Recent Refund Case Highlights IRS Tactics and Informal Claim Doctrine

By Mark A. Turner

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At issue in Ebert was whether the taxpayer was entitled to a refund for taxes paid on survivor benefit payments (SBP) that were retroactively converted to dependency and indemnity compensation benefits (DIC). The former is taxable income while the latter is not—a fact about which there was no disagreement. The IRS, however, denied the refund for the following reasons:

• The taxpayer failed to satisfy the requirements for a refund claim.
• Payments received under the SBP program are “closed transactions” and cannot be later recharacterized for tax purposes.
• The taxpayer failed to prove she was not already reimbursed for the taxes paid under the SBP program.
• An unpublished disposition of a similar case was decided in favor of the IRS.

Formal Refund Claim Requirements

In mid-2001, Ebert, a nonresident alien residing in the Philippines, received notice from the U.S. Department of Veterans Affairs (DVA) that she was entitled to DIC payments, retroactive to 1999. The SBP payments were thus discontinued at that point and the larger, nontaxable DIC benefit began, retroactive to February 1999. Ebert then wrote the IRS requesting a refund for 1999, 2000, and 2001. The letter was accompanied by Form 1042-S (Foreign Person’s U.S. Source Income Subject to Withholding), which detailed her gross income and the amount of U.S. tax withheld. The total refund requested was $4,887, plus interest. In a motion for summary judgment, the IRS contended that Ebert had not satisfied the requirements for a tax refund claim.

The taxpayer bears the burden of proving entitlement to a refund. That burden must meet the requirements of Treasury Regulations section 301.6402-2(b). In theory, the claim “must set forth in detail each ground upon which a credit or refund is claimed and facts must be verified by a written declaration that it is made under the penalties of perjury.” Timely submission of an appropriate claim form is required to obtain a refund. IRC section 6511 requires that requests be within three years from the time the return was filed or two years from the time the tax was paid, whichever is later. The limit is two years from the time the tax was paid if no return was filed.

Generally, taxpayers claim refunds on tax returns when originally filed. For those who first filed Form 1040, 1040A, or 1040EZ, subsequent refund claims must be made on Form 1040X, as required by Treasury Regulations section 301.6402-3(a)(2). This procedure will meet the requirements of IRC section 6402 (which authorizes the Treasury Department to issue refunds, subject to other liabilities that might be owed to other federal agencies). Taxpayers who elect to have overpayments refunded may not thereafter change the election to have the overpayment applied as a payment of estimated income tax.

With respect to nonresident aliens such as Ebert, the tax return must contain the tax identification number and the entire amount of income subject to tax, “even if the tax liability for that income was fully satisfied at the source through withholding under chapter 3 of the Internal Revenue Code” [Treasury Regulations section 301.6402-3(e)]. A copy of Form 1042-S must be attached to the return. Nonresident aliens may not claim refunds if the withholding agent has already reimbursed them. Treasury Regulations section 1.1461-2 sets forth the procedure to ensure that the IRS is informed of any such reimbursement.

For taxpayers who have agreed to an overassessment of tax as determined by the IRS, a timely filed Form 870 or Form 890 is considered a valid refund claim. Grounds for the overassessment are considered the basis for the claim.

Refund claims are filed with the IRS service center for the district in which the tax is paid. For tax paid to the Director of International Operations, the refund claim, along with supporting evidence, is filed with the director. For taxpayers who successfully prevail in court, the Justice Department issues documents to the IRS authorizing a refund.

Informal Refund Claim Doctrine Requirements

In practice, the courts have not adhered to such a rigorous standard, but have developed their own “informal refund claim” standard. This doctrine originated with the Supreme Court’s ruling in U.S. v. Kales
(41-2 USTC para. 9785), which recognized a taxpayer’s right to claim a refund based upon an informal claim. In this case, the taxpayer paid a tax assessment, within the statutory period for filing a refund claim, and included a letter protesting the assessment. The letter asserted that if the value of stock sold (which gave rise to the income recognized) were to be revalued upward she would “claim a right to a refund.” When the stock was in fact later revalued, she claimed her refund. The Supreme Court recognized this informal claim entitling her to file suit in pursuit of her refund claim outside the limitation period.

