Posted by: Taxlitigator | January 20, 2015

PERENNIAL NOL QUESTION (WITH ANSWER) by EDWARD M. ROBBINS, JR.

I get this question from practitioners and taxpayers several times a year . . .

Question: We are under examination for our corporation in an open loss year, and now the IRS wants to go back and look at a closed year where we took part of the loss as a carryback.  How can they do that?  The carryback year is closed!  Not only that, the IRS already subjected the now closed carryback year to a full-blown examination and issued a “no-change.”  Isn’t this a second unnecessary examination on the carryback year?

Short Answer:  In its attempt to determine the correct taxable situation for your open loss year, the IRS may look at any other year, open or closed, that may relate to the examination.  The IRS can calculate or even recalculate the taxes for the carryover years to see their impact on the open examination of your loss year.  The overriding issue is “What’s the correct tax liability in the open year under examination?”  No facts are off limits.  No, it is not a second unnecessary examination.

Longer Answer:  Section 6501 (h) establishes an exception to the general 3 year limitations period.[1] Section 6501 (h) provides an enlargement of the general limitations period when a taxpayer carries back to the taxable year in question a net operating loss from a subsequent tax year. Section 6501(h) permits the Commissioner to assess a deficiency stemming from a net operating loss carryback deduction before the expiration of the limitations period for the taxable year in which the net operating loss was created.[2]  A similar rule exists under 6501(k) for enlargement of the assessment statute with a tentative carryback that has been applied, credited, or refunded under section 6411.

This rule, however, is often misunderstood.  Taxpayers frequently file refund claims based upon net operating losses, business tax credits, or capital losses on the basis of a claim carrying back a loss to an otherwise closed taxable year.  The easy way to remember the assessment rule is to remember that the year controlling the assessment statute is the year the loss arose.  If a loss arose in 2009 and was carried back to 2007 to obtain a 2007 refund the assessment statute for the 2007 year attributable to a deficiency because of the 2009 carryback is controlled by the 2009 statute of limitations – the year the loss arose. The Code permits assessment of a deficiency in one taxable year (2007) attributable to the carryback of an NOL from a later year (2009) before the expiration of the statute of limitations for the taxable year in which the NOL arose (2009).[3]

Section 6501(h) states:

In the case of a deficiency attributable to the application to the taxpayer of a net operating loss carryback or a capital loss carryback (including deficiencies which may be assessed pursuant to the provisions of Section 6213(b)(3) [dealing with assessments that may arise out of tentative carryback or refund adjustments arising out of excess refunds made under Section 6411]), the deficiency may be assessed at any time before the expiration of the period within which a deficiency for the taxable year of the net operating loss or net capital loss which results in such carryback may be assessed.

Congress enacted this section to provide the Service with an additional amount of time to properly review the claim and determine if any deficiencies are associated with the year in which the loss is carried back.  In our hypothetical situation with a 2009 loss carried back into 2007, the Service would have 3 years from the time the 2009 return was filed to determine any deficiencies for the 2007 year resulting from the carryback.  A carryback extends the assessment period for the carryback year for the loss carryback.[4]

Because the assessment period for both the loss year and the carryback year are the same the assessment period can be extended by agreement, and its running may be suspended for several reasons (e.g., by filing a Tax Court petition). [5] If the normal assessment period for the loss year is extended by agreement, the extension also applies to the carryback years.  If the normal 3 year statute has expired for the carryback year the IRS can only assess a deficiency attributable to items related to the loss carryback, but not any items unrelated to the loss carryback.  The taxpayer is only at risk for a deficiency for the carryback.  The IRS could not assess any amounts above the loss carryback.[6]

IRS Ability To Adjust Attributes In Closed Years For NOL Determinations

Pursuant to IRC § 6501(a) – Limitations on Collection and Assessment a tax year is subject to adjustment for 3 years from filing the federal tax return.  Section 6501(b) states that if a return is filed prior to the due date then the return will be deemed filed on the last day prescribed by law or the regulations.  Therefore, the statute of limitations for each federal tax year will close 3 years from the due date of the federal return, including extensions, or the filing date, whichever is later.

When a company carries forward or back a tax loss or credit, however, the IRS may examine the loss year, and any intervening or prior year, to determine the correct loss or credit available for carryover purposes, even if the statute of limitations on assessment for those years has expired.[7]   The IRS could examine and adjust any “closed” year if the statute for the tax year in which the attribute was utilized remains open.  Note that the IRS could make no additional assessment in the closed year, the IRS’s adjustments would go only to adjusting the carryover amounts.

