IRS approving most NOL carryback claims with little vetting

Accounting

The Internal Revenue Service issued billions of dollars in tax refunds to companies claiming net operating losses for prior years after passage of the CARES Act, but did little to examine the merits of claims, according to a new report.

The report, released Tuesday by the Treasury Inspector General for Tax Administration, examined the IRS’s efforts to administer a provision in the COVID-19 relief package that Congress passed in March 2020 giving companies a special five-year carryback period for net operating losses for tax years beginning in 2018, 2019 and 2020, with some exceptions. To get the tax refunds, corporations only had to file Form 1139, Corporate Application for Tentative Refund, with the IRS.

The provision provided a boon to companies trying to cope with the economic fallout from the COVID-19 pandemic, but like many of the other relief provisions it was also exploited as the federal government rushed trillions in relief out the door. The report found that during the period from March 27, 2020, to March 31, 2021, 17,537 taxpayers submitted Form 1139 involving carrybacks to cover 19,262 loss tax years. The IRS issued a total of $17.4 billion in tentative refunds to 12,119 of these taxpayers. However, little verification was going on, at least initially.

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Internal Revenue Service headquarters in Washington, D.C.

Samuel Corum/Bloomberg

“Despite the large volume of Forms 1139 submitted, the business tax returns selected for examination represent a relatively low percentage of net operating loss tax years claimed on the Form 1139,” said the report. “From March 27, 2020, through July 26, 2021, the Small Business/Self-Employed Division selected a total of 12,760 Forms 1120, U.S. Corporation Income Tax Return, for examination of which 36 (less than 0.30%) involved a ‘loss’ year claimed on the Form 1139. Similarly, the Large Business and International Division selected a total of 5,214 Forms 1120 for examination of which 406 (7.8%) involved a ‘loss’ year claimed on the Form 1139. Further, the IRS is not assessing the potential risk these CARES Act provisions pose to tax administration in order to determine whether to adjust examination coverage.” 

The IRS didn’t let all of the refund applications go unexamined. TIGTA reviewed eight of the Form 1120 examinations that the IRS’s Small Business/Self-Employed Division closed and found the IRS examinations resulted in return adjustments on five cases (62.5%) that reduced the net operating loss that was carried back. However, according to the net operating loss provisions in the Tax Code, part of the tentative refunds issued in the five cases should have been recaptured, but the IRS examiner didn’t always take steps to recapture the tentative refund issued to the taxpayer. TIGTA did similar reviews of Large Business and International Division examination cases and did not find any exceptions. 

After TIGTA shared its findings with the IRS Small Business/Self-Employed Division, management took immediate corrective actions to update the examination guidance for both the Small Business/Self-Employed and Large Business and International Divisions and is in the process of taking the steps necessary to recover the excess tentative refunds they issued. 

In the report, TIGTA recommended that the Small Business/Self-Employed Division track and monitor the examination results for the 25 open examinations of Forms 1120 with reported net operating losses and an associated Form 1139 presented in its report, excluding Joint Committee Refund cases. (These are cases in which the IRS must review a refund or credit of more than $2 million, or $5 million for C corporations, and provide a report to Congress’s Joint Committee on Taxation. A Joint Committee Refund Case is assigned to an IRS examiner and either examined or surveyed. The tentative refund claimed on the Form 1139 could give rise to a Joint Committee Refund Case, and the tentative refund could be paid prior to the IRS’s review.) TIGTA also suggested the IRS should use the examination results from that recommendation to assess whether to increase the number of examinations of Forms 1120 with reported net operating losses and an associated Form 1139; and it should review the examination results and computations of proposed net operating loss adjustments for the 25 open examinations presented in this report (excluding Joint Committee Refund cases), to determine if the interim guidance regarding net operating losses is being properly followed. 

IRS officials agreed with all three of TIGTA’s recommendations. However, they pointed out that Congress has frequently changed the laws relating to net operating losses, and the IRS has struggled to keep up with all the changes.

“Between 2018 and 2021, tax laws related to NOL deductions changed three times,” wrote Lia Colbert, commissioner of the IRS’s Small Business/Self-Employed division. “At the time of this report, CARES Act provisions have expired and TCJA (Tax Cuts and Jobs Act) provisions are in place, which limit the deductibility of NOLs for tax years beginning after Dec. 31, 2020.”

She pointed out that corporations can claim NOL deductions not only on the Form 1139, but also Form 1120-X, the amended corporate tax return, but the IRS prioritized the 1139. “The processing of Forms 1139 is a priority, and we established a process to intake and facilitate processing,” she wrote. “Although a backlog of unprocessed tentative refund applications remain, IRS is taking steps to address this backlog as quickly as possible.”

With the enactment of the CARES Act, she added, the IRS performed its due diligence in evaluating the audit compliance risk associated with the changes to NOL deductions, just as it did with the changes under the TCJA back in 2017, but determined it did not change the audit risks. “We continue to verify the accuracy of requests for refund as they were received, processed and evaluated for audit potential,” Colbert added. “We also verify the accuracy of NOLs as part of the examination of a loss year return or when included as a carryback or carryforward.”

The net operating loss carryback isn’t the only tax break that companies may have been unduly exploiting. Another longstanding tax break, the Work Opportunity Tax Credit, was recently highlighted by the investigative news organization ProPublica, which found the WOTC was often going to temporary employment agencies that hired convicted felons as workers and soon laid them off. 

“ProPublica analyzed data from nine states’ WOTC applications and found that nearly a quarter of the jobs certified for the tax credit between 2018 and 2020 were with temp agencies,” said the report. “The numbers become even more striking when the analysis is limited to one eligible group — workers with felony records. Thirteen of the top 14 employers certified to get credits for those workers were temp agencies.”

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