This judicial doctrine requires that the taxpayer adequately apprise the IRS that a refund is sought for certain years. More specifically, an informal refund claim must do the following:

• Provide the IRS with notice that the taxpayer is asserting a right to a refund,
• Present the legal and factual basis for the refund, and
• Have a written component.

The written component need not encompass the taxpayer’s entire case. In addition, the written component can include oral statements of the taxpayer documented in written form by IRS personnel, and may precede the actual assessment of a tax [New England Electric System and Subsidiary Companies v. U.S. (95-1 USTC para. 50,069)]. The U.S. Court of Claims in New England Electric System noted:

A court must examine the facts and circumstances to discern whether the total mix of the written component and the particular facts indicate that the IRS knew or should have known that the taxpayer was asserting a right to a refund.

The court has consistently ruled that submission of Form 1045 does not constitute a refund claim, formal or informal. At best, “it informs the Commissioner of the possibility that petitioners have one or more claims for a refund. The form does not, however, assert the right to any refund, nor does it provide the legal or factual basis for any refund” [Larry J. Sumrall and Patricial A. Sumrall v. Commissioner, CCH Dec. 54,694(M)]. In contrast, Form 4868 (Application for Automatic Extension of Time to File U.S. Individual Income Tax Return) does constitute an informal refund claim, under the following circumstance: The taxpayer has made a designation on the form that the tax credit at issue is to be applied to another year’s tax liability. That is deemed sufficient to put the IRS on notice that the taxpayer was claiming a refund [E.J. Kaffenberger v. U.S. (2003-1 USTC para. 50,164) and AOD 2004-04].

In Kidde Industries, Inc. v. U.S. (98-1 USTC para. 50,162), the court determined that an informal claim need not be directed to the IRS official who will consider the claim. Rather, it is sufficient to direct the informal claim to those with sufficient related responsibilities to put the IRS on notice of the pertinent claim.

The informal claim doctrine as described in Ebert is most certainly a facts-and-circumstances doctrine:

The relevant inquiry is whether the claim is sufficient to notify the IRS that the party is asserting a right to a tax refund, and to enable the IRS to begin an examination of the claim. A plaintiff claiming a tax refund must prove her case by a preponderance of the evidence.

In Ebert, the court decided she had met the burden of proof. Ebert provided the IRS with a written request for a refund for each of the three years. She apprised the IRS of the factual and legal basis for the claim by stating that a refund was due as a result of the retroactive conversion of SBP payments into DIC payments. She also provided copies of Form 1040-S to substantiate the amount of the refund claim.

The Informal Claim Doctrine in Tax Planning

In Sullivan v. U.S. (2000-1 USTC para. 50,402), the court suggested a tax planning opportunity for those who find themselves in Ebert’s shoes. That is, Sullivan might have made an informal refund claim for the retirement income that potentially could be retroactively recharacterized as disability income. The court stated the following:

[I]n each instance when the Sullivans were filing tax returns and taking deductions for less than the 100 percent disability they felt Mr. Sullivan merited, plaintiffs could have announced their intention to claim a greater exemption in the future, transforming the joint returns also into protective assertions of present rights, should the amounts of the forward-looking claim become a reality.

This strategy can be taken too far. When refund claims are made, the taxpayer should establish the grounds for the refund. While the terms may be general, they cannot be indefinite. Comments like “the income items reported are not in fact income” are not sufficient without additional explanation. “Protective clauses” intended to permit the taxpayer to amend the claim with additional detail after expiration of the limitation period will not qualify.

A review of cases involving informal refund claims suggests a wide array of ways to meet the described requirements. This issue most often arises, however, when taxpayers wish to sue the IRS for a refund but have failed to make a formal refund request as described in Treasury Regulations section 301.6402-2. IRC section 7422(a) requires that in order to bring suit in court for the recovery of any internal revenue tax, a claim for a refund must have been filed timely with the Treasury Secretary, as required by law. In many cases, this formality has not occurred; hence, the courts have derived the “informal claim doctrine.” If such an informal claim occurred during the period of limitation, a suit can be filed and a refund might still be forthcoming. Absent a formal or informal claim, no suit may be filed.

