Federal Income Tax Update
By I. 2024 IRS Audit Statistics.
The 2024 IRS Data Book released in April 2025 contains audit statistics for years 2014 through 2022, as of the fiscal year ended September 30, 2024 (FY 2024). For tax years 2020 and earlier, the statute of limitations for audits had generally expired as of September 30, 2024. However, for 2021 and later returns, the statute of limitations has yet to expire, so additional returns of those years may be audited.
For 2014 through 2022, audit rates dropped significantly. For example, individual tax returns had an audit rate of 0.6% for 2014 returns versus 0.2% for 2022 returns. For individuals with income between $1 million and $5 million, the audit rate dropped from 2.7% for 2014 returns to 1.1% for 2022 returns.
The overall audit rate for C corporations dropped from 1.1% for 2014 returns to 0.2% for 2022 returns. For partnerships and S corporations, the audit rate for 2014 returns was 0.3% and 0.3%, respectively, compared to less than 0.05% for 2022 returns.
In FY 2024, 22% of audits were field audits. The other 78% were correspondence audits.
Below are the FY 2024 audit statistics for 2022 tax returns:
A. Audit Rates for Individual Tax Returns. During FY 2024, only 0.2% of individual income tax returns filed for 2022 were audited (same as for 2021 returns).
Total 2022 Individual Returns Audited in FY 2024: 0.2%
(1) No positive income 3%
(2) $100,000 to $200,000 1%
(3) $500,000 to $1 million 6%
(4) $1 million to $5 million 1%
(5) $5 million to $10 million 1%
(6) $10 million or more 4%
B. Audit Rates For Partnerships and S Corporations: For partnership and S corporations, the FY 2024 audit rate for 2022 returns was less than 0.05% (down from 0.1% for 2021 returns).
C. Audit Rates for C Corporations. C corporation returns filed for 2022 had an audit rate of 0.2% during FY 2024 (down from 0.3% for 2020 returns).
Total 2022 C Corporation Returns Audited in Fiscal Year 2024: 0.2%
(1) Assets $1 million to $5 million 0.2%
(2) Assets $5 million to $10 million 0.2%
(3) Assets $10 million to $50 million 1.1%
D. Offers in Compromise. For FY 2024, the IRS received around 33,600 offers in compromise but accepted only about 7,200.
E. Criminal Case Referrals. The IRS initiated 2,667 criminal investigations for FY 2024 and completed 2,481 cases. The IRS referred 1,794 cases for criminal prosecution (465 for legal source tax crimes, 806 for illegal source financial crimes, and 523 for narcotics-related financial crimes) and obtained 1,571 convictions. For convictions, 1,198 were incarcerated.
II. Taxpayer’s Assertion of Financial Disability Did Not Save a Late-Filed Refund Claim; Hamilton vs. US, 135 AFTR 2d 2025-1141.
In November 2021, Ms. Hamilton filed a refund claim with her original tax return for 2017 and claimed a tax refund for employment tax withholdings during that year. The 2017 return was clearly more than three years late, as the return was due on April 15, 2018. Ms. Hamilton, however, claimed the statutory period for asserting her claim should be tolled because her financial incapacity prevented her from perfecting the refund claim within the normal three-year statute of limitations.
The Tax Court explained the mechanical operation of Section 6511 to demonstrate the untimeliness of her refund claim. In seeking a tax refund, taxpayers must comply with two interrelated time limitation provisions: the limitation period of Section 6511(a) and the look-back period of Section 6511(b)(2).
Under the limitation period requirement, the taxpayer must file a refund claim within three years after the original return was actually filed. Because Ms. Hamilton’s claim for refund was made on her original return for 2017, the claim was necessarily filed within three years of the filing of that return. However, Ms. Hamilton’s refund claim was untimely under the look-back rule. Under the three-year look-back requirement, a taxpayer can claim a refund only for the portion of the tax actually paid during the three-year look-back period immediately prior to the tax return filing date of November 2021. All Ms. Hamilton’s taxes were withheld during 2017, which means they were deemed paid on the due date of the 2017 return, which was April 15, 2018. Therefore, no portion of her taxes were paid within the three-year look-back period that ended in November 2021.
Ms. Hamilton’s final argument was her refund claim was subject to tolling for financial disability under Section 6511(h). That section provides an individual may benefit from tolling if she shows she was financially disabled. Section 6511(h) provides the running of the limitation and look-back periods will be suspended during any period in which the individual is financially disabled. To establish financial disability, a taxpayer must submit certain documents with the refund claim. Revenue Procedure 99-21 sets forth the documentation requirements, including a written statement signed by a physician that includes the physician’s opinion that, during the period of disability, the taxpayer was prevented by virtue of physical or mental impairment from managing her own financial affairs. Ms. Hamilton submitted no such statement with her return but instead provided a physician’s statement with her IRS administrative appeal. In addition, the physician’s statement failed to include an opinion that Ms. Hamilton suffered from physical or mental impairment that prevented her from managing her financial affairs as required for tolling under Section 6511(h).
