Taxpayer's Refund on Unfiled Return Falls Into “Black Hole” Based on Date IRS Issued Deficiency Notice

Note; On April 2, 2019 the Second Circuit reversed the Tax Court in this case. See Second Circuit Reverses Tax Court, Removing "Black Hole" for Claiming Refunds.

Taxpayers who fail to timely their tax returns will sometimes tell advisers that it doesn’t matter because they are sure they are overpaid.  That’s fine—except that any overpayment can be lost if the taxpayer waits too long to timely file the return.

In the case of Borenstein v. Commissioner, 149 TC No. 10, the taxpayer discovered a way to lose a refund that probably will be new to most readers.

A taxpayer who has a claim for refund, including that overpayment on that not yet prepared late return, must file the claim for refund (which would be the original return in the case of a late filed return) by the time period found in IRC §6511. 

A taxpayer must ask for a refund by:

  • The later of

    • Three years from the time the return was filed (assuming a return was timely filed) or

    • Two years from the time the tax was paid. Or

  • If no return was filed, within two years from the time the tax was paid.[1]

What happens if the IRS discovers the failure and issues a notice of deficiency before that late return is filed?  For instance, if the IRS were to issue a notice of deficiency more than two years after the return should have been filed, but before the three-year period would have expired had a return been filed. 

To deal with that time period where an IRS assessment could cause a taxpayer to lose the right to the refund before the three year period expired, Congress added a special provision to IRC §6512(b)(3) in its final sentence—it provides that if the “date of the mailing of the notice of deficiency is during the third year after the due date (with extensions) for filing the return of tax and no return was filed before such date, the applicable period under subsections (a) and (b)(2) of section 6511 shall be 3 years.”

The provision appears meant to allow the taxpayer who receives a notice of deficiency issued in that third year but who is overpaid to be able to claim that refund in Tax Court—and, since the Tax Court would be able to award the refund, to claim that refund during the examination process.

But in this case the meaning of the parenthetical statement “with extensions” was in dispute among the parties.  The timeline, which is the key factor in this matter, was as follows:

  • January 17, 2013-Taxpayer makes her final estimated tax payment for her 2012 return, with total estimates of $72,000.

  • April 15, 2013-Taxpayer files for an extension of time to file her return, and encloses a $40,000 payment with the extension. Thus, as of the due date of the return (April 15, 2013) she had paid in $112,000.

  • October 15, 2013-The extended due date for the taxpayers return passes without her filing her return.

  • June 15, 2015-The IRS issues a notice of deficiency on the 2012 return, which remained unfiled at this time. Not unexpectedly the IRS included only items of income they were aware of, including substantial sales of securities for which the IRS assumed a zero basis. Thus, the IRS determined a total deficiency of over $1,600,000

  • August 29,2015-Taxpayer finally files her return for 2015, including the deductions and basis that were not present on the IRS’s notice of deficiency. That return showed that her total tax just under $80,000 and showed a refund of over $38,000 due to her.

The parties all agree that the return the taxpayer prepared has the correct amount of tax due, and that the payments she had paid more than $38,000 in excess of what was due.  However, the IRS claimed that because of when the agency had issued the notice of deficiency, the two year rather than three rule applied.

In the IRS’s view, the notice of deficiency (which is treated as the date she filed a refund claim for these purposes) was issued more than two years after the tax was paid.  Since she had not filed a return by that time, she did not qualify for the three-year period under the provisions of §6511.

But what about that special rule that says if the IRS issues the notice in the third year when no return had been filed, then a three statute applies.  The IRS argues that its notice was not issued in that one-year period.

As the Court explains the IRS position:

Respondent offers what he believes to be a “plain language” interpretation of the final sentence of section 6512(b)(3). In his view, the parenthetical phrase “with extensions” modifies “due date.” Here, the “due date (with extensions) for filing the return of tax” was October 15, 2013, pursuant to the automatic extension petitioner received to file her 2012 return.

The “third year” after that date began on October 15, 2015. But the notice of deficiency was mailed on June 19, 2015. That date was during the second year, not during the third year, “after the due date (with extensions) for filing the return,” as the 1997 amendment requires. Respondent accordingly contends that the exception set forth in the final sentence of section 6512(b)(3) does not apply, with the result that a refund or credit of petitioner’s $32,411 overpayment is barred by the two-year lookback rule generally applicable to nonfilers.

The taxpayer argues that this interpretation can’t be correct—since it meant that by filing for extension of time to file her 2012, she created a six-month “black hole” into which refunds would fall if the IRS gets its notice of deficiency out during that period.

In her case, the IRS view would provide for the following results:

  • Up to April 15, 2015 taxpayer would be allowed a refund since she would be filing her claim within 2 years of the date the tax was deemed paid;

  • April 16, 2015 to October 15, 2015- The taxpayer’s claim would be filed more than two years after the tax was paid. If a notice of deficiency is issued during this period, it is still less than two years after the extended due date for her 2012 return, the special rule on notices of deficiency would not apply.

  • October 16, 2015 to April 15, 2016-If no notice of deficiency had been issued before this date, the taxpayer may either file a return and claim the refund under the general three-year rule or, if the IRS issues a notice of deficiency, that would be issued in the third year following the extended due date and the taxpayer could obtain the refund.

In the view of the taxpayer, clearly Congress could not have meant to create an absurd six month period during which a notice of deficiency would block any refund, followed by another six month period that, if the taxpayer made to that date without IRS action, would again allow claiming the refund.

But, the Tax Court notes, there really is no ambiguity in what Congress said.  And, as the Court concludes:

Anyone who has managed to plod thus far through this Opinion will understand that the statutory provisions we are construing are extremely technical and complex. It is possible that the drafters of the 1997 amendment did not think through all of the ramifications of Congress’ decision to “inject filing extensions into the lookback period mechanism,” as petitioner puts it. But wittingly or unwittingly Congress placed the words “with extensions” in the text of the statute immediately after “due date.” We must give meaning to those words.

The text enacted by Congress makes syntactic sense and has an unambiguous meaning. Construing that text according to its plain meaning does not produce a result “so gross as to shock the general moral or common sense.” Harrelson, 282 U.S. at 60. “Our unwillingness to soften the import of Congress’ chosen words even if we believe the words lead to a harsh outcome is longstanding. It results from ‘deference to the supremacy of the Legislature.’” Lamie, 540 U.S. at 538 (quoting United States v. Locke, 471 U.S. 84, 95 (1985)).

[1] IRC §6511(a)