Closed Transactions

The second argument offered by the IRS in denying Ebert’s refund claim was that the transactions were closed. In order to assess the tax effect of any transaction, it must be completed. For example, where property is sold subject to nonquantifiable subsequent events, no value can be placed on the transaction, and the tax impact must await the outcome of those events. The IRS argued that agreeing to Ebert’s refund claim would require a recharacterization of income previously realized and recognized. Closed transactions cannot be retroactively reclassified “if the transaction was unambiguous in character at the time it took place.” For Ebert, her SBP payments were unambiguously taxable and thus closed. Any subsequent conversion of those benefits into DIC payments (nontaxable) would not alter the previous tax reporting.

Administratively, the IRS position makes sense. Absent this principle, taxpayers with the benefit of 20/20 hindsight could attempt to recharacterize past transactions in order to obtain tax advantages. For example, what if a taxpayer’s closely held corporation relabeled last year’s salary as a dividend so as to enable a carryback of this year’s net operating losses? Permitting recharacterization of closed transactions would create an unwieldy administrative burden for the IRS.

Denial of Ebert’s request to recharacterize the taxable SBP payments as nontaxable DIC payments suggests a broader question: What can be altered on tax returns within the three-year period of limitation? Generally, refund claims fall into one of three categories:

• Amounts paid exceed the amount of correct tax,
• Mistakes are discovered on a return, or
• Carrybacks exist.

It is important that the grounds for any refund claim be clearly described. They may be stated in general terms but cannot be indefinite. A timely filed claim can be amended prior to expiration of the period of limitation. Subsequent amendments are permitted to clarify or modify grounds already identified, but no new grounds can be claimed after the limitation period.

Ebert’s refund claim was not due to a mistake, as the return was correct at the time of filing. Additionally, no carrybacks were claimed. The grounds for refund were based upon the fact that the amounts paid were in excess of the correct tax. The original tax computation was incorrect because SBP payments became DIC payments. Is this the same as a taxpayer’s recharacterizing previously claimed salary as dividend income when his controlled corporation decided to change the nature of the distribution?

The distinguishing fact in Ebert’s case hinges upon a nontax statutory authority to convert, retroactively, SBP payments to DIC payments. The right to receive nontaxable Veteran’s Administration (VA) disability benefits (DIC) rather than the already awarded taxable retirement benefits (SBP) is conditioned upon filing VA Form 21-651, which waives the right to the retirement pay to the extent of any disability pay, thus preventing double benefits to the same individual. Any award granted is effective upon the date of the application rather than upon waiver of the retirement income (38 USC section 5110). This factor contemplates retroactive effectiveness.

The effective date for excluding this award is date of application rather than date of approval by the VA. In Stickland v. Comm’r (76-1 USTC para. 9291), the court found that a retired Army colonel, who filed the VA 21-651 and then had retirement pay converted to disability pay as of the date of that filing, “cannot be charged with the eleven month delay” from time of filing to date of approval. “He had done all he could do and all the Veterans Administration required him to do.”

Retroactive reclassification in such cases, however, does not extend beyond the three-year period of limitation. In Sullivan, 100% of a retired Navy captain’s retirement pay was retroactively converted to disability pay. Refund claims associated with reported income outside the three-year window were not allowed. “The government’s delay in making its disability determination did not equitably estop the IRS from denying the refund because the limitations periods were not affected by equitable considerations.”

A favorable outcome for the taxpayer in Ebert would not necessarily mean open season for “closed transactions.” The factor that distinguishes this case from other attempts to reclassify completed transactions is the fact that recharacterization was controlled by a third party. Ebert did not employ hindsight to alter the nature of a past transaction, as contemplated in the hypothetical example above. Control by a statutory authority can effect a retroactive reclassification.

Proving That the Taxes Are Not Already Refunded

In its third argument, the IRS contended that Ebert had not shown that the DIC payments had not effectively reimbursed her for the tax withheld under the SBP program. The court did not accept this argument, stating that Ebert had met her burden by presenting documentary evidence of the facts, undisputed by the IRS. Moreover, it is well within the power of the government to produce documentation evidencing that the DIC payments effectively reimbursed her for the tax withheld. In a footnote, the court cited 28 U.S.C section 520(a), which states:

In suits against the United States in the United States Court of Federal Claims … founded on a … transaction with an executive department or military department … the Attorney General shall send to the department … a printed copy of the petition filed by the claimant, with a request that the department … furnish to the Attorney General all facts, circumstances, and evidence concerning the claim in the possession or knowledge of the department.

