The US Supreme Court has granted an appeal to review the Ninth Circuit's ruling in the case of Moore v. United States.[1] Previously, the Ninth Circuit had declined a motion to reconsider the case en banc, despite four judges expressing dissent from the decision. The original panel had upheld the constitutionality of the IRC §965 transition tax, which was introduced as part of the Tax Cuts and Jobs Act.

The summary sheet posted on the Supreme Court’s website provided the following summary of the question presented in the case:

The Sixteenth Amendment authorizes Congress to lay “taxes on incomes ... without apportionment among the several States.” Beginning with Eisner v. Macomber, 252 U.S. 189 (1920), this Court’s decisions have uniformly held “income,” for Sixteenth Amendment purposes, to require realization by the taxpayer. In the decision below, however, the Ninth Circuit approved taxation of a married couple on earnings that they undisputedly did not realize but were instead retained and reinvested by a corporation in which they are minority shareholders. It held that “realization of income is not a constitutional requirement” for Congress to lay an “income” tax exempt from apportionment. App.12. In so holding, the Ninth Circuit became “the first court in the country to state that an ‘income tax’ doesn’t require that a ‘taxpayer has realized income.”’ App.38 (Bumatay, J., dissenting from denial of rehearing en banc).[2]

And the summary provides the following as the question presented by the case:

Whether the Sixteenth Amendment authorizes Congress to tax unrealized sums without apportionment among the states.[3]

History of the Transition Tax

As a component of the Tax Cuts and Jobs Act, Congress introduced IRC §965 to the Internal Revenue Code. The Internal Revenue Service (IRS) provides a concise overview of IRC §965 on its webpage titled "Section 965 Transition Tax." The summary is as follows:

Section 965 requires United States shareholders (as defined under section 951(b)) to pay a transition tax on the untaxed foreign earnings of certain specified foreign corporations as if those earnings had been repatriated to the United States. Very generally, a specified foreign corporation means either a controlled foreign corporation, as defined under section 957 (“CFC”), or a foreign corporation (other than a passive foreign investment company, as defined under section 1297, that is not also a CFC) that has a United States shareholder that is a domestic corporation. Section 965 allows U.S. shareholders to reduce the amount of the income inclusion based on deficits in earnings and profits with respect to other specified foreign corporations. The effective tax rates applicable to income inclusions are adjusted by way of a participation deduction set out in section 965(c). A reduced foreign tax credit applies to the inclusion under section 965(g). Taxpayers may elect to pay the transition tax in installments over an eight-year period.[4]

In this article, our primary objective is to highlight the proactive steps taxpayers can take to safeguard their right to file a claim for a refund regarding a specific portion of the Section 965 tax. While it is worth noting that the statute of limitations for filing a refund claim may not have expired for certain amounts of the 965 tax paid, it is crucial to be aware of the potential risk of expiration before a final resolution is reached in the case.

Statute of Limitations for Filing a Claim for Refund

The primary regulation that governs the timeframe within which taxpayers must file a claim for refund is outlined in IRC §6511. Specifically, IRC §6511(a) establishes the general limitations period for filing such claims:

(a) Period of limitation on filing claim. Claim for credit or refund of an overpayment of any tax imposed by this title in respect of which tax the taxpayer is required to file a return shall be filed by the taxpayer within 3 years from the time the return was filed or 2 years from the time the tax was paid, whichever of such periods expires the later, or if no return was filed by the taxpayer, within 2 years from the time the tax was paid. Claim for credit or refund of an overpayment of any tax imposed by this title which is required to be paid by means of a stamp shall be filed by the taxpayer within 3 years from the time the tax was paid.

The available amount of refund for the taxpayer is specified in IRC §6511(b):

(b) Limitation on allowance of credits and refunds.

(1) Filing of claim within prescribed period. No credit or refund shall be allowed or made after the expiration of the period of limitation prescribed in subsection (a) for the filing of a claim for credit or refund, unless a claim for credit or refund is filed by the taxpayer within such period.

