Tax Refunds Lost to Timing Rules: Lesson, File Early, Pay Late – Houston Tax Attorneys

You should always pay your taxes on time, right? After all, early payment avoids tax penalties and interest, and shows good faith compliance with tax obligations.

This is not always the best approach. Why? Taxpayers who pay early or even on time may be precluded from getting money back from the IRS if they overpaid their tax liability. In some cases, taxpayers who delay making payments to the IRS may have more refund rights than those who pay on time.

This issue typically arises in two scenarios where taxpayers make advance payments to the IRS. First, when taxpayers make payments but fail to file timely returns. Second, when taxpayers make payments and the IRS conducts an audit or makes an adjustment that results in a statutory notice of deficiency. In both cases, the taxpayer may later discover they not only don’t owe additional tax—they actually overpaid and are due a refund. This problem lies with payments made before either the late-filed tax return or the IRS’s notice of deficiency–which taxpayers may not be able to get back from the IRS. The recent Applegarth v. Commissioner, T.C. Memo. 2024-107, provides an opportunity to consider these timing issues.

Note: there are other rules that come into play for refunds in collection due process hearings, which are similar but different than when you have an IRS adjustment or notice of deficiency as we are addressing in this article.

Facts & Procedural History

The taxpayer in this case made estimated tax payments to the IRS for 2014 and 2015. The payments were all made on or before the extended due dates for the tax returns for 2014 and 2015.

The taxpayer then filed his 2014 return in June 2019 and never filed his 2015 return.

In November 2019, the IRS issued notices of deficiency to the taxpayer for both years. The taxpayer filed a petition with the U.S. Tax Court to challenge the IRS’s determinations.

The taxpayer provided an amended return to the IRS attorney during the tax litigation. The parties ultimately agreed that there were significant overpayments–$78,472 for 2014 and $9,603 for 2015. So not only did the taxpayer not owe the amounts asserted by the IRS in its notice, the taxpayer was actually owed money back from the IRS.

The question before the court was whether the U.S. Tax Court could order refunds of the overpayments given the statutory time limitations.

The Refund Claim Framework

This is probably not a surprise, but there are a number of deadlines set out in the tax code. For this case, there are two key provisions to consider, i.e., Section 6511(b)(2) and 6512(b)(3).

Section 6511(b)(2) establishes the “lookback” periods for refund claims. For taxpayers who file a tax return, they can recover payments made within three years plus any extension period before the refund claim. For taxpayers who don’t file a return, they can only recover payments made within two years of their refund claim.

Section 6512(b)(3) applies specifically to cases brought in the U.S. Tax Court. It limits the Tax Court’s ability to order refunds to: (1) payments made after the IRS issues its notice of deficiency, (2) payments that would be refundable if a refund claim had been filed on the notice date, or (3) payments covered by an actual refund claim filed before the notice date.

This creates a connection between the notice date and refund rights. Taken together, these code sections limit refund rights based on when payments were made relative to when refund claims are filed or deemed filed. This is why a taxpayer who files a petition with the U.S. Tax Court in response to a notice of deficiency has to focus on the date of the IRS’s notice of deficiency. The code treats this date as a hypothetical refund claim date and only allows recovery of payments made within specific “lookback” periods measured from this date. For taxpayers who haven’t filed returns, this lookback period is generally just two years before the date of the IRS notice. That is the issue in the Applegarth case.

In Applegarth, the taxpayer’s payments were all made more than two years before the November 2019 notice of deficiency. Because he hadn’t filed returns within the proper timeframe, the two-year lookback period applied. As a result, the U.S. Tax Court could not order refunds of the overpayments, even though everyone agreed that the taxpayer was otherwise entitled to the refunds.

Understanding the Lookback Periods

IIt is helpful to consider an example here. Imagine a taxpayer who paid $10,000 in taxes on April 15, 2020, but later discovers they only owed $5,000. Their ability to get back the $5,000 overpayment depends on when they take action.

If they file a tax return (which serves as a refund claim), they can recover payments made within 3 years plus any extension period before filing the refund claim. So if they file the tax return on April 15, 2023, they can get back the April 2020 payment. The 3-year lookback period protects their refund rights.

