Protecting the Refund Statute of Limitations for those in OVDI (1/4/12)

I state the issue of this blog in layman's terms first.  The issue is whether the statute of limitations for refund claims might upset the normal expectations of persons entering the OVDI program.  The answer to that question is perhaps.  I will try to explain more detail below, but the problem is the way the tax statutes of limitation work.  Just as the statute of limitations may prevent the IRS from assessing tax that might have otherwise been due for a year barred for assessment, so the statute of limitations prevent the IRS from refunding a tax paid for a year barred from filing a refund claim.  The protective fix for the potential problem -- and it really may only be a potential problem rather than a real one depending upon future administration of OVDI and the opt out procedures -- is for the taxpayer to file a written protective refund claim (formal or informal) within the normal statute of limitations for refunds of any taxes paid pursuant to the programs or the opt out  procedures.

Let me illustrate the problem in an example.  Taxpayer A joined the OVDI program on August 1, 2011.  Taxpayer A submitted the OVDI package on September 9, 2011 (the extended due date for submission).  Along with the package, the taxpayer calculated and remitted by check the income tax, income tax penalty and interest on the income tax and income tax penalty for the years 2003 through 2010.  Pending further processing, the IRS posts the payments as calculated to the respective years pursuant to the taxpayer's calculations.  (I have some anecdotal evidence that the IRS may be doing an interim posting to the year 2007 for all amounts paid, even  if according to the taxpayer's calculations they relate to years other than 2007; let's set that aside for later consideration and just assume that the IRS posts to the years 2003 forward as the taxpayer has indicated.)  That means that some portion of the tax, penalty and interest gets allocated to tax years beyond the normal three year statute of limitations on assessment.  Although we are talking here about refunds, the statute of limitations on assessment is important because, although, inside the programs, the statute of limitations is irrelevant, if the taxpayer opts out of the program, the IRS will only be able to assess tax for the years that are otherwise open.  That means any tax allocated to years that are otherwise closed for additional assessments is, under the law, an overpayment of tax that should be refunded.


Those of you that have paid attention so far may wonder whether all years from 2003 forward are open because of the Form 872 that the taxpayer was required to execute and send in with the OVDI package (or sooner if an extension was requested).  Keep in mind in this regard, that inside the program, the statute of limitations is irrelevant; if the taxpayer wants the penalty regime inside the program, the taxpayer must agree to pay for the years 2003 forward without regard to the assessment statute of limitations; that is just the deal.  In this light, the Form 872 is relevant only if the taxpayer opts out of the civil  penalty settlement inside of the OVDI program.  Then, the taxpayer is subject to the normal audit regimen and the statutes of limitations -- both on assessment and refund -- are quite important.  So, focusing on the opt out regime, what exactly does the Form 872 do with respect to years that are otherwise closed.  I hope you have asked the question -- what the hell is he talking about?

Technically, without getting into the legal lore, the Form 872 can keep open the assessment statute of limitations for years that were otherwise open at the time the Form 872 was executed by both parties (i.e., on the date of the last signature, being the IRS's).  (Now, how many of you in the program have received back signed Forms 872; and, if so, did you make a note of the date of the IRS's signature?)  For example, this means that, although the Form 872 may state that it covers 2003, it really does not cover 2003 unless the year 2003 were otherwise open for assessment when the IRS signed the Form 872.  Now, what does otherwise open mean?  Well, it means that, in this example, 2003 would not be otherwise open unless the taxpayer had committed fraud in the filing of the 2003 year return.  This is because the statute of limitations on assessment is generally 3 years unless one of two exceptions apply -- a 6 year statute if the taxpayer omitted 25% of the gross income and an unlimited statute if the taxpayer committed fraud.  As to the year 2003, even a 6 year statute would not apply, so, as noted, the 2003 year is not open if the 2003 return did not involve fraud.  This means that, although the Form 872 purports to cover 2003 it does not unless the IRS can prove fraud by clear and convincing evidence.  And, the Form 872 also, for years it purports to cover, provides a special statute of limitations for refunds -- being 6 years after the end of the nominated extension of the statute of limitations on assessment.  That too will not apply if the Form 872 is not effective to extend the statute of limitations for assessment.

Now, we come to the statute of limitations on refunds which was the initial point of concern.  First, I review the general rules of on statutes of limitations on refunds.  A claim for refund for tax paid has to be made by the later of three years of the date the return was filed or two years from the date the tax was paid.  If the latter rule applies, the amount of the refund is limited to the amount paid in the two years.  Focusing on the 2003 year example we have considered above, this would mean that the three year prong has long since expired and the taxpayer can obtain a refund only by making a claim within 2 years of the date of payment of the tax.  The tax paid with the original return is long since outside the 2 year period.  So we are talking about the tax paid as a result of joining the program.  Remember that, along with the final package, the taxpayer was required to compute and pay the tax, penalty and interest for all years from 2003 forward.  So the tax thus paid will be subject to this rule that the taxpayer must claim the refund within two years of the date of payment.  Of course, assuming that the taxpayer correctly and computed the payment for the years (including 2003 in this example), then the taxpayer who stays in the program will not be entitled to a refund in any event.  But the taxpayer who opts out may stand to lose his refund of the 2003 taxes (if indeed the IRS applies the calculated amount to the 2003 tax liability) unless he or she claims the refund in the refund statute of limitations period (i.e., 2 years from the date of payment).  This should not be a real problem if the IRS processes the opt out in a reasonable amount of time so that the taxpayer knows that he or she is entitled to a refund in time to protect the statute of limitations by filing a claim for refund (assuming that he or she is aware that he or she needs to protect the statute of limitations).

But, what if there are delays?  What does the taxpayer do to protect his or her right to any refund that might ultimately be determined to be due on the opt out?  I suggest that taxpayers and their practitioners consider the following protective measures.

1. The ultimate protection will be to file a protective 1040X before the two year refund statute of limitations applies (2 years from the date the taxpayer paid the tax, penalty and interest pursuant to the OVDI program).  This would be appropriate for years where the statute of limitations on assessment is otherwise closed on the date the Form 872 was signed by the IRS.  This will require that the practitioner at least think about the possible application of the exceptions to the normal three year statute of limitations periods on assessment.

2. A fall back position would be for the taxpayer to submit within the two year period a formal writing stating specifically that, in the event settlement acceptable to the taxpayer is not otherwise reached, the taxpayer claims any refund that he or she is entitled to for the years covered by the payments.  The IRS and courts will generally recognize some written documents in the IRS files that clearly show the taxpayer was claiming a refund.  A protective 1040X would be the best protection, but a straight-forward letter making the claim protective would probably work.  (Taxpayers pursuing this alternative should seek the guidance of an attorney in drafting the letter to pursue this opportunity.)  This type of letter could be submitted at any time before the refund statute of limitations closes.

3. Finally, if the taxpayer does neither of the above (or some reasonable equivalent), the taxpayer could always argue that the nature of the  program as reflected in the IRS's public pronouncements and in the written communications between the IRS and the taxpayers contemplated that, upon opt out, the taxpayer would be refunded the tax, penalty and interest for otherwise closed years.  Of  course, a taxpayer advised of the risk should take one of the two measures noted above and not have to try to rely upon the gambit in this third paragraph, but if it is all you have, go for it.