IRS not permitted to credit overpayments against subsequent year's potential deficiency.

The IRS National Office recently ruled that the Service had no authority to credit prior years' overpayments against a subsequent year's potential deficiency (Letter Ruling (TAM) 9739003).

The IRS based its holding on the fact that a potential deficiency was not an outstanding liability. In other words, crediting such overpayment against a potential deficiency was not allowed.

Moreover, the Service ruled that the taxpayer was entitled to additional interest on those overpayments for the period of the potential deficiency and was not barred by the statute of limitations (SOL) from making a claim for this interest. The National Office also concluded that, even though underpayment interest did accrue on the potential deficiency, the IRS was barred by the SOL from assessing and collecting interest on the potential deficiency

The taxpayer (T) timely filed a return and paid taxes for Year 1. On April 4 of Year 4, the taxpayer filed an application for tentative refund (Form 1139, Corporate Application for Tentative Refund) for Year 1 based on a net operating loss (NOL) and general business credit carryback from Year 3; the Service issued a refund on April 20 of Year 4. T's Year I return was examined and on August 31 of Year 4,T made an advance payment (including interest) to account for a proposed adjustment.

On September 21 of Year 4,T filed a second tentative refund application for Year 1, also based on a carryback from Year 3; the Service issued a second refund for Year 1 on November 2 of Year 4.

On October 4 of Year 4, the IRS assessed additional tax and interest in an amount equal to T's advance payment. The interest was computed from the due date of the Year 1 return (March 15 of Year 2) to the date of the advance payment (August 31 of Year 4). Both T and the IRS agreed that this interest was miscalculated because underpayment interest stopped accruing 011 March 15 of Year 4 (the due date of the Year 3 return that gave rise to the carryback). On December 6 of Year 10, T filed a claim for refund of this overpaid interest, the timeliness of which was questioned.

Also, some time after December Year 4,T filed Form 872, Consent to Extend the Time to Assess Tax, and agreed to extend the limitations period for Year 1 to December 31 of Year 8. On December 28 of Year 8, the Service accepted a Form 870-AD, Offer of Waiver of Restrictions on Assessment and Collection of Deficiency in Tax and Acceptance of Overassessment, reflecting an overassessment composed of a tax increase (the potential deficiency) and a tax decrease due to an additional NOL carryback from Year 3.

During this same period, T's account also reflected unrefunded overpayments for three tax years prior to Year 1. On February 17 of Year 9, the IRS applied these "pre-Year 1 overpayments" against the Year 1 potential deficiency. According to the Service, the credit was applied for the sole purpose of triggering Sec. 6601(f) and eliminating the underpayment interest due from March 15 of Year 2 to March 15 of Year 4. On February 12 of Year 9, the IRS issued T a refund for Year 1.

The first issue was whether the Service could credit T's pre-Year 1 overpayments against the potential deficiency for Year 1 that was eliminated by the NOL carryback. T argued that the IRS was without authority to make such a credit because a potential deficiency was not an outstanding liability. The Service asserted that the credit was made for purposes of triggering Sec. 6601(f) to reduce underpayment interest, but acknowledged that for all other purposes the potential deficiency was eliminated by the NOL carryback.

The second issue concerned the impact of the SOL on (1) T's right to receive a refund of additional interest on its overpayments; (2) T's right to receive a refund of overpaid deficiency interest; and (3) the IRS's ability to assess additional interest on the potential deficiency.

Citing Northern States Power, 73 F3d 764 (8th Cir. 1996), cert. denied, the National Office held that, because the potential deficiency was not an outstanding liability, the Service had no authority to credit pre-Year 1 overpayments. Since the IRS was not authorized to credit the prior years' overpayments, Sec. 6611(b)(1) did not apply Sec. 6611(b)(1) provides that, in the case of a credit, interest shall be allowed and paid from the date of the overpayment to the due date of the amount against which the credit is taken. Therefore, the Service ruled that interest accrued on the pre-Year 1 overpayments during the period of March 15 of Year 2 through March 1 5 of Year 4. As to the timeliness of the claim, the National Office stated that because the facts represented in those pre-Year 1 returns were resolved in December of Year 8,T fell within the six-year SOL under 28 U.S.C. Sections 2401 and 2501 for claiming this additional interest.

With regard to the Year 1 "potential deficiency" since the credit of overpayments was not authorized, additional underpayment interest did accrue during the period of March 15 of Year 2 through March 15 of Year 4. However, the Service was barred from assessing that additional underpayment interest; pursuant to the Form 872 that was executed, the period within which the potential deficiency could have been assessed and collected terminated by the end of Year S.

Finally, the IRS ruled that, since there was no authority to credit the prior years' overpayments, there was no payment for purposes of the period of limitations under Sec. 6511 (which governs the recovery of underpayment interest).While T had filed a claim for refund of the Year 1 deficiency interest that was erroneously paid in Year 4 on December 6 of Year 10, the Service concluded that to be timely, a claim must have been filed by the later of March 15 of Year 5 or two years from the date of payment.

FROM KATHRYN L. EVERIDGE, DALLAS, TEX.