The IRS may adjust items in any closed year to correctly compute the tax in an open year.[8]  In Lone Manor Farms, the court held that when a taxpayer claimed an NOL for an open year, it was necessary to determine whether the NOLs claimed for that year were still available, or should have been absorbed in closed years, allowing adjustment to the income in such closed years, regardless of whether the taxpayer had claimed the NOL in the closed years.[9]

In Revenue Ruling 85-64,[10] the taxpayer timely filed returns for 1978 through 1981 and reported no tax liability for each of these years.  The IRS examined the returns and found that 1978 had taxable income of $15,000 and 1979 had taxable income of $8,000.   The IRS also found that 1981 had an NOL of greater than $23,000.  At the time of examination, the 1978 year was closed for assessment.  The ruling holds that the 1982 NOL must first be carried back and “absorbed” in 1978, so that only if the NOL exceeded $15,000 would the NOL be available to carry back to 1979.

Taxpayer’s Ability To Make Adjustments To Items In Closed Years For NOL Determinations

The Service has stated frequently that for Section 172 of the Internal Revenue Code, “taxable income” means “correct taxable income.”[11]     Revenue Ruling 56-285,[12] holds that the fact that the statutory period for assessment of income taxes for the year in which a loss was sustained has expired does not preclude the Service from making such adjustments as may be necessary to correct the net operating loss deduction.   The rationale underlying these rulings and the authority to be discussed following is that when a prior year’s taxable income has impact on another taxable year, it is that year’s “correct” taxable income controlling in the related year not the taxable income previously erroneously stated on the return.

In Revenue Ruling 81-87,[13] 1981-1 C.B. 580, the IRS ruled that the correct tax must be considered in determining the amount of an overpayment of tax.  The correct tax is determined by including all adjustments (adjustments that decrease the tax and adjustments that increase the tax), regardless of the expiration of the periods of limitation.  Any excess of tax paid over the correct tax is an overpayment and will be credited or refunded if adjustments decreasing the tax are covered by timely claims for refund.  Revenue Ruling 81-87 was applied by the IRS in rulings involving the computation of foreign tax credit carryovers which have been interpreted to be governed by the same rules applicable to net operating loss carryovers.

The concept of utilizing “correct taxable income” in computing the amount of loss carryovers or carrybacks has long been recognized by the courts.  In Phoenix Coal Company v. Commissioner,[14] the Court of Appeals for the Second Circuit affirmed the Tax Court’s holding that the amount of a net operating loss carryover from a prior and otherwise barred year could be recalculated to determine the amount available for that year.  This rule was repeated by the Tax Court in ABKCO Industries, Inc. v. Commissioner,[15] and in State Farming Co. v. Commissioner.[16]  

With, Hill v. Commissioner,[17] the Tax Court, citing  Mennuto, again allowed the Commissioner to adjust a prior year and reduce unused investment credit available to be carried over to a later year even though the prior year was “barred” to assess additional tax as provided in IRC §6501(a).[18]

While the above cases and rulings concern adjustments to prior years which reduced the loss or credit carryover available to the year in dispute, the taxpayer in Springfield Street Railway Company v. United States[19] could decrease its 1953 taxable income by an available but unclaimed deduction to determine its 1955 net operating loss carryback to be applied against its 1953 and 1954 income.  Similarly, in Situation 2 described in Rev. Rul. 81-88, supra, the Service held that the taxpayer could increase a net operating loss carryover to consider a deduction it had failed to claim in a prior year.  In GCM 38292 (which authorized the issuance of Revenue Ruling 81-88), the Office of the Chief Counsel noted that the cited court decisions concerned adjustments made to the taxpayer’s net operating losses that were favorable to the government but added:

We think that the same logic that allows the Commissioner to correct a NOL with an upward adjustment in a year barred by the statute of limitations also allows the taxpayer to correct a NOL with a downward adjustment in such year.  It would appear inequitable to allow the government to be able to make an upward adjustment in the taxpayer’s NOL, even though the statute of limitations has run, without also permitting the taxpayer to make a downward adjustment in similar circumstances.

Revenue Rulings 81-88 and 56-285 (discussed above) were cited as authority in PLR 9504032 (October 31, 1994) where the Service ruled that the taxpayer was not barred by the statute of limitations from recharacterizing events that occurred in Year 1 to redetermine net operating loss carryovers (either from Year 1 or prior years) that are available for the taxpayer to deduct as net operating loss deductions in subsequent tax years.  While the IRS often states that private letter rulings are not to be cited as precedent, the conclusion reached in this ruling is in accord with previously issued revenue rulings and judicial opinion and appears to be a correct statement of current law.

