Waiting Too Long For Refund Of Excess Withholdings

It happens when someone fails to file with the IRS. It might be a “sleeping dog” rationalization, but people will allow a string of tax years to go unfiled, even if some of those years have refunds rather than tax due.

This is a trap, and I saw it sprung earlier this year on a widow. It was unfortunate, as she still has kids at home and could use the money.

The trap is that tax refunds are not payable after a period of time. The Code wants closure on tax matters. The IRS has three years to audit you. You in turn have three years to request a refund. These are general rules, and there are relief valves for the unusual situation: the IRS can request you to voluntarily extend the statute, for example, or you can file a protective claim if your three years are running out.

Let’s look at the Golden case.

Michael Golden did not file his 2015 tax return. In fact, he waited so long that the IRS prepared a return for him (called a substitute for return or SFR). The IRS does not spot a taxpayer any breaks when they do this (no itemized deductions or head of household status, for example). The IRS instead is trying to get a taxpayer’s attention, prompting them to file a return and opt back into the system. In April 2021 (five years after the return was actually due) the IRS issued its notice of deficiency (NOD, sometimes referred to as SNOD). The SNOD is the IRS trying to perfect its assessment prior to sending the account to Collections for their tender mercies. The SNOD showed tax due.

A few days after receiving the SNOD, Golden filed his 2015 tax return. It showed a refund.

Of course.

Golden wanted his refund. The IRS said it could not issue a refund.

There is a technical rule.  

Here it is:

         Section 6511(a)  Period of limitation on filing claim.

Claim for credit or refund of an overpayment of any tax imposed by this title in respect of which tax the taxpayer is required to file a return shall be filed by the taxpayer within 3 years from the time the return was filed or 2 years from the time the tax was paid, whichever of such periods expires the later, or if no return was filed by the taxpayer, within 2 years from the time the tax was paid. Claim for credit or refund of an overpayment of any tax imposed by this title which is required to be paid by means of a stamp shall be filed by the taxpayer within 3 years from the time the tax was paid.

Tax law can be tricky, but there are two rules here:

(1) The default period is three years (to coincide with the statute of limitations). The period starts on April 15 (when the return is due) and ends 3 years later, unless one requested an extension, in which case the default period also includes the extension (normally to October 15).

(2) Refuse to go along with the default rule and you might trigger the second rule: only taxes paid within two years of filing can be refunded.

As a generalization, you do not want the second rule. Why limit yourself to taxes paid within two years when you can have taxes paid within three years (and the extension period, if an extension was requested).

The IRS was also looking at this shiny:

Section 6511(b) Limitation on allowance of credits and refunds.

(1)  Filing of claim within prescribed period.

No credit or refund shall be allowed or made after the expiration of the period of limitation prescribed in subsection (a) for the filing of a claim for credit or refund, unless a claim for credit or refund is filed by the taxpayer within such period.

Notice that Congress included the phrase “shall be allowed.” Another way to say this is that – if you do not fit within the three-year test or the two-year test – your refund claim “shall” not be allowed. This was the IRS position: hey, we do not have much discretion here.

Let’s review the dates for Golden.

We are talking about his 2015 return. The return was due April 15, 2016. Add three years. Let’s be kind and add three years plus the extension. His three years clock-out on October 15, 2019. Three years will not get you to a refund.

The two year rule is even worse.

Golden argued fairness. He was working in the private sector as well as the Navy Reserve, and the demands therefrom made his life “extremely difficult.” In tax terms, this argument is referred to as “equity.” Some courts can consider equitable arguments, but the Tax Court is not one of them.

Here is the Court:

          We sympathize with petitioner’s predicament.

The Supreme Court has made clear that the limitations on refunds of overpayments prescribed in section 6512(b)(3) shall be given effect, consistent with Congress’s intent as expressed in the plain text of the statute, regardless of any perceived harshness to the taxpayer. See Commissioner v. Lundy, 516 U.S. at 250–53. Because Congress has not given us authority to award refunds based solely on equitable factors, we are compelled to grant respondent’s Motion for Summary Judgment.”

It was not a total loss for Golden, however. Since he did file a return, the IRS reduced his 2015 tax due to zero. He did not owe anything. He could not, however, recover any overpayment. He left that 2015 refund on the table.

What do you do if you are caught in a work situation like Golden? It is not a perfect answer, but file with the information you can readily assemble. Pay someone to prepare the return (within reason, of course). Hey, maybe you missed interest on a small money market account or took the standard deduction when itemized deductions would have given you a smidgeon more. The IRS will let you know about the first one (computer matching), and if there is enough money there you can amend later (the second one). At least you will get your basic refund claim in.

