SOL on Tax Refunds

Editor:
Steven F. Holub, CPA
Aidman, Piser & Co.
Tampa, FL

Editor's note: Steve Holub is the former chair of the AICPA Tax Divisions Tax Practice Management Committee. Dr. Grooms is a member of the Tax Practice Improvement Committee and the Tax Accounting Simplification Task Force.

If you would like additional information about this column, contact Mr. Holub at (813) 222-8555 or stevenh@apcpa.com, or Dr. Grooms at (803) 790-4400 or wmgcpa@aol.com.

This column addresses some of the rules concerning the statute of limitations (SOL) on tax refunds. Basic guidance on the SOL is provided in Sec. 6511(a), "Limitations on credit or refund," which states:

Claim for credit or refund of an overpayment of any tax imposed by this title in respect of which tax the taxpayer is required to file a return shall be filed by the taxpayer within 3 years from the time the return was filed or 2 years from the time the tax was paid, whichever of such periods expires the later, or if no return was filed by the taxpayer, within 2 years from the time the tax was paid.

Thus, generally, a taxpayer must file a refund claim within three years of the date he or she filed the return. However, in actual practice, many issues arise, including:

• What is a refund claim?

• Do the SOL rules apply only to income tax?

• When is a return deemed filed for purposes of the three-year rule?

• When is tax deemed paid for purposes of the two-year rule?

• What happens if a return is filed late?

• What happens if no return is filed?

• If a refund is barred pursuant to the rules, can an overpayment be applied to the next year?

• What happens if a taxpayer is unable to file a refund claim?

• How do these rules affect the use of net operating losses (NOLs)?

While a failure to use official refund claim forms (e.g., Form 1040X, 1120X or 843, Claim for Refund and Request for Abatement) is not necessarily fatal, the courts have not been liberal in sustaining informal refund claims; see Rock Island, A. & L.R. Co., 254 US 141 (1920), in which the Supreme Court disallowed a refund for failure to file a proper claim. Filing an official form is not absolutely required, but it is good practice. S corporations, partnerships and certain other taxpayers normally file an amended return, which serves as a refund claim. The claim must state the refund amount being sought, the year in which the tax was paid and the basis for the refund. It must be clear and concise to enable the Service to determine the merits of the refund request.

Because Sec. 6511(a) applies to "any tax imposed by this title," the three- and two-year time limits apply to income, excise, employment, estate and gift taxes. Clearly, a refund claim has two "time" rules; a taxpayer must file a claim within one of these or forgo a refund, regardless of the claims merits. Sec. 6511(a) sets forth very specific time requirements. The IRS cannot waive these rules.

The first of the two time requirements states that a claim "shall be filed by the taxpayer within 3 years from the time the return was filed." What happens if the taxpayer files a return early, before the original due date of the return? Does the three-year SOL begin on the actual filing date or on the returns due date? According to Sec. 6513(a), the early return is deemed filed on the last day of the required filing period (e.g., the 15th day of the third or fourth month following the close of the taxpayers tax year, for corporations and individuals). However, under Regs. Sec. 301.6511(b)-1(b)(i), if the due date is extended, the three-year SOL would start to run on the expiration of the returns extended due date. For example, the SOL for a 2002 individual return filed on or before April 15, 2003 would start on April 15, 2003. Any tax shown paid (including prepaid tax) with that return would potentially be subject to a refund claim until April 15, 2006. However, if the returns due date had been extended to Oct. 15, 2003, the refund claim potential, including prepaid taxes, would apply to claims filed on or before Oct. 15, 2006.

If a return is filed more than three years after its original due date, a refund claim may be filed within three years of that filing, but the refund would be limited to the tax paid with the return. Under Sec. 6513(b), any tax paid by withholding or as an estimate is deemed paid on the original due date, without regard to extensions, rather than the date that the delinquent return was actually filed. As a result, if a 2002 return were filed after April 15, 2006, the only tax potentially eligible for a refund would be the tax paid with the return, if the refund claim was filed within three years of the return filing.

Sec. 6511(b)(2)(A) provides that "[i]f the claim was filed by the taxpayer during the 3-year period prescribed in subsection (a), the amount of the credit or refund shall not exceed the portion of the tax paid within the period, immediately preceding the filing of the claim, equal to 3 years plus the period of any extension of time for filing the return." (Emphasis added.)