The situation is quite different if they never file a return and the IRS sends a notice of deficiency. In this case, they can only recover payments made within 2 years before the notice date. So if the IRS sends a notice on April 15, 2023, they can only get back payments made after April 15, 2021. Their April 2020 payment falls outside this 2-year window and is lost.

This is why the Applegarth case turned out the way it did. Since the taxpayer hadn’t filed returns within the proper timeframe, he was stuck with the shorter 2-year lookback period. His payments were made too early to fall within this window.

Planning Around the Timing Rules

These refund rules create some counterintuitive results. A taxpayer who files their return late but within three years of payment has more refund rights than a taxpayer who doesn’t file at all and waits for an IRS notice. And a taxpayer who pays at the last minute (but within two years of an IRS notice) may have more refund rights than one who paid years earlier.

This doesn’t mean taxpayers should delay payments to the IRS. Late payment penalties and interest usually outweigh any theoretical benefit from preserving refund rights. However, it does mean that taxpayers who have made payments should prioritize filing their returns, even if late. A late-filed return is far better than no return when it comes to preserving refund rights.

Given these concepts, there are a few issues that you may be thinking about. One is situations in which a taxpayer is required to file a return with an estimate, and has to true up the return later? There are situations like this built into our tax laws. We covered that topic here as to fixing estimates.

The other question is whether the taxpayer can argue that they did file a timely tax return, even though they technically did not. If the taxpayer has no other arguments, one argument might be that they did file a tax return as a refund claim, it was just an informal refund claim. There is some chance that something the taxpayer provided to the IRS could count as a refund claim–even if it was just a letter or other correspondence the taxpayer sent to the IRS.

Takeaway

The lesson from this case isn’t that taxpayers should delay paying their taxes. Rather, it highlights the critical importance of filing tax returns, even if they’re late. While timely tax payments are important, they must be paired with a filed return to preserve refund rights. Taxpayers who have made significant payments should file returns or protective claims if they discover potential overpayments. Otherwise, as Applegarth shows, the taxpayers could permanently lose their right to substantial refunds due to timing rules alone.

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Stephan Dorsey

Stephan is the sports journalist for the Maple Grove Report.

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IRS Cannot Assess Foreign Information Return Penalties – Houston Tax Attorneys

Many businesses today have some international transactions. Many U.S. businesses even have operations in foreign countries–which may include ownership of entities, operations, or just sales.

Our tax laws include several provisions that require U.S. taxpayers to report most of these foreign business interests and activities. These filings are mostly made by filing various information returns.

Failing to file these information returns can result in significant penalties. The U.S. Tax Court had concluded that the IRS does not have the authority to assess these penalties. An appeals court did not agree. The issue came back before the U.S. Tax Court in Mukhi v. Commissioner, 4329-22L (Nov. 18, 2024), which again asks whether the IRS can assess these penalties or must pursue them through district court litigation.

Facts & Procedural History

The taxpayer in this case created three foreign entities in 2001 through 2005. This included a foreign corporation.

From 2002 through 2013, the taxpayer failed to file Forms 5471 to report his ownership interest in the foreign corporation. After the taxpayer pleaded guilty to criminal tax violations, the IRS assessed $120,000 in penalties under Section 6038(b)(1). That’s a $10,000 penalty for each year the taxpayer failed to file the returns.

The IRS then attempted to collect the penalties. It issued a notice of intent to levy and filed a federal tax lien. The taxpayer challenged these actions in the U.S. Tax Court, arguing that the IRS lacked authority to assess these penalties in the first place. As we’ll get into below, while the U.S. Tax Court initially ruled for the taxpayer based on its Farhy v. Commissioner, 160 T.C. 399, 403-13 (2023), decision, the D.C. Circuit reversed Farhy. See Farhy v. Commissioner, 100 F.4th 223 (D.C. Cir. 2024). The IRS filed a motion to reconsider based on the appeals court’s Farhy decision. That led to the current opinion reconsidering whether the IRS has assessment authority for these penalties.

To understand the significance of this case, it’s helpful to first understand the Form 5471 reporting requirements.

