Rebate in Excess of Tax Shown on Return Increases Taxpayer's Deficiency

(Parker Tax Publishing October 2017)

The Tax Court held that, when the IRS makes a rebate to a taxpayer for a year in excess of the amount of tax shown on the taxpayer's return for the year, that excess increases the taxpayer's "deficiency," within the meaning of Code Sec. 6211(a). The court noted that it was explicitly holding what it said was implicit in several of its prior cases: the excess of the tax shown on a taxpayer's return over rebates made, for the purpose of computing a deficiency, can be a negative number, regardless of whether the IRS, in fact, made any rebates to the taxpayer for the year at issue. Galloway v. Comm'r, 149 T.C. No. 19 (2017).

On their 2011 federal income tax return, James Galloway and his wife, Sarah, claimed a $7,500 American opportunity tax credit (AOTC) credit under Code Sec. 25A for expenses related to their children's post-secondary education. The couple reported a total credit of $7,500 on Form 8863, Education Credits (American Opportunity and Lifetime Learning Credits), including a refundable portion of $3,000. They failed, however, to carry the $4,500 nonrefundable portion of the credit to their Form 1040. The IRS reduced the couples' tax liability by $4,500 in processing their return to take into account the nonrefundable portion of the credit and refunded $4,500 more to the couple than they had requested. After auditing the Galloways 2011 tax return, the IRS disallowed the $7,500 education credit in full and assessed a tax deficiency of $7,500 and a $1,500 accuracy-related penalty.

The Galloways subsequently conceded that they were not entitled to any credit under Code Sec. 25A for 2011. However, they argued that the IRS did not correctly compute their 2011 deficiency. According to the Galloways, the excess of the rebate the IRS made over the tax shown on their return (net of the refundable credit) should not have increased their deficiency from $6,984 to $7,500. They argued that their deficiency was $6,984.

Under Code Sec. 6211(a), the term "deficiency" means "the amount by which the income tax imposed exceeds the excess of the sum of the amount shown as the tax by the taxpayer upon his return plus the amounts previously assessed (or collected without assessment) as a deficiency, over the amount of rebates made." Code Sec. 6211(b)(2) defines a "rebate" as so much of an abatement, credit, refund, or other repayment, as was made on the ground that the income tax imposed was less than the excess of the amount specified in Code Sec. 6211(a) over the rebates previously made.

Before the enactment of the Technical and Miscellaneous Revenue Act of 1988 (TAMRA), taxpayers could not contest the IRS's disallowance of refundable credits in deficiency proceedings before the Tax Court where they had no tax liability, even after disallowance of the credits, and thus had no deficiencies. Congress amended Code Sec. 6211(b)(4) as part of TAMRA to remedy that situation. Under Code Sec. 6211(b)(4), any excess of refundable credits allowable over the tax, and any excess of reported refundable credits over the tax reported on a taxpayer's return, is taken into account as negative amounts of tax for purposes of Code Sec. 6211(a). Thus, the disallowance of refundable credits claimed by a taxpayer with no tax liability, even after that disallowance, would result in a deficiency because the tax imposed would be larger (that is, less negative) than the tax shown on the taxpayer's return.

The refundable portion of the AOTC is among the refundable credits to which Code Sec. 6211(b)(4) applies. Although the AOTC is generally limited to the taxpayer's tax liability, Code Sec. 25A(i)(5) provides that 40 percent of the credit is refundable to the taxpayer to the extent it exceeds the taxpayer's tax liability. The credits to which Code Sec. 6211(b)(4) applies include the credits allowable under Code Sec. 25A by reason of Code Sec. 25A(i)(5).

The IRS calculated the Galloways $7,500 deficiency as follows: $6,984 tax imposed - ($3,984 tax shown on return - $4,500 rebate). The $3,984 tax shown on the Galloways return - an amount with which the Galloways agreed - equaled the $6,984 total tax shown on line 61 of their 2011 Form 1040 reduced by the $3,000 refundable credit reported on line 66 of that form.

The IRS's position rested on the premise that the excess of the tax shown on a taxpayer's return over any rebates made can be a negative amount that increases the taxpayer's deficiency when the amount of the rebate exceeds the amount of tax shown. Because the excess of the tax shown on the return over rebates is subtracted from the tax imposed to arrive at the taxpayer's deficiency, if that excess is a negative number, subtracting it from the tax imposed will increase the taxpayer's deficiency.

The Galloways and the IRS agreed that the $4,500 additional refund was a "rebate," within the meaning of Code Sec. 6211(b)(2). The Galloways did not challenge the general proposition that, in computing a taxpayer's deficiency, the excess of the tax shown on a return over rebates can be a negative number. They alleged, however, that the proposition holds only "where no rebates exist." They argued that it does not follow from the general proposition that an "excess" of tax shown over the rebate exists when the IRS has made a "rebate" exceeding the positive tax shown on the return. According to the Galloways, the logical extension of the IRS's argument was that it would permit the IRS to manipulate the deficiency calculation by unilaterally issuing rebates whenever it benefitted the IRS. On the basis of that concern, the couple argued that their deficiency was limited to the tax imposed of $6,984.

The Tax Court rejected the couple's argument and held that, when the IRS makes a rebate to a taxpayer for a year in excess of the amount of tax shown on the taxpayer's return for the year, that excess increases the taxpayer's "deficiency," within the meaning of Code Sec. 6211(a). Thus, the court said, the Galloway's deficiency for 2011 was $7,500 ($6,984 - ($3,984 - $4,500)). The court noted that it was explicitly holding what it said was implicit in several of its prior cases: the excess of the tax shown on a taxpayer's return over rebates made, for the purpose of computing a deficiency, can be a negative number, regardless of whether the IRS, in fact, made any rebates to the taxpayer for the year in issue. Thus, the excess of the tax shown on a return over rebates can be negative not only when rebates are zero but also when, as here, the IRS has made a rebate of a positive amount.

Finally, the court also held that because the couple could not explain why they took the AOTC in the first place, they had not met their burden of proving the existence of reasonable cause for any portion of the underpayment resulting from the IRS's disallowance of the claimed AOC. As a result, the court upheld the IRS's assessment of the $1,500 accuracy-related penalty.

For a discussion of the calculation of a tax deficiency assessment, see Parker Tax ¶260,120.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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