If the Internal Revenue Service makes an error in issuing a refund, it can recover the amount incorrectly refunded by filing a suit for erroneous refund. Section 7405[1] provides the Service with the ability to recover erroneous refunds within two years of payment. The two-year period can be extended to five years if any part of the refund was “induced by fraud or misrepresentation of a material fact.”[2] Assuming the statute of limitations on assessment remains open, the Service can also recoup the amount incorrectly refunded by following the normal deficiency procedures of Subchapter B of Chapter 63 requiring the Service to issue a notice of deficiency and supplemental assessment.[3]
ERRONEOUS REFUND DEFINED. The IRM defines an erroneous refund[4] as “the receipt of any money from the Service to which the recipient is not entitled.” This definition includes all erroneous refunds, regardless of taxpayer intent or whether the error that caused the erroneous refund was made by the IRS, the taxpayer or a third party.[5]
The recipient of an erroneous refund has a legal obligation to repay the amount to the IRS.[6] Legally, however, the IRS must follow specific guidelines to recover and collect erroneous refunds. For it to recover an erroneous refund, the IRS must clearly show that an erroneous refund was issued, the amount of the erroneous refund, and that the applicable limitation period has not expired. In an action to recover an erroneous refund brought pursuant to section 7405, the government bears the burden of proof.[7] Equitable considerations do not preclude the government from pursuing an erroneous refund.
CIVIL ACTION TO RECOVER ERRONEOUS REFUND. The government is entitled to institute a civil action under section 7405 to recover any portion of a tax erroneously refunded to a taxpayer. “Equity has no power to change this wholly legal result.”[8] While an erroneous refund action is subject to equitable considerations, the premise behind such an action “is that the taxpayer is unjustly enriched at the expense of the government and other taxpayers.”[9] “As such, the government must show that the taxpayer has money ‘it ought not to retain.’ Usually, once the government proves that a refund is erroneous, this is sufficient to demonstrate that the taxpayer has money that it ought not to retain and that the government is entitled to recover.”[10] Thus, the government will satisfy its burden by proving that a refund was erroneous. To demonstrate that a refund was erroneous under section 7405, the government must establish:
(1) that a refund was paid to the taxpayer,
(2) the amount of the refund,
(3) that the government’s recovery action was timely, and
(4) that the taxpayer was not entitled to the refund.[11]
When determining whether the Service is entitled to recover an erroneous untimely refund from a taxpayer, a court need not examine the intrinsic merits of the case.[12]
EXAMPLES OF ERRONEOUS REFUNDS. Some examples of erroneous refunds[13] include: misapplied payments (a payment applied to the wrong Taxpayer Identification Number (TIN)); a taxpayer’s designated payment posts to the correct TIN, but the wrong type of tax or tax year; a credit refund of any type if the taxpayer is not entitled; an incorrect tax assessment causing an incorrect refund; a taxpayer fraudulently or by mistake receives refunds from more than one TIN for the same tax period; a direct deposit is applied to the wrong person’s bank account due to IRS error; the tax liability has been understated due to an error on either a tax assessment or on an adjustment to the tax liability and the error results in a refund; errors on refundable or non-refundable credits that are subject to the deficiency procedures; and the taxpayer overstates their federal income tax withholding credits or estimated income tax payments on a return or claim for refund.
The Service recognizes two types of refunds—rebate and nonrebate.[14] Rebate refunds are issued on the basis of a substantive recalculation of a taxpayer’s tax liability—for example, the amount of tax due is less than the tax shown on the return.[15] If the recalculation of tax liability is correct, the taxpayer may, of course, retain the refund. However, sometimes the recalculation of tax liability is incorrect, and the Commissioner must recover the erroneous refund. Rebate refunds issued in error may only be recovered through the deficiency procedures of sections 6211–6215 (Subchapter B of Chapter 63) or an action for recovery of an erroneous refund under section 7405.
Nonrebate refunds, on the other hand, are issued to taxpayers because of clerical or computer errors and bear no relation to a recalculation of tax liability.[16] A hallmark of nonrebate refunds is that, unlike rebate refunds, nonrebate refunds are always erroneous. Examples of nonrebate refunds are refunds issued because the Commissioner credited a taxpayer’s payment twice or the Commissioner applied a payment to the wrong tax year. However, the IRS is limited to erroneous refund actions under section 7405 to recover nonrebate refunds. The deficiency procedures are not available to the Commissioner to recover nonrebate refunds because of the definition of “deficiency” in section 6211(a):
A “deficiency” is the amount by which the tax actually imposed exceeds—
(1) the sum of
(A) the amount shown as the tax by the taxpayer upon his return, if a return was made by the taxpayer and an amount was shown as the tax by the taxpayer thereon, plus
(B) the amounts previously assessed (or collected without assessment) as a deficiency, over—
(2) the amount of rebates, as defined in subsection (b)(2), made.
In Lesinski v. Commissioner,[17] the Tax Court held it does not have jurisdiction over nonrebate refunds.
Prior to 1997, the IRS took the position that whether a refund is a rebate refund or a nonrebate refund affects the procedures it can employ to recover the refund. For many years, it was the IRS position that a nonrebate erroneous refund could be recovered by following normal collection procedures without further assessment if the original liability was timely assessed and the amount of the refund did not exceed the amount of the original assessment.
The theory was that the refund did not extinguish the assessment, which became unpaid upon the nonrebate erroneous refund.[18] Consistent with this position, the IRS would treat assessments as revived to the extent of the nonrebate erroneous refund.[19] The resulting underpayment would be collected using normal summary tax collection procedures as if the underlying assessment had never been paid.
