Can the IRS Disallow Your Net Operating Loss Carryback?

Here is a quiz question:

            Can the IRS reopen a tax year if you file an NOL carryback?

Most tax accountants will remember the intent of IRC Section 7605(b), even if they may not remember the specific citation:

No taxpayer shall be subjected to unnecessary examination or investigations, and only one inspection of a taxpayer's books of account shall be made for each taxable year unless the taxpayer requests otherwise or unless the Secretary, after investigation, notifies the taxpayer in writing that an additional inspection is necessary.

This language entered the Code in 1921, and its intent was and is to relieve taxpayers from unnecessary annoyance.

The question is whether it is the original year that is being reopened or whether it is the carryback from a later year that is being reviewed.

The IRS expounded on IRC Section 7605 in Rev Procedure 2005-32. The wording we are after is “reopening.” Section 2.04 of the Rev Procedure informs us that new section 4.02 is being added to define the “reopening” of a closed tax case.

The new section 4.02 states:

A reopening of a closed case involves an examination of a taxpayer’s liability that may result in an adjustment to liability unfavorable to the taxpayer for the same taxable period as the closed case, with exceptions, some of which are noted below. The Service’s review, including an inspection of books of account, of a taxpayer’s claim for a refund on an amended excise or income tax return, as well as the Service’s review of a Form 843, Claim for Refund and Request for Abatement, claiming a refund for an overpayment reported on a return, is not a reopening.

Someone ran face-first into this in FAA 20114701F. Here are the facts:

Taxpayer deducted a bad debt loss in Year 1. It was audited and the IRS allowed the loss. Enough time goes by that the statute of limitations for Year 1 expires. In a later year Taxpayer has an NOL, which it carries-back to Year 1. The IRS however was still churlish about that bad debt deduction in Year 1.

The FAA goes on to reason that the IRS did not pick this fight. Rather the Taxpayer did by electing to carryback its net operating loss and claiming a refund. The Taxpayer’s action allowed the IRS to “reopen” the closed year.

There was some saving grace, thankfully. The IRS decided it could deny Taxpayer’s claim for refund dollar-for-dollar – but only to the extent of the refund. The worst that could happen is that the Taxpayer would not receive any refund, resulting of course in a total waste of the net operating loss carryback. But hey, at least the Taxpayer did not have to write a check to the IRS for the audacity of claiming a tax refund.