Editor: Jon Almeras, J.D., LL.M.
With the introduction of the five-year net operating loss (NOL) carryback in Sec. 172(h) as part of the Worker, Homeownership, and Business Assistance Act of 2009, P.L. 111-92, many taxpayers are now modeling their tax situations to determine how to best situate themselves under the law. However, as taxpayers perform their evaluations, they should also consider the impact that carrying back an NOL has on the assessment statute of limitation. As discussed below, carrying back an NOL unlocks years previously barred from assessment and opens the door for the IRS to potentially assess additional tax or offset refunds due.
The rules governing the assessment statute of limitation vary depending on the form used by a taxpayer to carry back a loss. It is helpful, therefore, to understand the forms that taxpayers may use and the differences between them. They include:
- Form 1120X, Amended U.S. Corporation Income Tax Return, and Form 1040X, Amended U.S. Individual Income Tax Return. Taxpayers may use these forms to correct previously filed returns or to carry back losses to an earlier year.
- Form 1139, Corporation Application for Tentative Refund, and Form 1045, Application for Tentative Refund, for individual taxpayers, estates, or trusts. These forms enable taxpayers to request a refund of previously paid tax by carrying back an NOL, unused business credit, or capital loss.
There are several key differences in these forms, as outlined in the exhibit on p. 174.
Amended Income Tax Return (Form 1120X or 1040X)
In general, tax must be assessed within three years of the later of (1) the date on which the return is filed or (2) the unextended due date of the return (Sec. 6501(a)). There are several exceptions set forth in Sec. 6501 that extend the general three-year limitation period. One such exception is Sec. 6501(h), which provides an expansion of the general limitation period when a taxpayer carries back an NOL to the tax year in question from a subsequent tax year. Sec. 6501(h) permits the IRS to assess a deficiency attributable to an NOL carryback deduction at any time before the expiration of the assessment limitation period for the tax year in which the net operating loss was created. An example may best demonstrate this concept.
Example 1: T, a calendar-year taxpayer, has an NOL for 2009. T elects to carry back its NOL from 2009 to 2004 under the new five-year carryback provisions. Assume T filed its 2004 tax return on September 15, 2005, and the statute of limitation on assessment has not been extended for any other reason. Prior to the carryback, the assessment statute of limitation for 2004 would have expired on September 15, 2008. However, after the NOL carryback, Sec. 6501(h) permits the IRS to assess a deficiency attributable to the 2009 NOL carryback until September 15, 2013 (assuming T files the 2009 return on September 15, 2010).
Under the extended Sec. 6501(h) limitation period, the IRS may assess a deficiency for additional tax for the year to which the taxpayer applies the carryback if the deficiency assessed is related to the carryback claim. However, the IRS may not assess a deficiency for additional tax unrelated to the claim (see Jones, 71 T.C. 391 (1978)). “Assess” is a term of art; while the IRS cannot assess additional tax on items unrelated to the carryback, it may be able to offset the refund due to the taxpayer on the refund claim.
The IRS may offset a refund claim filed on a Form 1120X for adjustments unrelated to the claim, up to the amount of the refund claim (see Lewis v. Reynolds, 284 U.S. 281 (1932)). In Lewis v. Reynolds, the Supreme Court held that “[a]lthough the statute of limitations may have barred the assessment and collection of any additional sum, it does not obliterate the right of the United States to retain payments already received when they do not exceed the amount which might have been properly assessed and demanded.”
Following a similar reasoning, the IRS concluded that the correct tax is determined by “including all adjustments, regardless of the expiration of the periods of limitation,” and that “[a]ny excess of tax actually paid over the correct tax is an overpayment and will be credited or refunded to the extent that adjustments decreasing the tax are covered by timely claims” (Rev. Proc. 81-87). Therefore, if a taxpayer files Form 1120X or 1040X to carry back an NOL and the IRS finds adjustments in the year to which the taxpayer is carrying back the loss, it can reduce the refund payment by the amount of the adjustments, even if the carryback year is a closed year for assessment statute of limitation purposes.