The ability to adjust items in a closed year to correctly compute tax in an open year is also available to a taxpayer.  In PLR 9504032, Taxpayer determined that as a result of the bankruptcy reorganization it had realized an amount of income from discharge of indebtedness. Pursuant to section 108 of the Internal Revenue Code, Taxpayer excluded this amount from gross income, but reduced its NOL carryovers to Year 1 by the amount of debt discharged.

Subsequently, in May of Year 5, Taxpayer’s liquidating trustee filed an amended federal income tax return for Year 1, asserting that Taxpayer’s net operating loss carryover from Year 1 should be increased, on the ground that all but a small amount of the indebtedness in question was not in fact discharged in Year 1. The Service Center responded that Taxpayer’s claim was being disallowed because the statute of limitations for Year 1 had expired.

The IRS, following Phoenix Coal v. Commissioner and Rev. Rul. 56-285, ruled:

The real question is whether, in determining the NOL deduction for an open year, taxpayers (and the service) may redetermine correct taxable income in a closed year in order to ascertain either the amount of an NOL, or the amount of an NOL that is absorbed, in the closed year.

Rev. Rul. 56-285, 1956-1 C.B. 134, holds that the fact that the statutory period for assessment of income taxes for the year in which a loss was sustained has expired does not preclude the Service from making such adjustments  [*7]  as may be necessary to correct the net operating loss deduction.

Rev. Rul. 81-88, 1981-1 C.B. 85, applies the same principle to the refund limitations period. It holds, in part, that in determining the amount of a net operating loss that may be carried from a closed year forward to an open year, all adjustments to taxable income, whether or not barred by the statute of limitations, will be taken into account.

Accordingly, we conclude that Taxpayer is not barred by the statute of limitations from recharacterizing events that occurred in Year 1 for purposes of redetermining net operating loss carryovers–either from Year 1 or from prior years–that are available for Taxpayer to deduct as net operating loss deductions in subsequent tax years.

The cases and rulings cited above support a general rule that when the tax liability for a prior year is necessary to a determination of the correct tax liability for a year placed in issue that is otherwise an open year, either the Taxpayer or the Commissioner can recompute the “correct tax liability” for a prior year to correct for errors or omissions in such prior year.  Taxpayers can correct and increase its NOL carryover schedule to reduce its taxable income.  Taxpayers are not required to file amended returns to increase its NOL for a subsequent return rather it can reflect the changes on its NOL schedule.

There Is No Second Unnecessary Examination Here, Even If the Carryover Year Was Previously Examined

The IRS published policy on reopening closed examinations section 7605(b) is found in Revenue Procedure 2005-32, 2005-1 C.B. 1206 which states that the examination may be reopened if one of the following three conditions is met:

(1) there is evidence of fraud, malfeasance, collusion, concealment, or misrepresentation of material fact;

(2) the closed case involved a clearly-defined, substantial error based on an established Service position existing at the time of the examination; or

(3) other circumstances exist indicating that a failure to reopen the case would be a serious administrative omission.

The decision whether to reopen an examination pursuant to this administrative policy must be reviewed and approved by the Chief, Examination Division or Chief, Compliance Division, for cases under his/her jurisdiction and based upon historical experience reopening is a rare occurrence.  Under the Revenue Procedure examining an amended return or verifying a net operating loss carryover year is not considered a reopening as it is a separate tax matter, even if the particular loss year or refund year was previously subjected to an examination.

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 http://www.taxlitigator.com

[1] For Amended Corporate Returns, Form 1120X, see Rev. Rul. 81-88, 1981-1 C.B. 585.  Application of otherwise barred deduction in NOL carryback year.  The taxpayer is permitted to carryback an NOL to the full extent possible, without first applying the barred deduction to reduce taxable income in the carryback year.  If the barred deduction were taken into account first, the taxpayer would be denied that portion of the refund attributable to the barred deduction (as the claim would not be timely).  For a further analysis of this rule, see GCM 38292.

[2] IRC § 6501(h); see also Colestock v. Commissioner, 102 T.C. 380 (1994); and Schneer v. Commissioner, T.C. Memo 1993-372.

[3] IRC § 6501(h).  See also, Bryce E. Nemitz et ux. v. Commissioner, 130 T.C. 9 (2008).