Our case this time was Golden v Commissioner, T.C. Memo 023-103.

Let's Talk Tax Inversions - Part Two

Last time we discussed the taxation of an inverting corporation.

There are three levels of tax severity to the corporation itself:

(1)   The IRS ignores the inversion completely and continues to tax the foreign company as if it were a U.S. company

(2)   The IRS will respect the foreign company as foreign, but woe to whoever tries to move certain assets out of the U.S. or otherwise use certain U.S. – based tax attributes for a period of 10 years.

(3)   The IRS will respect the transaction without reservation.

Then there is the toll-charge on the shareholders. If they own more than 50% of the new foreign company, the shareholders will pay tax on their shares AS IF they had sold them rather than exchanged them for stock in the new foreign parent.  The practical effect is that any inversion has to include cash to the U.S. shareholders, otherwise such shareholders would be reaching into their wallet to pay tax (and would likely vote to scuttle any inversion deal).

It was this toll charge that caught the attention of Congress. If you think about it, someone owning actual shares would be taxed, but someone having a future right to shares would not. Who would such a person be? How about corporate insiders: management and directors? Executives frequently receive stock options and other stock-based compensation. Congress felt that management and directors should also have “skin in the game,” thus the origin of Section 4985. 

One quickly realizes the parity Congress wanted:

(1)   First, Section 4985 applies only if gain is realized by any shareholder. If there is no toll charge on the shareholders, then there will be no toll charge on management and directors.

(2)   The Section 4985 tax will be the highest tax rate payable by the shareholders, which is the capital gains rate (15%)

There is some technical lingo in here. The tax Code dragnets all individuals “subject to the requirements of Section 16(a) of the Securities Exchange Act of 1934” – in short, the officers, directors and 10% shareholders. It also includes their families.

So Congress wanted insiders to also pay tax. That’s great. I wanted to play in the NFL.

Let’s take a look at another Congressional attempt to “rope in” executive pay: the golden parachute limitations of Section 280G. This tax applies to “excess” compensation payments upon a change in corporate control. The insider is allowed a base amount (defined as average annual compensation for the five years preceding the year of change in control). The excess is subject to an additional 20% excise tax – in addition to the payroll and income taxes already paid.

How does it work away from the fever swamp of Washington?

It doesn’t. Corporations routinely “gross-up” the executive compensation until the tax is shifted back to the corporation.

I suspect that every tax accountant has run into a compensation “gross up” exercise. I have done enough over the years to make my eyes cross.

Let’s return to our inversion discussion. What do you think companies are doing when their executives are subjected to the 15% Section 4985 excise tax?

Yep, the gross-up.

The mathematics of a gross-up are terrible. Let’s take the example of someone who is subject to the maximum federal tax rate (39.6%), add in the ObamaCare Medicare tax (0.9%), the Section 4985 tax itself (15%) and a state tax (say 6%), and 61.5% of every dollar is going to tax (I am leaving out the deductibility of the state tax). If I am to gross-up a payroll, I am saying that only 38.5 cents of every dollar will be available to satisfy the original Section 4985 tax liability. This means that the gross-up will have to be $2.60 (that is, 1 divided by 38.5%) for every dollar of the original Section 4985 tax.

But Congress, never willing to leave a bigger mess undone, added yet another twist to Section 4985: the corporation is not allowed to deduct the gross-up. Let’s say that the excise tax was $1 million. The gross-up would be $2.6 million, none of which is deductible by the company.

Yipes!

Medtronic is a medical device maker based in Minneapolis. It operates in more than 120 countries and employs approximately 50,000 people worldwide. It has agreed to acquire Covidien, an Irish medical device company. Since we are talking about inversions, you can surmise that the new parent will be based in Ireland. For its part, Medtronic says it will be leaving its Minneapolis-based employees in Minneapolis, which makes sense when you consider that they have employees located throughout the planet.

Medtronic will of course continue to pay U.S. tax on its U.S. income. What it won’t do is pay U.S. tax on income earned outside the U.S. This is not an unreasonable position. Think about your response if California tried to tax you because you drank Napa Valley wine.

Medtronic triggered the Section 4985 excise tax on its executive officers and directors. This tax is estimated to be approximately $24 million.

Remember the loop-the-loop involved with a gross-up. How much will it cost Medtronic to gross-up its insiders for the $24 million?

Around $63 million.

None of which Medtronic can deduct on its tax return.

Can you explain to me how this can possibly be good for the shareholders of Medtronic? It isn’t, of course.

Way to play masters of the universe, Congress.