Furthermore, “vague assertions regarding purported deficiencies in the movant’s case are not sufficient to create an issue of fact.”

Does a Prior Pro Se Case Control?

The IRS’s final argument for denying the refund claim recommended that the court follow the decision in an unpublished related case. In Caba v. U.S. (2001-1 USTC para. 50,406), the taxpayer claimed a refund was due with respect to SBP payments that were converted into DIC payments. This case, however, differed from Ebert in one salient respect: The VA decision to convert the payment occurred after the taxpayer filed her complaint. Under the “substantial variance rule,” taxpayers are barred from presenting in a tax refund suit claims that “substantially vary the legal theories and factual bases set forth in the tax refund claim presented to the IRS” (Lockheed Martin Corp. v. United States, 2001-1 USTC para. 50,401). Furthermore, under the rule, “a ground for a refund that is neither specifically raised by a timely claim for a refund, nor comprised within the general language of the claim, cannot be considered by a court in a subsequent suit for a refund” (Ottawa Silica Co. v. United States, 83-1 USTC para. 9169).

IRS Tactics

Ebert provides some insight into how the IRS can dispute a refund claim. The first thing the IRS did was attempt to discredit the claim on the basis that all technical requirements were not met. Tax preparers are cautioned to “cross all the t’s and dot all the i’s” when requesting taxpayer refunds, especially if the refund may be challenged by the IRS. It is highly unlikely the IRS would employ the judiciary’s informal claim doctrine to circumvent formal refund requirements.

Next, when past transactions are recharacterized, expect the IRS to challenge the refund claims on the basis of the transactions being closed, even if they are within the limitation period.

Third, the IRS may expect taxpayers to bear the burden for proving that the refund has not already been realized, even though that information is already available to the IRS. This seems to be a particularly disingenuous tactic to derail refund claims.

Finally, in Ebert, the IRS offered support for its position in the form of cases that followed a similar but not identical fact pattern. It is not clear whether this was a deliberate attempt to undercut the refund claim or simply the result of poor research.

Court Standards for Pro Se Plaintiffs

To “level the playing field” for taxpayers pleading their own cases, the courts are more forgiving of improper procedure than might be allowed for members of the legal profession, who should know better. For example, in Haines v. Kerner et al. (404 U.S. 519), an inmate alleged he suffered injury during disciplinary confinement. Both the district and appeals courts dismissed his case because the inmate failed to state a claim upon which relief could be granted. The Supreme Court reversed, ruling that the inmate’s pro se petition though “inartfully pleaded” should be held “to less stringent standards than formal pleadings drafted by lawyers.” As noted in Conley et al v. Gibson et al (355 U.S. 41), the Federal Rules of Civil Procedure “reject the approach that pleading is a game of skill in which one misstep by counsel may be decisive to the outcome and accept the principle that the purpose of pleading is to facilitate a proper decision on the merits.” This leniency applies to attorneys and nonattorneys alike, with a focus on arriving at a just outcome. Rule 1 of the Federal Rules of Civil Procedure provides that all the rules “be construed and administered to secure the just, speedy, and inexpensive determination of every action.”

Ebert’s pro se complaint was held to this lower standard in the interest of fairness, however “inartfully pleaded.” It is not uncommon for taxpayers to argue their own case, and a variety of websites and books exist that instruct individuals on how to do so.

Advice for Taxpayers and Preparers

Besides the interesting nature of this pro-taxpayer pro se decision, Ebert also provides an opportunity to consider both formal refund claim requirements and the judiciary’s informal claims doctrine. Tax practitioners should be aware of the informal claims doctrine when concerned about meeting the statue-of-limitation requirements for filing refunds. A few fairly simple actions on the part of a tax preparer can preserve a future opportunity to pursue a refund.

Finally, Ebert provides insight into IRS tactics in challenging taxpayer refund claims. It is surprising how easily the court dismissed each IRS argument to rule in favor of the taxpayer. It is equally surprising that this case found its way to court, given the seeming weakness of the IRS’s arguments and the relatively small amount of money involved.