A tax attorney might say that you should never go into an iffy transaction naked. This refers to a tax position that covers a real or perceived tax liability from a transaction.
This is a corporate tax concept. Larger corporations often have a longer view when it comes to business tax planning. Given their time horizon, they often have tax attributes from one year that carries over to later tax years. This tax attribute can prevent other tax positions from being apparent.
Take the simple example of foreign tax credit (“FTC”) carryovers. Unused FTCs carryover to future years. The IRS may not closely examine some transactions for taxpayers with unused FTC carryovers that are expected to expire unused in the short term.
Why would they? If any IRS adjustment would just result in FTC carryovers being used up and those FTCs would have just expired anyway, why bother? The answer is often that taxpayers can come up with transactions at the last minute to use up FTCs before they expire. The IRS may have passed on reviewing the transactions that occurred in the years leading up to the time the FTCs were used up. If the IRS was to adjust the underlying position, then the taxpayer would just not undertake the transaction to use up the FTCs. Maybe they would execute another transaction that adds additional FTCs. This type of tax planning would already be planned in advance and the taxpayer would simply wait to see what the IRS does on their account. This is an example of how a taxpayer may not go into a transaction naked.
There are quite a few variations of this type of cover. It can involve everything from tax basis, capital gains, gain recognition agreements, method changes, exchanges, loans, intercompany transactions, and even other deductions and credits.
This type of cover is often used when there are areas of law that are not clear. The thinking is that taxpayers shouldn’t have to live with the risk of unclear tax laws–particularly when the consequences are so large that they would disrupt the taxpayer’s business operations. Congress, the Treasury, and the IRS should do better to clear these issues up or provide a viable method to get an advance ruling. Absent that, this type of cover position can help smooth the taxpayer’s tax liability from year to year–which is particularly important for publicly traded companies whose investors do not appreciate large downward adjustments to share prices due to tax adjustments.
These opportunities are not always available to individual taxpayers. Most individual taxpayers do not have the varying tax attributes or engage in the transactions that larger corporations do.
The Goldring v. United States, No. 20-30723 (5th Cir. 2021) case provides an example that individual taxpayers can use. It addresses using a credit-elect as cover to avoid interest that would accrue on an uncertain tax position.
Facts & Procedural History
The taxpayer was a minority owner of a private business. The majority owners executed a tax-free merger. The merger resulted in the taxpayer’s shares being canceled and the taxpayer being awarded an amount computed based on a stated share price. This was in 1997.
The taxpayer filed suit and requested an appraisal of her shares. The litigation went on for quite some time.
In 2010, the litigation finally came to an end. The court concluded that the majority owners undervalued her shares. It determined that the share price was actually more than double the amount she was previously paid. The court also ordered pre- and post-judgment interest. The interest was $185,000.
The taxpayer reported the award and interest as capital gain on her 2010 income tax return. Knowing that the IRS might assert that the interest portion was not capital gain subject to lower tax rates, the taxpayer computed the amount of tax due as if the interest was ordinary income. She then remitted this amount of tax for 2010 and checked the box on her 2010 return to have the excess payment as a credit elect for the 2011 tax year.
The IRS eventually audited her tax return and determined that the interest portion was ordinary income. The IRS adjusted the taxpayer’s account for 2010 and assessed underpayment interest on the balance.
The trial and appellate court determined that the interest was ordinary income. The appeals court then addressed whether there was an underpayment given the credit-elect.
About the Credit-Elect
The term “credit-elect” refers to an overpayment in one year that the taxpayer elects to have applied to a later year. The taxpayer does this by noting that it is not asking for a refund, but rather asking the IRS to apply the overpayment to a later tax period.
On an individual income tax return, this is accomplished by entering the amount on Line 36. Line 36 says “Amount of line 34 you want applied to your 2021 estimated tax.”
The credit-elect is set out in Section 6402(b). These same regulations address refunds. They say that the decision to request a refund or make a credit-elect is an election. Readers of this site may know that an “election” is special. It refers to a decision one has to make and declare. They differ from accounting methods, which are also special.
Tax elections almost always trigger a corollary rule that once the election is made, it is irrevocable (which is the case for NOLs). They may also trigger a rule that the elections are not valid unless they are made on a timely filed tax return. Some of these rules even say whether the time period includes tax return extensions or not and which taxpayer has to make the election (such as elections for tip credits). Each election has its own rules like this.
Section 301.6402-3(d) confirms that the election to ask for a refund is irrevocable. One cannot change from a refund to a credit-elect. There is no such rule for going the other way. There is also no requirement that the credit-elect election is made on a timely filed tax return. Section 301.6402-3(a)(5) just confirms that the credit-elect is an election.
Once elected, the IRS has to record the credit as a payment on the next year’s income tax return account. The other consequence is that the taxpayer is not entitled to interest on this credit-elect amount. Thus, the taxpayer loses out on any interest it would have received on the overpayment.
No Underpayment Given Credit-Elect
This brings us back to this case. In this case, the taxpayer argued that the IRS had the use of her money during the entire time, and therefore, no interest should be charged.
The court considered the prior court cases that apply the “use-of-money” principle. The court states this principle as follows: “underpayment interest does not accrue for any period the IRS possesses sufficient funds from the taxpayer to satisfy the later-determined deficiency.” This looks to all of the taxpayer’s tax years collectively and asks whether the IRS has sufficient funds on account with the IRS.
The IRS’s position seems to be for a more narrow view. This view would consider each tax year individually. The Federal Circut had applied this narrow view in FleetBoston Fin. Corp. v. United States, 483 F.3d 1345 (Fed. Cir. 2007). The present appeal was in the Fifth Circuit. The Fifth Circuit court rejected the FleetBoston holding. This provides needed clarity to those in the Fifth Circuit, including taxpayers in Texas.
Those who do not want to pay interest to the IRS and who have a questionable tax position may want to consider the credit-elect rules. As demonstrated by this case, the credit-elect rules can allow the taxpayer to avoid interest on any underpayment while still allowing them to get the future benefit of any tax payments. This plus written tax advice to avoid tax penalties might make taking the uncertain tax position tax-neutral.