We have previously discussed the statute of limitations regarding tax audits when the taxpayer applies a net operating loss (NOL) to a year that is before or after the year that the loss occurred. Although the IRS may not audit a taxpayer three years beyond the return, when a taxpayer applies a net operating loss, the IRS may examine records and other evidence from the year when the loss occurred – even when it is outside the three-year statute of limitations.
But what happens when your client incorrectly reported a NOL or a tax credit years ago and only catches the error when they carry it forward to the year they want to apply it – more than three years past when it was generated and thus past the statute of limitations for claiming a refund?
Statutory Limitation on Assessment and Refunds
- IRS Section 6501 says the statute of limitations to assess income tax is three years after the taxpayer files the return.
- Under IRS Section 6511,
- The statute of limitations for claiming a refund is three years from when the tax return was or two years from when the tax was paid, whichever is later.
- For a NOL carryback or capital loss carryback, the statute of limitations is three years after filing the return for the taxable year of the net operating loss or capital loss. (However, NOLs from after 2017 may no longer be carried back.)
The law imposes statutes of limitations so tax issues may be settled with some finality and don’t drag out forever. Unfortunately, the statutes don’t spell out what happens if your client makes a good faith mistake on a carryover that is outside the statute of limitations.
The Problem in Pictures
Let’s say your client is a C corporation that had a $2 million investment credit in 2015 that they carried over, and they want to apply it in 2019. However, you discover that your client’s former CPA made an error in the amount of the credit due. In fact, the credit should have been $2,500,000 rather than $2,000,000. But more than three years have passed, and your client is now outside the statute of limitations.
Or consider a different scenario where another client claimed a $3 million net operating loss in 2015, when in fact the loss was $4 million. Can they claim a NOL for $4 million when they carry over to 2019?
Must your clients live with these mistakes or do they have options?
Net Operating Loss Adjustment Beyond the Statute of Limitations
If the IRS audits your client, the agency may examine supporting evidence for NOLs that occurred in closed tax years despite the three-year statute of limitation.
The courts and the IRS give taxpayers similar leeway. If your client made a mistake and understated a NOL in what is now a closed tax year, your client may adjust its NOL carryover. This is supported by Springfield St. Railway Co., 312 F.2d 754 (Ct. Cl. 1963) where the court decided if the IRS gets to reexamine a NOL from a closed year when assessing tax for an open year, the taxpayer should also have the benefit of the same statute of limitations standard when they are requesting a refund.
The IRS agrees. In Rev. Rul. 81-88, the IRS ruled that a taxpayer could take a deduction to which they were entitled (but didn’t claim) in a closed year because the deduction increased a net operating loss carryover to an open tax year. The IRS references Rev. Rul. 81-88 in Internal Revenue Manual Section 126.96.36.199(10) and specifically states “errors in a closed year are corrected for purposes of determining the taxable income of an open year.”
Tax Credit Adjustments Beyond the Statute of Limitations
The IRS has taken a similar view on the statute of limitations for investment tax credits. In Rev. Rul 82-49, the IRS cited Springfield in allowing the taxpayer to amend open tax years to claim a carryover investment credit from a closed year when the taxpayer overlooked the credit. The IRS has not ruled on all types of carryover credits, but it is reasonable to assume that their stance on other general business credits would be the same as it is on investment credits.
26 U.S. Code § 38 covers general business credits, including the investment business credit. This section lists over 30 credits, including, among others, the work opportunity credit, the alcohol fuels credit, the research credit and the low-income housing credit. There is good reason to think that the IRS would treat all general business credits the same in regard to adjusting carryovers in open years that originate in closed years.
NOTE: State Laws Vary
State tax laws do not always mirror federal law. Check for how your state treats this issue as well as for the statute of limitations in your state.
Learn more about Statues of Limitations at the American Institute of Certified Tax Planners.