[4]  See Mennuto v. Commissioner, 56 tc 910 (1971); see also Rev. Rul. 69-543, 1969-2 c.B. 1.)  Similarly a taxpayer with a NOL carryover generated in years for which the statute of limitations on assessment is closed may increase the amount of the NOL as long as the statute of limitations is open for the year the NOL is utilized.  PLR 9504032.

[5] Note that the IRS may offset tax, interest, and penalties, the assessment of which is otherwise time-barred, against a claim for refund so long as the items fall within the same tax year.  Fisher v. United States, 96-1 USTC ¶50,204 (Fed. Cir. 1996).  This is consistent with the long-standing doctrine of Lewis v. Reynolds, 284 U.S. 281 (1932), 52 S. Ct. 10 that permits the IRS to offset a tax refund by any additional time-barred amounts the taxpayer owes for the year.  See also Dysart v. United States, 340 F.2d 624 (Ct. C1. 1965). For an exception see Pacific Gas & Electric Co. v. U.S. 417 F. 3d 1375 (Fed. Cir. 2005).

[6]  See Rev. Rul. 56-285, 1956-1 C.B. 134—NOL carried over to a subsequent open year and claimed as a deduction could be adjusted to reflect proper depreciation even though the statute of limitations on assessment for the year of the NOL had expired.

[7]   ABKO Industries v Commissioner, 56 T.C 1083, 1088-89 (1971; State Farming Co. v. Commissioner, 40 T.C 774, 781 (1963).

[8]  See Lewis v. Reynolds, 284 U.S. 281 (1932); Lone Manor Farms, Inc., v. Commissioner, 61 T.C. 436 (1974).

[9]  See also, Rev. Rul. 81-87, 1981-1 C.B. 580 and Rev. Rul. 81-88, 1981-1 C.B. 585.

[10]  Rev. Rul. 85-64, 1985-1 C.B. 365.

[11]  See, e.g., G.C.M. 39358; G.C.M. 38292; Rev. Rul. 81-88, 1981 C.B. 585; Rev. Rul. 85-64, 1985-1 C.B. 7.

[12]  Rev. Rul. 56-285, 1956-1 C.B. 134.

[13]  Rev. Rul. 81-87, 1981-1 C.B. 58.

[14]  Phoenix Coal Company v. Commissioner, 231 F. 2d 420 (2d Cir. 1956).

[15]  ABKCO Industries, Inc. v. Commissioner, 56 T.C. 1083 (1971) aff’d on other grounds 482 F. 2d 150 (3d Cir. 1973).

[16]  State Farming Co. v. Commissioner, 40 T.C. 774 (1963).  See also Mennuto v. Commissioner, 56 T.C. 910 (1971)(affirming the Commissioner’s right to adjust a prior year’s taxable income in order to determine the amount of unused investment credit available to be carried over to the year in dispute).

[17]  Hill v. Commissioner, 95 T.C. 437 (1990).

[18]  See also Calumet Industries, Inc. v. Commissioner, 95 T.C. 257 (1990); Lone Manor Farms v. Commissioner, 61 T.C. 436 (1974) aff’d without opinion 510 F. 2d 970 (3d Cir. 1975); Rev. Rul. 77-225, 1977-2 C.B. 73.

[19]  Springfield Street Railway Company v. United States, 160 Ct. Cl. 111, 312 F.2d 754 (Cl. Ct. 1963).


Responses

  1. Today is June 17, 2015 and I just read your article on unclaimed deductions in statute barred years as well as adjusting the taxable income in statute barred years. Well done! I enjoyed reading it because it was my primary area of expertise at the time I retired from IRS in July of 2013. I was the IRS’ technical advisor in the area of NOLs and ATNOLs as well as alternative minimum tax tech advisor for 3 years at the end of a 34 year IRS career mainly doing LB&I work. Ultimately, the job title switched to subject matter expert inside of the Issue Practice Group under the Pre-Filing & Technical Guidance (PFTG) business unit.

    It was a pleasure reading an article that was well written and highlighted the on-point rulings and court cases for the issue. Many practitioners, revenue agents, and tax compliance officers have difficulty understanding the premise of recalculating correct taxable income for the purpose of determining the correct carryback and carryover of NOLs, ATNOLs, credits, and corporate capital losses. This was a very nice summary of the issue.

    The only thing I would possibly have added is that the same rules apply to the ATNOL carryback and carryover issue under Rev Rul 87-44, Treas Reg 1.55-1(a), and Plumb v Comm, 97 TC 632 (1991).

    I currently represent taxpayers who are being audited by IRS and enjoy reading articles like yours.

    Gary Markowitz


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