Due to overwhelming adverse case law,[20] however, both the Justice Department and the Office of Chief Counsel agree that the Service’s position regarding revival of previously paid assessments where nonrebate erroneous refunds were issued was no longer defensible and must be abandoned.[21] The abandonment of the revival theory with respect to collection of nonrebate erroneous refunds, however, did not negate the IRS position that a tax liability which has been reduced as a result of a clerical or ministerial error, but where no refund has yet been issued, can, under certain circumstances, be reinstated.[22] This would be accomplished by a reversal of the transaction which leads to the reduction in the taxpayer’s liability.
Assuming the taxpayer does not respond to the IRS’s informal requests to voluntarily return the erroneous refund, it is a serious administrative headache for the IRS to go to the trouble of activating the Justice Department to bring an erroneous refund suit for each of the many nonrebate erroneous refunds that occur each year. The IRS often avoids this headache by continuing to follow pre-1997 procedures by using normal collection procedures without further assessment and ignoring the requirements of the deficiency procedures of sections 6211–15 and ignoring an action for recovery of an erroneous refund under section 7405 in order to recover nonrebate refunds, particularly if the refund amount is relatively small.
The practitioner should be alert to this practice and, if the IRS uses summary collection procedures to recover an erroneous refund of either type, the taxpayer should seek recovery of that amount through a tax refund suit.
EDWARD M. ROBBINS, Jr. – For more information please contact Edward M. Robbins, Jr. –EdR@taxlitigator.com Mr. Robbins is a principal at Hochman, Salkin, Rettig, Toscher & Perez, P.C., the former Chief of the Tax Division of the Office of the U.S. Attorney (C.D. Cal) and represents clients throughout the United States and elsewhere involving federal and state, civil and criminal tax controversies and tax litigation. Additional information is available at www.taxlitigator.com
[1]. See also I.R.C. § 6532(b).
[2]. Id. The ten-year collection statute of limitations of an assessment has uniformly been held not to apply to collection of an erroneous refund, because the original payment of the assessment extinguished it. See Stanley v. United States, 35 Fed. Cl. 493 (1996), following United States v. Wilkes, 946 F.2d 1143 (1st Cir. 1991); O’Bryant v. United States, 49 F.3d 340 (7th Cir. 1995); Clark v. United States, 63 F.3d 83 (1st Cir. 1995).
[3]. See Singleton v. United States, 128 F.3d 833 (4th Cir. 1997).
[4]. IRM 21.4.5.1 (Erroneous Refunds Overview) (06-25-2013).
[5] One issue that occasionally comes up for financial statement purposes is whether the company
needs to establish a reserve for a potential erroneous refunds situation. Companies need to review
their specific facts and circumstances to determine if establishing a reserve would be appropriate in
light of their situation. Keep in mind that the IRS can create an erroneous refund by simply correcting its legal position on the legal issue generating the initial refund.
[6]. It should be noted that interest is recoverable on the erroneous refund at the underpayment rate from the date of payment of the refund.
[7]. Soltermann v. United States, 272 F.2d 387 (9th Cir. 1959); United States v. Wood, 79 F.2d 286 (3d Cir. 1935).
[8]. Valley Ice & Fuel Co. v. United States, 30 F.3d 635, 640 (5th Cir. 1994).
[9]. United States v. MacPhail, 313 F. Supp. 2d 729, 735 (S.D. Ohio 2004).
[10]. Id.
[11]. United States v. Phila. Marine Trade Ass’n/Int’l Longshoreman’s Ass’n Vacation Fund, 471 F. Supp. 2d 518, 524 (E.D. Pa. 2007). In an action to recover an erroneous refund under section 7405, the government bears the burden of proof. United States v. McFerrin, 492 F. Supp. 2d 695, 701 (S.D. Tex. 2007) (citing United States v. Commercial Nat’l Bank of Peoria, 874 F.2d 1165, 1169 (7th Cir. 1989)).
[12]. See United States v. C.E. Mathews, Inc., 59-1 USTC ¶ 9265 (5th Cir. 1959); see also Smyth v. United States, 92 F.2d 900, 37-2 USTC ¶ 9396 (10th Cir. 1937) (untimely payments are to be recovered by the taxpayer or the Service on the basis of time without regard to the merits of the case).
[13]. IRM 21.4.5.2 (Examples and Causes of Erroneous Refunds) (10-01-2013).
[14]. O’Bryant v. United States, 49 F.3d 340, 342 (7th Cir. 1995).
[15]. I.R.C. § 6211(b)(2); O’Bryant v. United States, supra.
[16]. See O’Bryant v. United States, supra; Clayton v. Comm’r, T.C. Memo 1997-327.
[17]. Lesinski v. Comm’r, T.C. Memo 1997-234.
[18]. See G.C.M. 36,624, Legality of Overpayment Offsets to Collect Unassessable Erroneous Refunds (No. 70-14) (Mar. 11, 1976).
[19]. See IRM 3(17)(42)9.4.
[20]. See a summary of adverse cases at Bilzerian v. United States, 86 F.3d 1067 (11th Cir. 1996). In AOD 1998-002, the IRS acquiesced in the court’s holding in Bilzerian that issuance of an erroneous refund does not revive an extinguished assessment.
[21]. General Litigation Bulletin, Bulletin 440, Nonrebate Erroneous Refund Procedures.
[22]. See Clark, 63 F.3d at 89; see also In re Bugge, 99 F.3d 740 (5th Cir. 1996); Crompton-Richmond Co. v. United States, 311 F. Supp. 1184 (S.D.N.Y. 1970).
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