? Murray suggests that particular attention should be paid to such situations.
Mark Cook is a partner at SingerLewak LLP in Irvine, Calif.
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