Claim for refund: Beware of sinkholes

The taxpayer’s road to a claim for refund of income tax is littered with various requirements that may produce sinkholes that can swallow and destroy the claim’s successful outcome. Moreover, an adverse outcome for a client may result in a claim for damages against the refund claim’s preparer in the amount of the lost refund or more. Consequently, the tax professional must be aware of the most troublesome areas and be ever vigilant in avoiding the “fatal flaws” that can cause the IRS to deny a claim for refund.

Generally, Sec. 6511 provides that a taxpayer must file a claim for refund by (1) three years from the date an income tax return to which the claim pertains was filed (or the return’s due date, if later) or (2), if later, two years from the date the tax was paid. Withholding and estimated tax and other early tax payments are treated as paid on the prescribed due date for filing the return (not including extensions) — April 15 for individual taxpayers (Sec. 6513).

Note that if the taxpayer files his or her return before April 15, the filing date for purposes of the three-year limitation for claiming a refund remains April 15 even when it falls on a Saturday, Sunday, or legal holiday and the taxpayer is permitted under Sec. 7503 to complete a timely return filing on the next day that is not a Saturday, Sunday, or legal holiday. However, if a return is filed on the next day that is not a Saturday, Sunday, or legal holiday under Sec. 7503, the three-year limitation period begins on the actual filing date. For example, if April 15 is a Sunday, and the last authorized day for filing is April 16, if the return is filed on April 16, the three-year limitation period begins on April 16.

Filing during a valid extension of time also extends the deemed date of payment. However, it is critical to note that the three-year period runs from the date the return was filed during that extension period, not the extended due date of the return (generally, for individuals, Oct. 15).

The potential sinkhole

Put simply, failure to meet the three-year filing requirement results in disallowance of the claim as untimely. And that is not the only hazard taxpayers face. The amount of overpayment available for refund may be limited by a statutory lookback period.

The lookback limitation: When the three-year rule is applied (i.e., the taxpayer files the refund claim within three years of filing the return), the amount of taxes recoverable is that paid within a three-year period preceding the filing of the claim, including any period during which there was a valid return filing extension (the lookback period). If the claim was not filed within the three-year period, the amount of taxes recoverable is that paid during the two preceding years (Sec. 6511(b)(2)).

Example: If a return on extension to Oct. 15, 2024, is filed on Sept. 19, 2024, the last date for filing a claim for refund is Sept. 19, 2027. However, suppose no extension is filed (and April 15, 2024, is not a Saturday, Sunday, or legal holiday), but the taxpayer files the return (electronically or by provable mailing) on April 17, 2024. In that case, the three-year period will expire on April 15, 2027 — not on April 17, 2027 (see Chief Counsel Advice (CCA) 201321022).

In this situation, a claim filed on April 17, 2027, would revert to the lookback-period rule of tax paid within the past two years, of which there was none. (Note that if April 15, 2027, were to fall on a Saturday, Sunday, or legal holiday, the act of filing the claim would be permitted to take place the next business day.)

Note that, while a late-filed original return triggers the running of the three-year rule, the lookback limitation will ordinarily limit the refund to the taxes paid within the two-year period, which is usually zero. This treatment will often limit or eliminate refunds arising when a taxpayer files late returns to replace a substitute-for-return assessment made by the IRS (including credits that might otherwise have been applied to the succeeding year’s estimated tax). This particular area is, of course, virtually always a “taxpayer problem” rather than attributable to the professional adviser.

A similar issue exists with regard to IRS postponements of filing dates — for example, in 2020 and 2021 regarding the COVID national emergency period and more recently for postponements related to natural disasters. Postponements are not extensions and could result in denial in part or the entirety of refunds for withholding and estimated payments under the lookback limitation. Fortunately, IRS Notice 2023-21 “lengthened” the lookback periods for returns filed between April 16 and June 15, 2020, and between April 16 and May 17, 2021, to include those postponement periods. (But remember, the three-year rule for filing commenced for returns filed between those dates for a refund claim to be considered timely.) However, this is a matter of “administrative grace” for those periods, and the tax adviser should not assume that a similar notice will be issued for subsequent postponements.

In addition, in CCA 202026002, the IRS takes the position that a superseding return (a second return filed by a taxpayer before the due date, including extensions) has a filing date that reverts to that of the filing date of the first (superseded) return for both the assessment and claim statutes of limitation). This could effectively result in a refund claim being considered untimely if filed after that earlier date (see Dilorio, “Superseding Returns and Statutes of Limitation,” 52 The Tax Adviser 460 ( July 2021)).

Timing is everything

The tax adviser must always be attuned to the interplay of Secs. 6072 (return due dates); 6081 (extended due dates); 7502 (timely mailing as timely filing and its application to electronic filing); 7503 (Saturday, Sunday, and holiday delay rules but not extensions), 7508A (due date postponements but not extensions) with the application of Sec. 6513 (time return deemed filed and tax considered paid). These provisions should also be assessed for their impact on Sec. 6511 (limitations on refund), as further addressed in the regulations and additional guidance for them.

Rev. Rul. 2003-41 provides an excellent example of that interplay, as well as comparisons with other guidance that might be misunderstood or misinterpreted. Also, IRM Section 25.6, addressing statutes of limitation, and IRM Section 4.10.11, pertaining to claims for refund, provide valuable and useful information with regard to the subjects discussed here.

The 5-minutes-to-midnight claim

This item has focused on avoiding the painful economic consequences of untimely filing. As stated earlier, the statute for assessment of additional taxes by the IRS runs simultaneously with the taxpayer’s statute for claiming a refund — both generally run to three years from the date the return is received by the IRS (or, if later, from the return’s original due date) and considering the timely mailing or electronic transmission rules.

Knowing the precise day the statute expires may be important because the taxpayer may desire to come as close to that point as possible without stepping over it. This may occur, for example, when the taxpayer has taken aggressive but entirely permissible positions on an original tax return that is being amended to claim a refund for items apart from the items that comprise the aggressive positions.

For example, the taxpayer filed a 2020 federal income tax return on Sept. 20, 2021, (which was on extension to Oct. 15, 2021) to claim additional deductions. That return contained a significant deduction for which the taxpayer (on the advice of a tax adviser) concluded they had substantial authority; additionally, the return contained an exclusion of a significant item for which the taxpayer believed there was a reasonable basis for contending the item was not income, and the taxpayer disclosed the tax position on a Form 8275, Disclosure Statement, contained in the return.

The taxpayer becomes aware of the additional deductions in August 2022 in the course of providing information for the preparation of the 2021 income tax return. The tax adviser may advise the taxpayer to delay filing the amended 2020 return until shortly before the assessment and refund statute for the 2020 return expires in September 2024.

If the IRS has not examined the 2020 return by that date, the statute for assessing additional taxes pertaining to the aggressive positions will expire, but the timely filed claim can be processed. Long-standing law permits the IRS to disallow the aggressive items on the original return to offset the claim for refund. However, if the offsets exceed the claim, the IRS cannot assess additional taxes because the assessment statute has expired. Also, the tax adviser can advise the taxpayer that if the IRS does commence an audit between August 2022 and September 2024, the entitlement to the 2020 additional deductions can always be raised during the examination.

Avoiding sinkholes

A key to avoiding timing sinkholes is to take a twofold approach. First, at the earliest point that a tax adviser believes a potential claim for refund may exist, obtain from the IRS a transcript of the taxpayer’s account to determine the timeliness matters that must be met. Second, based on the analysis, “calendar” the due date for filing the claim and coordinate it with due dates for filing original returns or other date-sensitive activities in the tax adviser’s firm or practice.

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