It is not unusual for a taxpayer to make an error on a return that results in a misstatement of a net operating loss (NOL) or a credit that is then carried forward. In some cases, these mistakes might not be noticed until after the statute of limitation for the tax year generating the NOL or credit carryover is closed.
Example: W, a C corporation, generated a $10 million NOL and a $1 million Sec. 41 research credit carryover in 2010. W could not carry back either amount. Each year from 2011 through 2014, W had taxable income. In 2015, W expects to use the allowable portions of its 2010 NOL and research credit carryovers. When preparing its 2015 tax return, W discovers the 2010 NOL carryover had been understated by $1 million and the research credit carryover had been understated by $500,000. The statute of limitation for 2010 is closed. Does W have any options to adjust the carryover amounts from 2010?
Statute of Limitation: NOL Carryover
The statute of limitation to assess income tax under Sec. 6501 is three years after the date a tax return is filed. The statute of limitation for filing a claim for refund under Sec. 6511 is the later of three years from the date a tax return is filed or two years from the date the tax is paid. Sec. 6511(d)(2) further prescribes that in the case of an NOL or capital loss carryback, the statute of limitation to claim a refund is three years from the filing date of the return that originates the carryback claim.
The statutes do not, however, address what statute of limitation applies to carryover items. Although the answer initially might seem straightforward, case law and IRS guidance yield a different answer from what might be expected.
One of the earlier cases to address how the statute of limitation applies in a similar situation, adjustment of a carryback NOL involving a closed tax year, is Phoenix Coal Co., 231 F.2d 420 (2d Cir. 1956). In Phoenix Coal, the taxpayer had NOLs in 1947 and 1948. The taxpayer timely filed NOL carryback amended returns to use the losses in 1945 and 1946. The NOLs eliminated all of the taxpayer's income in 1945 but only part of its income in 1946.
After the statute of limitation for 1945 closed but before the statute of limitation for 1946 closed, the IRS recomputed the taxpayer's income for 1945. This recomputation did not result in any additional tax assessment for 1945, but it reduced the NOL carryback available for 1946. The court allowed the IRS to reduce the NOL carryback on the 1946 tax return even though the adjustment related to a closed tax year. The court reasoned that the statute of limitation for the assessment of tax does not apply until the year items are used against taxable income.
This theory is raised again and more clearly stated in later case law, including Barenholtz, 784 F.2d 375 (Fed. Cir. 1986), in which the IRS was permitted to recompute taxable income in closed tax years to adjust NOL and charitable contribution carryovers to open years.
As interesting as the results in Phoenix Coal and Barenholtz might be, they are of little benefit to taxpayers, as they address the statute of limitation only on carryover amounts for purposes of the IRS's assessment of tax. Another case, Springfield St. Railway Co., 312 F.2d 754 (Ct. Cl. 1963), allowed a taxpayer to adjust its NOL carryback amount absorbed in a closed year to claim a refund in an open one. The taxpayer recomputed its income in the closed year by applying an abandonment loss it discovered it had been entitled to, decreasing its NOL carryback in that year. The taxpayer correspondingly increased its NOL carryback amount for the following tax year, which was still open, resulting in a refund. The court concluded that the same statute of limitation for carryback items should apply to taxpayers requesting a refund as to the IRS when assessing tax.
The IRS has consistently followed and agreed with this taxpayer-favorable interpretation. In Rev. Rul. 81-88, a taxpayer failed to claim a deduction it was entitled to, but did not realize this until after the statute of limitation had expired for the year the deduction should have been claimed. The IRS ruled that because the deduction increased an NOL carryforward to an open tax year, the taxpayer was allowed to use the NOL carryforward to reduce the taxpayer's income in that open tax year. The IRS continues to refer to Rev. Rul. 81-88 in Internal Revenue Manual Section 22.214.171.124(10), explaining that "errors in a closed year are corrected for purposes of determining the taxable income of an open year."
Based on this analysis, in the above example, W can adjust its NOL carryover to 2015 by the $1 million understatement of taxable loss for 2010, even though the statute of limitation for 2010 is closed. However, it should note that the same rules apply to IRS adjustments of the 2010 NOL that might reduce the NOL carryover.
Statute of Limitation: Tax Credits
Later, in Rev. Rul. 82-49, the IRS expanded the application of Springfield to the investment credit. In that guidance, the taxpayer placed in service in 1976 property for which it was entitled to an investment tax credit, but it did not timely claim the credit. Although the statute of limitation for 1976 had closed by the time the taxpayer noticed its error, so that no claim for refund could be filed for 1976, part of the credit would have been available as a carryover to open tax years. The taxpayer was allowed to amend those open tax years for the carryover.
Although this IRS guidance concerns the now mostly expired investment tax credit, it should apply to other credits as well. The investment tax credit is part of the Sec. 38 general business credit, so other general business credits, including the Sec. 41 research credit, should be eligible for a similar adjustment. Therefore, W in the example would be allowed to correct not only its NOL carryover from 2010 but also its research credit carryover from 2010.
Although case law and IRS guidance establish the opportunity to adjust in open years carryover amounts arising from closed years, practitioners should be aware of a few important issues. First, none of the IRS guidance or case law addresses how to adequately notify the IRS of an adjustment to a carryover amount made for a closed tax year. If a taxpayer needs to file an amended return to claim the adjustment to a carryover item, disclosing the issue in the explanation section of the amended return should be sufficient. However, if the change is discovered before an amount from a carryover item is used, it is unclear what, if any, explanation must be provided for the change in carryover amount. It might be advisable to include a short written statement in the year the carryover item is adjusted, to explain the reason for the change.
Second, state law might not necessarily conform to federal law. Although many states adopt the Internal Revenue Code, they frequently establish their own rules regarding tax return statutes of limitation. It is not unusual for a state to have a four-year statute of limitation. Furthermore, because the statute of limitation on carryovers is not formally established in the federal statutes, states may consider this an interpretation of the law and thus not conform to the federal treatment.
Finally, currently, there is no guidance that would allow a passthrough entity to adjust an item of taxable income in a closed year. Using the previous example, assume W is an S corporation with one owner instead of a C corporation. Assume 2010 is a closed year for both W and its shareholder and that the carryover amounts for the shareholder are identical to those listed for W in the example. There currently is no clear precedent that would allow W to adjust or amend its Schedule K-1, Shareholder's Share of Income, Deductions, Credits, etc., for the closed 2010 tax year. The shareholder may not be able to adjust its carryover item without receiving a timely filed Schedule K-1 from W, including the full amount of the NOL and research credit.
Businesses using loss and credit carryovers should take note of these rules. Taxpayers have an opportunity to favorably adjust carryover items from closed years, but they need to remember the IRS can use the same rules to reduce carryover items.
Howard Wagner is a director with Crowe Horwath LLP in Louisville, Ky.
For additional information about these items, contact Mr. Wagner at 502-420-4567502-420-4567 or firstname.lastname@example.org.
Unless otherwise noted, contributors are members of or associated with Crowe Horwath LLP.