A Stupid -- At Least Unfair -- IRS OVDI/OVDP Trick; Denying Overpayment Credit for Barred Years (8/13/12)

I write to rant about a practice inside the OVDI/OVDP civil penalty structure.  I start with the relevant Code sections, 6501, here, and 6511, here.  Section 6501(a) provides a 3 year statute of limitations for assessments.  Section 6501(c) provides certain exceptions to the 3 year limitations on assessments.  The key exception for present purposes is the Section 6501(c)(1) "a false or fraudulent return with the intent to evade tax," for which there is no statute of limitations.  (I ignore the 6 year statutes of limitations that might apply, and assume for present purposes they do not apply.)  Section 6511(a) provides a statute of limitations for refunds.  Basically, the taxpayer filing a timely original return and paying the tax has 3 years in which to file a claim for refund of the tax.

The OVDI/OVDP programs have involved a lookback window from 2003 forward.  (I ignore the possibility of a later starting date under 2012 OVDP but even if a later starting date were involved, the concepts discussed in this blog would still apply.)  The taxpayer is required to file amended returns during that lookback period and pay all applicable taxes.

Commenters to other blog entries have noted that, if there are refunds due for years for which refund is barred under the above rules, the IRS will not give the taxpayer credit for those refunds against taxes reported on the amended returns for years in the lookback window.  Here is an example:

2003 – additional tax reported on the OVDP/OVDI amended return - $1,000.
2004 – refund of tax paid with original return but claimed for first time on OVDP/OVDI amended return – ($1,000)
2005 – additional tax reported on the OVDP/OVDI amended return - $1,000.

Assume the years 2003-2005 are closed for assessments and refunds.  As to assessments, assume that the IRS has not made a specific finding of fraud as to the taxpayer and, should it investigate, could not prove fraud by clear and convincing evidence so as to invoke Section 6501(c)(1).   In this case, the IRS will not give the taxpayer credit for the $1,000 overpayment for 2004, even though it collects the underpayments for 2003 and 2005.

I have not experienced the barred year refund / credit denial in my filings.  Upon polling a group of practitioners, I find that others have experienced it.  As I understand the reports of the IRS's position on this issue, the IRS asserts that Section 6511(a) is a bar.   Some of the practitioners think that the IRS reading is correct and that it would be illegal for the IRS to credit the refund amount for the barred year.  Textually, of course, that is exactly what Section 6511(a) says.

I hope readers can see, however, a lack of symmetry here.  Although not worded in exactly the same text, the concept in Section 6501(a) is the same.  It is illegal for the IRS to assess taxes for a barred year and, if the IRS does that, any amount paid is an overpayment of tax for which the taxpayer is entitled to be credited and the IRS should refund or credit it.  Section 6401(a), here.  So, how is it that the IRS can refuse to do the supposedly illegal act (the refund outside the Section 6511(a) period) when it does the other illegal act (the assessment outside the 6501(a) period)?

Some practitioners perceive no lack of symmetry here because the taxpayer, by entering the program, is agreeing to the illegal assessment, whereas the IRS is not agreeing to the illegal refund.  I view this as nothing more than a statement that the IRS sets the rules of this game, and it has decided to impose this asymmetrical rule.  It is not a justification for being inconsistent.  Nor is it a justification, because of the inconsistency, to be unfair, in my view.

Some practitioners have asserted that, well, under the program the IRS just assumes that everyone committed fraud with a resulting unlimited statute of limitations via Section 6501(c)(1).  My argument to that is the same as Vinny's responsive argument in My Cousin Vinny, here, paraphrased, "That's bullshit."  Speaking from my experience, very few of the participants committed fraud -- at least fraud that the IRS could meet the civil burden of proof of fraud by clear and convincing evidence.  The IRS makes no finding of civil fraud and cannot, in my judgment, invoke Section 6501(c)(1) simply by making an assumption that is contrary to fact in many, perhaps most cases.  The IRS has to at least work the specific case and believe that it has sufficient facts to assert fraud by clear and convincing evidence before it can assert the consequences of that finding upon a taxpayer who, after all, is a citizen of the U.S.  It is patently not true that citizens joining the program are admitting fraud and thus relieving of the IRS of its predicate obligation to make a good faith finding of fraud specific to the taxpayer involved.

So, I am not convinced of the merits and fairness of the IRS hiding behind Section 6511(a) as a basis for being inconsistent and fair in this program.  But, I do recognize that the IRS makes the rules, so the better response for the IRS to make when asked why they are denying a credit for the otherwise barred year is that "We (the IRS) makes the rules."  At least that is a more honest answer, in my mind, for as I indicated, if the IRS can get past the requirement that it not make illegal assessments, it should be able to get past the requirement that it not make illegal refunds.  Basically, as I perceive the program, it is a program where the IRS can make the rules regardless of statutes of limitations and the taxpayer; the IRS can agree to reach a settlement requiring payments regardless of the statutes of limitations.

I would suggest as one solution, albeit partial, is that the IRS could permit a credit for an otherwise barred refund year against assessments due for an otherwise barred assessment year.  At least that would bring some partial symmetry.  This is just a small way in which the IRS could make the program more fair, in my view.

I would appreciate readers' comments.