(2) Limit on amount of credit or refund.

(A) Limit where claim filed within 3-year period. If the claim was filed by the taxpayer during the 3-year period prescribed in subsection (a), the amount of the credit or refund shall not exceed the portion of the tax paid within the period, immediately preceding the filing of the claim, equal to 3 years plus the period of any extension of time for filing the return. If the tax was required to be paid by means of a stamp, the amount of the credit or refund shall not exceed the portion of the tax paid within the 3 years immediately preceding the filing of the claim.

(B) Limit where claim not filed within 3-year period. If the claim was not filed within such 3-year period, the amount of the credit or refund shall not exceed the portion of the tax paid during the 2 years immediately preceding the filing of the claim.

While additional subsections present various special rules, the main focus for most taxpayers making installment payments for the §965 transition tax will primarily revolve around the aforementioned provisions.

The §965 Transition Tax and the Special Installment Payment Option

Under IRC §965(a) impacted taxpayers had to include the following amounts in their income:

(a) Treatment of deferred foreign income as subpart F income. In the case of the last taxable year of a deferred foreign income corporation which begins before January 1, 2018, the subpart F income of such foreign corporation (as otherwise determined for such taxable year under section 952) shall be increased by the greater of --

(1) the accumulated post-1986 deferred foreign income of such corporation determined as of November 2, 2017, or

(2) the accumulated post-1986 deferred foreign income of such corporation determined as of December 31, 2017.

In the case where both the corporation and the individual follow a calendar year for tax purposes, the taxpayer would have reported the relevant amounts in their income on their 2017 calendar year tax return.

Congress, recognizing that the amount of tax due could be substantial, provided an election for taxpayers to pay the tax due over eight annual installments under IRC §965(h):

(h) Election to pay liability in installments.

(1) In general. In the case of a United States shareholder of a deferred foreign income corporation, such United States shareholder may elect to pay the net tax liability under this section in 8 installments of the following amounts:

(A) 8 percent of the net tax liability in the case of each of the first 5 of such installments,

(B) 15 percent of the net tax liability in the case of the 6th such installment,

(D) 25 percent of the net tax liability in the case of the 8th such installment.

(2) Date for payment of installments. If an election is made under paragraph (1), the first installment shall be paid on the due date (determined without regard to any extension of time for filing the return) for the return of tax for the taxable year described in subsection (a) and each succeeding installment shall be paid on the due date (as so determined) for the return of tax for the taxable year following the taxable year with respect to which the preceding installment was made.

The special installment payment election allows taxpayers who choose to take advantage of the installment payment option to make payments over a span of eight years, despite the fact that the tax amount was calculated and reported on the 2017 tax return.

Based on the given circumstances, it appears that for a calendar year taxpayer with an affected calendar year corporation, the tax return referenced in IRC §6511(a) would be the individual's 2017 return. The due date for that return, assuming no extension was requested, would have been April 15, 2018. The three-year period mentioned in §6511(a) would have expired on April 15, 2021. In the event an extension was requested, the latest possible expiration date would have been October 15, 2021.

It is important to note that taxpayers making installment payments for the §965 transition tax only made a single installment payment with that first return. Assuming the taxpayer did not choose to accelerate the payment of the tax, either voluntarily or due to actions that would trigger immediate acceleration under IRC §965(h), they would have continued making such payments annually up to the present year.

Although the statute of limitations for claiming a refund based on the date of filing the tax return may have expired (unless certain events occurred to keep the statute open), it is worth noting that a refund claim could still be eligible for payment concerning any installment payments made within the two-year period before the claim is filed. Additionally, potential refunds could also cover future payments if the IRS approves the taxpayer's claim for a refund.

However, a significant challenge persists. The Moores’ case has not been resolved yet, and at best, a decision will not be reached until sometime in 2024, likely after the expiration of the statute for obtaining a refund on April 15 on payments made in 2022. Furthermore, even if the Supreme Court rules in favor of the Moores, there is a possibility that the case could be remanded back to the trial court for further findings, which would block the availability of refunds for additional years’ payments if the taxpayer waits for the Moores’ result.