The second of the time requirements allows a claim for credit or refund to be filed at any time within two years after the tax was paid, regardless of when the return was filed. Accordingly, this rule applies only to taxes paid within two years preceding the filing of a refund claim. This rule applies when a return is filed after the due date and the taxpayer later files a refund claim.

If a return is filed late, a refund claim may be filed within three years of the return filing, but the refund will be limited to the tax paid with the return. Under Sec. 6513(b), any tax paid by withholding or as an estimate is deemed to have been paid on the original due date, without regard to extensions.

Example: J files his delinquent 2001 return on July 15, 2005, with a $3,000 tax liability. His 2001 withholding was $2,000, so he pays $1,000 with the return. He later determines that he has no 2001 tax liability and, on Aug. 1, 2005, files Form 1040X, requesting a refund. The IRS considers the amended return a refund claim. Because J filed the original return late, the two-year rule applies and he receives only a $1,000 refund. Had his return been timely filed, he could have received a $3,000 refund.

If a taxpayer has a refund attributable to a year barred by the SOL, that refund may not be applied to the next years income tax liability; see Beal, 535 F Supp 404 (1981). To apply the overpayment as a credit to the next year would be tantamount to a refund, thwarting the purposes of the statute.

Put simply, if a taxpayer:

• Timely filed a return, he or she could file a refund claim for all of the taxes paid, including that paid via withholding or estimate, within three years of the returns due date, including extensions.

• Was delinquent, he or she may file for a refund within three years of the returns filing date, but only as to the tax paid within three years of the return filing (prepaid taxes are deemed paid on the original returns due date).

• Paid after filing the return (e.g., as the result of an IRS examination), he or she could recover the taxes paid within two years after payment. That date may be beyond three years of the returns filing date.

What if a taxpayer overpays because of withholding or estimating taxes? If a refund is claimed more than three years after the returns original due date, the claim is barred. Unfortunately, when the taxpayer owes tax for a delinquent year, it can be assessed; no setoff is available.

In some situations (such as for health reasons), a taxpayer may be unable to file a refund claim. Effective July 22, 1998, Congress gave some of these taxpayers relief from the Sec. 6511(a) rules; Sec. 6511(h) provides:

In the case of an individual, the running of the periods specified in subsections (a), (b), and (c) shall be suspended during any period of such individuals life that such individual is financially disabled.

Under this provision, if a taxpayer is "financially disabled," the harsh time limits would not apply and the taxpayer would receive a refund beyond the two- and three-year time limits. To determine who qualifies, Sec. 6511(h)(2) states:

an individual is financially disabled if such individual is unable to manage his financial affairs by reason of a medically determinable physical or mental impairment of the individual which can be expected to result in death or which has lasted or can be expected to last for a continuous period of not less than 12 months.

Under this circumstance, a taxpayer can file a claim outside of the normal rules. However, this relief is not available if another person holds the taxpayers power of attorney or a guardian has been appointed, etc. The failure to file a claim due to certain physical or mental disabilities will extend the date by which the taxpayer must file a refund claim, but only if no one is authorized to act on his or her behalf.

Given the Sec. 6511 time constraints, how do the rules affect the NOL carryback provisions? For example, if a taxpayer timely files a 2002 return and has a NOL, but does not become aware of the carryback provisions until October 2005, can he carry back his loss to 1999? Under the general SOL, any refund period from a timely filed 1999 return would expire on April 15, 2003. Congress realized this problem; accordingly, Sec. 6511(d)(2) provides that, for this purpose, the refund due to the carryback is available as long as the SOL is open on the loss year. Thus, the taxpayer could file the carryback claim as late as April 15, 2006. The same principle applies to capital-loss carrybacks.

Frequently, the IRS and the taxpayer may agree to extend the period of time set forth in Sec. 6511 for an assessment of additional tax. If this occurs, Sec. 6511(c) extends the time in which a refund claim may be filed for six months after the expiration of the period in which the additional tax could have been assessed.

Bad debts and worthless-securities losses may be claimed as a deduction only in the year in which the debt becomes bad or the security becomes worthless (the "event"). Frequently, there is a problem in determining the exact year the event occurred. Sec. 6511(d)(1) provides a seven-year period for filing a refund claim in such cases.

Certain other issues in connection with the SOL on refund claims can arise (e.g., foreign tax credits, certain tax credit carrybacks, etc.), but are outside of the scope of this column.

From W.M. Grooms, Ph.D., CPA, Columbia, SC