About the Form 5471 Information Return

Section 6038 requires U.S. persons to file information returns to report their ownership or control over certain foreign corporations. This is done by filing Form 5471, Information Return of U.S. Persons With Respect to Certain Foreign Corporations.

Form 5471 requires detailed information about the foreign corporation, including its ownership structure, financial statements, and various transactions with related parties. The form must be filed with the taxpayer’s annual tax return.

Different filing requirements apply based on the category of filer:

Category 1: U.S. shareholders of specified foreign corporations
Category 2: Officers and directors of foreign corporations with U.S. owners
Category 3: U.S. persons who acquire or dispose of significant ownership
Category 4: U.S. persons who control a foreign corporation
Category 5: U.S. shareholders of controlled foreign corporations

Those who trigger these provisions have to pay attention to these requirements. The penalties for non-compliance can be substantial. This is particularly true given how many different categories of persons must file the form.

The Section 6038 Penalties

The IRS has a number of tools at its disposal to “encourage” taxpayers to voluntarily comply with filing requirements. Civil tax penalties are one such tool.

Congress has created a number of different penalties related to foreign transaction reporting. The FBAR reporting requirements for foreign bank accounts are probably the most notorious as they are often extremely large.

For the Form 5471, there are two distinct penalties for failing to file. First, Section 6038(b)(1) imposes a $10,000 penalty for each annual accounting period. This penalty can be increased by $10,000 per month (up to $50,000) if the failure continues after IRS notification. Second, Section 6038(c) reduces the taxpayer’s foreign tax credits by 10%. This reduction increases quarterly if the failure continues, potentially eliminating all foreign tax credits for the unreported corporation.

Both penalties can be avoided if the taxpayer shows reasonable cause for the failure to file. The standard reasonable cause defenses apply. We have covered many of them on this site before, such as reliance on a tax advisor, honest mistake, etc.

The IRS Assessment Authority Question

With these penalties in mind, we can now turn to the key issue in Mukhi: whether the IRS can assess these penalties directly or must pursue them through court action.

The term “assessment” refers to the recording of a tax balance on the IRS’s books. It is what creates a balance due by a taxpayer that the IRS can collect.

The IRS’s authority to assess penalties is found in Section 6201(a). This provision allows the IRS to assess “all taxes (including interest, additional amounts, additions to the tax, and assessable penalties).” The question in this court case is whether Section 6038(b)(1) penalties fall within this authority.

The U.S. Tax Court analyzed this issue by comparing Section 6038(b)(1) to other penalty provisions that explicitly state they are assessable. The Court found that unlike those other provisions, Section 6038(b)(1) contains no language suggesting Congress intended these penalties to be assessable. Without explicit authority, the U.S. Tax Court held the IRS must pursue these penalties through district court litigation.

But What About Farhy?

The U.S. Tax Court’s analysis, however, isn’t the end of the story. The previous D.C. Circuit decision in Farhy reached the opposite conclusion.

The appeals court in Farhy held that the IRS could assess these penalties. That appeals court focused on Congressional intent and administrative efficiency, reasoning that requiring district court litigation would make the penalties “largely ornamental.”

However, under the Golsen rule, the U.S. Tax Court follows the precedent of the circuit court where appeal would lie. Since Mukhi would appeal to the Eighth Circuit (not the D.C. Circuit), and the Eighth Circuit hasn’t addressed this issue, the U.S. Tax Court was free to follow its own analysis rather than Farhy.

This creates different results depending on where taxpayers reside. Those in D.C. Circuit states face immediate IRS assessment, while those in other circuits may get the procedural protections of district court litigation.

For taxpayers facing these penalties, the IRS can no longer simply assess and begin collection actions in most circuits. Instead, the Department of Justice must file suit in district court. This gives taxpayers additional procedural protections and opportunities to raise defenses before paying.

The Takeaway

For the time being, the U.S. Tax Court’s decision creates different procedures depending on where taxpayers reside. Outside the D.C. Circuit, the IRS must pursue these penalties through district court litigation rather than immediate assessment and collection. This gives taxpayers additional procedural protections and opportunities to raise defenses. However, the penalties themselves remain substantial – only the collection process has changed. Taxpayers should continue to prioritize compliance with foreign information reporting requirements to avoid these penalties entirely.