A viable solution to address this challenge lies in the concept of a protective refund claim.

Protective Refund Claims

A protective claim refers to a refund claim that a taxpayer files with the IRS, requesting the agency to withhold processing until a specific contingency is resolved. In the case of a pending Supreme Court decision that would determine the constitutionality of a tax, such as the question at hand, a protective claim can be utilized to await the outcome before the IRS determines whether to approve or deny the claim. This allows taxpayers to safeguard their refund rights while awaiting a definitive resolution on the constitutional issue.

The Internal Revenue Manual provides guidelines and procedures concerning the handling of a protective claim for refund. While it is conceivable that a court may deem a protective claim valid even if the IRS procedures are not strictly followed, it is advisable to adhere to the prescribed procedures to ensure a smooth process and minimize the risk of the IRS rejecting the claim, with a potential agreement from the court. Following the established procedures enhances the chances of a favorable outcome and strengthens the validity of the claim in the eyes of both the IRS and the court.

IRM 4.10.11.2.1.3(4) (09-04-200) provides the following description of the reason that protective claims for refund are filed:

(4) In some instances, a claim may be filed by the taxpayer in anticipation of an expected change in the tax law, other legislation, regulations, case law, or other contingency. A “protective claim” is a claim for credit or refund filed by the taxpayer to preserve the right to pursue a refund based on the resolution of an issue contingent on future events that may not be determinable until after the refund statute has expired. Taxpayers file protective claims to ensure they meet the timeliness requirement.

The Internal Revenue Manual (IRM) provides guidance on the various types of contingencies for which a taxpayer may file a protective claim.

(1) Protective Claims may be informal claims, formal claims, or amended returns for credit or refund normally based on expected changes in a:

Current Regulation
Pending legislation or
Current litigation[5]

Of particular relevance to this matter is the provision outlined in IRM 21.5.3.4.7.3.1 (09-10-2013):

1) Any claim identifying a pending court case or decision should be considered a Protective Claim.

What must be in such a protective claim? The IRM continues to describe what should be found in a valid protective claim for refund:

With regard to the requirements of form and content, a protective claim must be in writing, include the taxpayer’s name, address, TIN and signature, identify the contingency affecting the claim, be sufficiently clear and definite to alert the IRS as to the essential nature of the claim, and identify the specific year(s) for which the refund is sought. The exact amount of refund requested may not be known at the time the claim is filed. See IRM 25.6.1.10.2.6.5, Protective Claims, for additional information.[6]

IRM 21.5.3.4.7.3.2(3) and (4) (10-21-2009) provides that all claims will be checked for the following items before sending them on to Examination:

(3) Protective Claims must be processible before sending to Examination Classification. Screen all Protective Claims for:

Statute timeliness
Completeness
Signatures

(4) If the claim is not processible, call or correspond with the taxpayer for all missing information. Refer to IRM 21.3.3.5.1.1, Suspense Time Frames, for information on suspense periods. Follow normal adjustment procedures for rejecting the claim if no reply is received.

According to IRM 25.6.1.10.2.6.5(3), the Internal Revenue Service (IRS) has discretion in determining how to process a protective claim for refund. While the IRS is not obligated to hold the claim pending the resolution of the contingency, it is generally considered to be in the best interest of all parties involved to put the claim on hold and await the outcome of the contingency. This approach ensures a more coherent and efficient handling of the claim, aligning with the interests of both the taxpayer and the IRS.

(3) The Service has discretion in deciding how to process protective claims. In general, it is in the best interests of the Service and taxpayers to delay action on protective claims until the pending litigation or other contingency is resolved. Once the contingency is resolved, the Service may obtain additional information necessary to process the claim and then allow or disallow the claim.

