Refund Requests After Federal Adjustments: How Timely is Timely?

The South Dakota Supreme Court recently ruled that Citibank was not entitled to a franchise tax refund because the request was not submitted within the statue of limitations – even though the request was filed within days of the federal adjustment to its net income.

By Jess Johannesen, SALT senior associate

If you have ever endured an IRS audit where the result was an increase in federal taxable income, then after the audit was closed you most likely received a timely letter from each state in which you filed. Behind the scenes, the state received a transcript of the federal adjustments from the audit. Now, the state is letting you know that they know about the audit and that additional state taxes are likely due. In fact, states generally require taxpayers to file tax returns reflecting federal audit adjustments within a certain period of time following the audit, and the state has the ability to assess additional taxes within a specific time period after the audit even if the original statute of limitations for that tax year has expired.

On the other hand, what happens if federal taxable income decreases as a result of the audit? Do you recall if the state came back and said to you, “we’re sorry, here’s the extra state tax that we owe you”? That’s highly doubtful. What right do you have to file a state refund claim after the audit is concluded? Do you get additional time to claim your refund like the state does to assess you as noted above? Not necessarily. A recent South Dakota Supreme Court case illustrates a scenario that taxpayers need to be aware of in relation to IRS audits.

The South Dakota Supreme Court recently ruled that Citibank was not entitled to a $30 million bank franchise tax refund because the refund request was not submitted within the statute of limitations, even though the refund request was filed within days of the federal adjustment to its net income. [1] The IRS audited Citibank’s 1999, 2000, 2001 and 2002 federal income tax returns, and due to Citibank’s application of a new accounting method, the audit resulted in significant reductions in the company’s federal taxable income for each of the years under audit. The IRS audit was resolved in 2012 (the audit period had been extended by the parties), and Citibank then filed amended bank franchise tax returns with South Dakota reflecting its reduced taxable income. The South Dakota Department of Revenue denied the refund request because the refund claim was filed after the statutory three-year statute of limitations period expired. [2] Citibank argued that South Dakota regulations allowed it to file a refund claim after the expiration of the three-year statute of limitations because the regulation carved out an exception to the limitation period by allowing taxpayers to file a supplementary return for a tax year in which a decrease in income occurred due to a federal audit adjustment. [3]

The Court ultimately ruled that the statute’s language is “clear, certain, and unambiguous” in establishing the statute of limitations, since the statute requires that a refund claim be filed within three years from the earlier of the date the tax was paid or the date the return was due. The Court then stated that the regulations do not carve out a limited exception to the statute of limitations, but the regulation simply provides a procedural framework for when taxpayers may file supplementary returns for overpaid taxes. The Court noted that taxpayers are able to file such supplementary returns before an official IRS adjustment if a decrease in taxable income is anticipated. The Court noted that Citibank was aware of the change in accounting method and its impact on federal taxable income, and therefore could have filed a supplementary return at that time within the three-year statute of limitations period.

While the language in the South Dakota law is clear and unambiguous, the Court held a strict view in applying the law to Citibank. It is not intuitive to file a refund claim when a refund does not yet exist. However, this illustrates the importance of recognizing when a refund claim may exist and interpreting the state tax laws in order to determine when to file said refund claim, even if an official adjustment to federal taxable income has occurred. Next time you are going through an IRS audit, be sure to think through how and when this impacts your related state taxes and what actions you may need to take before the IRS audit is concluded. HA&W SALT team can assist you in navigating the state or local tax consequences of an IRS audit, and we can assist with your state or local tax audits.

Contact Jess Johannesen, SALT senior associate, at jess.johannesen@aprio.com or Jeff Glickman, partner-in-charge of HA&W’s SALT practice, at jeff.glickman@aprio.com for more information.

[1] Citibank, N.A. v. South Dakota Dept. of Revenue, 2015 S.D. 67, (S.D., 07/29/2015).

[2] S.D. Codified Laws § 10-59-19.

[3] S.D. Admin. R. § 64:26:02:06.

Any tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or under any state or local tax law or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. Please do not hesitate to contact us if you have any questions regarding this matter.

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