Accrual of Tax Refunds

Rev. Rul. 2003-3 provides favorable guidance on the accrual of state and local tax refunds. It holds that a state or local tax refund is includible in an accrual-method taxpayers income the earlier of when the taxpayer receives the refund or when the taxpayer receives notification by the taxing authorities that they have approved the refund.

Under Regs. Sec. 1.451-1(a), accrual-basis taxpayers accrue income when all the events have occurred that fix the right to receive the income. Various cases and revenue rulings have held that if all events have occurred, except ministerial documentation, then the all-events test will be considered satisfied. Prior to the issuance of Rev. Rul. 2003-3, the IRSs position on state or local tax refunds was that the approval of a refund claim by the taxing authorities was ministerial in nature. For example, Rev. Rul. 65-190 held that a refund of New York State corporation franchise taxes resulting from a net operating loss (NOL) carryback was accruable as income in the tax year of the loss that gave rise to the refund. This ruling was based on the premise that approval of the claim by the New York State Tax Commission was ministerial in nature if the claim was properly submitted. Rev. Rul. 69-372 stated the same conclusion for Colorado state income tax refunds.

The Tax Court disagreed with the Services position in Rev. Rul. 65-190. In Doyle, Dane, Bernbach, Inc., 79 TC 101 (1982), the facts also pertained to a refund claim generated from  New York NOL carrybacks. The Tax Court reasoned that the New York State Tax Commission has the right under law to review any refund claim before determining whether to allow it. The court concluded that the taxpayer was not required to accrue refunds of state or local taxes until the year the right to receive those refunds was ultimately determined by the taxing authorities.

With the issuance of Rev. Rul. 2003-3, the IRS has changed its position on accruals of state and local tax refunds. It reconsidered its previous position and concluded that the approval of refund claims by state or local taxing authorities involves substantive review and is not ministerial in nature. The Service revoked Rev. Ruls. 65-190 and 69-372, and withdrew its nonacquiescence in Doyle, Dane, Bernbach, Inc.

Rev. Rul. 2003-3 will allow taxpayers to maximize refund claims generated by Federal NOLs. These losses will not be reduced by expected state tax refunds attributable to these NOLs. The income attributable to the state refunds will not accrue until a later period, when the refund is either received or approved by the state taxing authorities.

Example: B Corp. incurred a $1 million Federal NOL in 2002 before the consideration of any state or local income tax refund attributable to the loss. A state NOL carryback will probably generate a $100,000 state income tax refund. B will file its Federal and state NOL carryback claims in 2003. Because the state tax refund was not received or approved by taxing authorities in 2002, it is not accrued as income in 2002. Accordingly, Bs Federal refund will be based on the $1 million NOL, without a reduction for the expected state tax refund.

According to Rev. Rul. 2003-3, a change in the timing of the accrual of state and local tax refunds is an accounting-method change. The change in method may be made by filing Form 3115, Application for Change in Accounting Method, under Rev. Proc. 2002-9s automatic-consent procedure for tax years ending after Dec. 11, 2002 (the publication date of Rev. Rul. 2003-3).

Summary

Rev. Rul. 2003-3 provides that refunds of state or local income or franchise taxes are includible in the income of accrual-basis taxpayers in the year the refund is received or the year the refund claim is approved by taxing authorities, whichever is earlier. This rule will allow taxpayers to obtain greater tax benefits from Federal NOL carrybacks, due to the delay in recognition of the income attributable to state or local tax refunds. Implementing Rev. Rul. 2003-3 in place of the prior method is a change in accounting method for which Form 3115 is required.

From Jeff Sanders, CPA, Dallas, TX