Mechanical Issues

The process of filing a protective claim for a unique scenario like the Section 965 transition tax installment payments may present some complexities. While the IRS instructions typically require using Form 1040-X for any income tax-related claims, the specific nature of these installment payments may not align well with reporting on Form 1040-X. However, it’s important to note that the actual tax computation, which would be zero if the taxpayers prevail in Moore, exists only on the 2017 or 2018 Form 1040.

Reg. §301.6402-2(c) provides that “[i]f a particular form is prescribed on which the claim must be made, then the claim must be made on the form so prescribed.” The same provision goes on to note that “[a]ll claims by taxpayers for the refund of taxes, interest, penalties, and additions to tax that are not otherwise provided for must be made on Form 843, ‘Claim for Refund and Request for Abatement.’”

The most recent version of the instruction for Form 843 provides:

Do not use Form 843 when you must use a different tax form.

Use Form 1040-X, Amended U.S. Individual Income Tax Return, to change any amounts reported on Form 1040, 1040-SR, 1040A, 1040EZ, 1040-NR, or 1040-NR-EZ, to change amounts previously adjusted by the IRS, or to make certain elections after the prescribed deadline (see Regulations sections 301.9100-1 through -3).

Based on the available guidance as of late June 2023, it is indeed indicated that filing a Form 1040-X to revise the 2017 tax return would be the appropriate approach for claiming the refund. As previously mentioned, the protective claim must be in writing and include

The taxpayer’s name,
Address,
Tax identification number, and
Signature.[7]

Additionally, the claim must:

Clearly identify the contingency affecting the claim, which in this case would be the US Supreme Court’s decision in the Moore case and any subsequent court actions directed by the Supreme Court to lower courts.
Be sufficiently clear and specific to inform the IRS about the essential nature of the claim, namely the potential reduction of the Section 965 transition tax reported on the 2017 or 2018 tax return.
Identify the specific year(s) for which the refund is sought. It is crucial to provide a careful explanation that refunds are being sought for installment payments previously made, for which the statute of limitations remains open at the date the claim is filed. Additionally, any payments made during the period when the dispute’s resolution is under consideration by the courts should be included as part of the claim as each payment is made.[8]

Although the three-year statute of limitations for refund claims based on the date of filing of the 2017 or 2018 return will have expired, the deferred tax payment installment structure allows for two payments to be made within the two-year statute for claiming a refund (i.e., within two years after the date the tax is paid) for taxpayers who have been making payments according to the schedule.

Certainly, in situations where the taxpayer is not facing an imminent expiration of a potential statute, it may be advisable for an advisor to consider delaying the filing of the protective claim. This approach allows for the possibility of the IRS releasing specific guidance to address the unique nature of the Form 965 installment payment regime and provide clearer instructions on the appropriate format for such protective claims.

By staying informed and monitoring any updates or guidance from the IRS, taxpayers and their advisors can ensure that the protective claim is filed in accordance with the most up-to-date instructions and requirements. This approach helps to mitigate any potential uncertainties and increases the chances of a smooth and successful claims process.

[1] Moore v. United States, cert. granted, Case 22-800, June 26, 2023, https://www.supremecourt.gov/orders/23grantednotedlist.pdf (retrieved June 27, 2023)

[2] 22-800 MOORE V. UNITED STATES, June 26, 2023, https://www.supremecourt.gov/qp/22-00800qp.pdf (retrieved June 27, 2023)

[3] 22-800 MOORE V. UNITED STATES, June 26, 2023

[4] “Section 965 Transition Tax,” IRS website, Last Reviewed or Updated February 3, 2023, https://www.irs.gov/businesses/section-965-transition-tax#:~:text=What%20is%20section%20965%3F,repatriated%20to%20the%20United%20States. (retrieved June 27, 2023)

[5] IRM 21.5.3.4.7.3(1) (10-01-2018)

[6] IRM 4.10.11.2.1.3(4) (09-04-2020)

[7] IRM 4.10.11.2.1.3(4) (09-04-2020)

[8] IRM 4.10.11.2.1.3(4) (09-04-2020)