Example 2: In 2010, taxpayer T timely files Form 1120X to carry back an NOL from 2009 to 2004 claiming a refund of $100,000. Upon examination, the IRS detects adjustments for the 2004 tax year that are unrelated to the 2009 NOL carryback that would result in an additional $40,000 of tax. At the time the IRS completes its examination, the assessment statute of limitation for 2004 (the carryback year) is closed under Sec. 6501(a).
- Assume the IRS allows the 2009 NOL claimed on the Form 1120X in full and has paid the refund of $100,000. The IRS would be barred from assessing the 2004 tax deficiency for the adjustments to the 2004 tax year that are unrelated to the 2009 NOL carryback. Sec. 6501(h) only provides an expansion of the general three-year limitation period to assess a deficiency attributable to an NOL carryback deduction.
- Assume the 2009 NOL claimed on the Form 1120X is allowed in full but the IRS has not yet paid the refund. While the IRS is barred from assessing the 2004 tax deficiency for the adjustments to the 2004 tax year that are unrelated to the 2009 NOL carryback, the IRS can offset the $40,000 of additional tax as a result of the adjustments against the amount of the claim under the rationale of Lewis v. Reynolds. T will receive $60,000 ($100,000 – $40,000) in refunds.
- If the IRS disallows the 2009 NOL claimed on the Form 1120X in full, T will not receive any refund in relation to the claim. In addition, the IRS is barred from assessing the additional $40,000 because the carryback year is closed.
Application for Tentative Refund (Form 1139 or 1045)
Where an amount has been applied, credited, or refunded under Sec. 6411 (relating to tentative carryback adjustments) by reason of the carryback of an NOL to a prior tax year, Sec. 6501(k) extends the period for assessing additional tax for the same time period provided in Sec. 6501(h). The primary difference between subsections (h) and (k) is that under subsection (k), assessments do not have to be attributable to the underlying NOL, but any such assessments are limited to the amount of the tentative refund.
The purpose of Sec. 6501(k) (formerly Sec. 6501(m)) was to supplement the special statute of limitation set forth in Sec. 6501(h). As discussed above, Sec. 6501(h) provides that the statute of limitation to assess a tax deficiency remains open for the year to which an NOL or capital loss is carried back (carryback year) as long as the assessment statute of limitation remains open for the year in which the loss is generated (loss year). However, in challenging the refund in the carryback year, the statute of limitation remains open only insofar as the tax deficiency assessed is attributable to the carryback claim.
The purpose of Sec. 6501(k) was to create an additional statute of limitation when the taxpayer received a tentative refund. Specifically, the IRS may challenge any items on the taxpayer’s return in the carryback year as long as the assessment statute of limitation for the loss year remained open. The House committee report described how Sec. 6501(k) was designed to operate:
[T]he bill extends the period for assessing a deficiency when a quick refund has been made because of a carryback of . . . a net operating loss . . . even though the deficiency is not attributable to the carryback. Under this provision, a deficiency for [the] year with respect to which a quick refund was made because of a tentative carryback, may be assessed at any time up to 3 years after the return is filed for the taxable year in which the carryback arose (provided this period is not further extended by other provisions of §6501; i.e., where there was fraud involved, etc.). However, in such a case the deficiency assessment made as a result of this provision cannot exceed the amount of the original refund reduced by any deficiency attributable to the carryback. [H.R. Rep’t No. 2161, to accompany H.R. 11660, 89th Cong., 2d Sess. (1966)]
Several courts and the IRS have discussed the distinction between related and unrelated adjustments. In Jones, 71 T.C. 391 (1978), the Tax Court provided a detailed analysis of the distinction between Secs. 6501(h) and 6501(k). The Tax Court held that the deficiency at issue was “assessable under subsection (h) only to the extent that it is not based on items unrelated to the loss carryback for which the refund was initially granted.”
Regs. Sec. 301.6501(m)-1(a)(2) contains an example that illustrates (1) how Sec. 6501(k) opens the door to allow the IRS to assert deficiencies that are not attributable to a carryback and (2) how the assessment period for the carryback year is also extended:
Assume that M corporation, which claims an unused investment credit of $50,000 for the calendar year 1968, files an application under section 6411 of the Codefor an adjustment of its tax year for 1965, and receives a refund of $50,000 in 1969. In 1971, it is determined that the amount of the unused investment credit for 1968 is $30,000 rather than $50,000. Moreover, it is determined that M Corporation would have owed $40,000 of additional tax for 1965 if it had properly reported certain income which it failed to include in its 1965 return. Assuming that M Corporation filed its 1968 return on March 15, 1969, and that the 3-year period described in section 6501(a) has not been extended, the period prescribed in section 6501(j) for assessing the excessive amount refunded, $20,000 (i.e., $50,000, original amount refunded, less $30,000, correct amount of unused investment credit), does not expire until March 15, 1972, and $20,000 may be assessed on or before such date under section 6501(j). Under section 6501(m), M corporation may be assessed on or before March 15, 1972, an amount not in excess of $30,000 ($50,000, the amount refunded under section 6411, minus $20,000, the amount that may be assessed solely by reason of section 6501(j)).
Another example highlights the impact on the assessment statute of limitation by carrying back an NOL on a Form 1139 and demonstrates how it differs from a carryback of an NOL on a Form 1120X.
Example 3: In 2010, T files Form 1139 to carry back an NOL from 2009 to 2004 claiming a refund of $100,000. T receives the refund claimed on the Form 1139. Upon examination, the IRS detects $40,000 of adjustments for the 2004 tax year that are unrelated to the 2009 NOL carryback. The general three-year assessment statute of limitation under Sec. 6501(a) is closed for the carryback year.
- If the claim on Form 1139 is allowed in full, T will retain the refund of $100,000 that it already received; however, under Sec. 6501(k), the IRS can assess the tax deficiency for the $40,000 of adjustments for the 2004 tax year unrelated to the 2009 NOL carryback that the IRS found upon examination.
- If the claim on Form 1139 is disallowed in full, the IRS will assess the $100,000 deficiency related to the refund T had already received. The additional $40,000 of adjustments that the IRS discovered for the 2004 tax year that are unrelated to the 2009 NOL carryback could not be assessed because Sec. 6501(k) limits the amount of tax deficiency that can be assessed to the amount refunded on the Form 1139. Thus, the IRS may not assess an amount in excess of the amount of refund requested from the carryback (in this example that is $100,000) under Sec. 6501(k).
- If T had used a Form 1120X to carry back the 2009 NOL rather than the Form 1139, under these facts the IRS would be barred from assessing a tax deficiency for the 2004 tax year because the $40,000 of adjustments that the IRS discovered for the 2004 tax year are unrelated to the 2009 NOL carryback. If the IRS had not paid the refund prior to examining the claim, it could have offset the $40,000 of adjustments against the amount of the claim under the rationale of Lewis v. Reynolds.
Based on the foregoing, if an NOL is carried back using Forms 1139 or 1045, Sec. 6501(k) allows the IRS to assess tax in the carryback year for items related and unrelated to the carryback as long as the assessment statute of limitation for the loss year is still open. However, the total amount that may be assessed is limited to the amount of tax refunded as a result of the carryback claim. If an NOL is carried back using Form 1120X or Form 1040X, the IRS can assess a deficiency attributable to an NOL carryback deduction at any time before the expiration of the assessment limitation period for the loss year. Moreover, while the IRS may be barred from assessing a tax deficiency for adjustments unrelated to the NOL carryback deduction, the IRS may have the ability to offset the adjustments against the amount of the refund claim under the rationale of Lewis v. Reynolds.
As taxpayers prepare refund claims to carry back their losses, it is important to consider the impact on the statute of limitation. The refund claims may unlock and open the door for the IRS to examine returns that were otherwise closed.
Jon Almeras is a tax manager with Deloitte Tax LLP in Washington, DC.
This article does not constitute tax, legal, or other advice from Deloitte Tax LLP, which assumes no responsibility with respect to assessing or advising the reader as to tax, legal, or other consequences arising from the reader’s particular situation.
Unless otherwise noted, contributors are members of or associated with Deloitte Tax LLP.
For additional information about these items, contact Mr. Almeras at (202) 758-1437 or email@example.com.