III. Limited Partners’ Share of Distributable Income Subject to Self-Employment Tax Under Functional Analysis Test; Soroban Capital Partners vs. Commissioner, TC Memo 2025-52.
Soroban Capital Partners, LP was an investment management limited partnership that earned income from managing investments. Soroban was owned, directly or indirectly, by three individuals, Mr. M, Mr. K and Mr. F (the “Principals”). Soroban’s sole source of income was its fees charged for managing client investments. Soroban managed eleven different investment funds. Soroban’s quarterly management fees were based on a percentage of the value of the funds. Some funds also paid Soroban annual performance compensation based on relative appreciation of the fund assets.
The Principals managed both the investments and operations of Soroban and the funds Soroban managed. The three Principals were responsible for daily risk management oversight by monitoring and hedging transactions. All three Principals served on committees that oversaw Soroban’s operations. The Principals exercised control over the daily operations of Soroban, including hiring and firing. All three Principals treated Soroban as their full-time jobs, working between 2,300 and 2,500 hours per year. The Principals were required to devote their full time and attention to Soroban’s business operations. Soroban’s advertising materials touted the unique skills and talents of the Principals. They stated investors will have access to the Principals’ unique talents, and the Principals “have worked together for over a decade and have demonstrated investment success managing teams and capital across asset classes, sectors, geographies and market cycles.”
Soroban and the Principals treated certain guaranteed payments as self-employment income while excluding from self-employment income the Principals’ shares of Soroban’s partnership income, which greatly exceeded the guaranteed payment amounts. In concluding self-employment taxes should have been paid on the Principals’ distributive shares of Soroban’s income, the court applied the functional analysis test, which determines whether the partnerships’ owners were generally akin to passive investors. Under that test, to exclude a partner’s distributive share of partnership income from self-employment net earnings, the surrounding circumstances must indicate their economic relationship with the partnership is generally one of a passive investment nature.
The court analyzed the Principals’ roles and responsibilities. The court reviewed the sources of Soroban’s income, the Principals’ roles in generating the income, and the relationship between the Principals’ distributive shares of Soroban’s income and any capital contributions they had made to the partnership. The court held the Principals’ distributive share of Soroban’s income is subject to self-employment tax. Each of the Principals participated in the management of Soroban and devoted virtually all of their working hours to Soroban. Soroban marketed the investment management expertise of the Principals. Also, the Principals’ insignificant capital contributions indicated their distributive shares of Soroban’s income were not returns on their investments in the partnership.
IV. Claim of Right Doctrine Allows Taxpayer to Deduct Overpayments Included in Prior Years’ Taxable Income; Norwich Commercial Group, Inc. vs. Commissioner, TC Memo 2025-43.
Norwich was a mortgage originator that erroneously over reported more than $7 million of taxable income on its 2007 through 2013 returns. The overreported income related to erroneous transfers of funds that Norwich and its primary lender treated as taxable loan origination fees. Norwich took a claim of right doctrine deduction of about $7.6 million on its 2014 tax return for amounts it repaid to its primary lender. As a mortgage originator, Norwich borrowed funds from its primary lenders and paid the borrowed funds to homebuyers in exchange for notes. Norwich sold the mortgage receivables to investors and remitted the sales proceeds received from the mortgage investors to its lenders to repay the funds Norwich borrowed. The lenders subtracted amounts Norwich owed them and transferred the remaining funds, representing Norwich’s mortgage origination fees, to Norwich.
During 2007 to 2013, Norwich used an outside CPA firm to prepare tax returns. Norwich relied on its CPA to reconcile the differences between amounts it owed to its primary warehouse lender and the amount of mortgage origination fees it had earned for the applicable tax year. The problem was Norwich’s primary lender had transferred significantly more funds to Norwich’s operating account than Norwich was entitled to receive as mortgage origination fees. That resulted in Norwich overstating its mortgage fees for 2007 through 2013. Both Norwich and its primary warehouse lender believed all amounts swept into Norwich’s operating account were Norwich’s earned fees from completed warehouse lending transactions.
In early 2014, Norwich realized the mistakes and notified its lender. Norwich agreed to pay the lender $7 million in over-advanced funds and offered additional collateral to secure its repayment obligations. Norwich fully satisfied its obligations by transferring over $7.5 million to the lender in 2014 and 2015 and claimed a $7.5 million claim of right deduction on its 2014 return. The IRS disallowed the deduction on the basis that the claim of right doctrine did not apply.
The claim of right doctrine originated under the 1932 Supreme Court case of American Oil Consolidated vs. Burnet, 286 US 417 (1932). The Court articulated the claim of right doctrine as follows:
If a taxpayer receives earnings under a claim of right and without restriction as to its disposition, he has received income which he is required to include on his return, even though it may still be claimed that he is not entitled to retain the money, even though he may still be adjudged liable to restore its equivalent.
Under the claim of right doctrine, if it later appears a taxpayer was not entitled to keep the money, it should be entitled to a deduction in the year of repayment. In other words, if income is received in one year under claim of right and without restriction but is required to be repaid, it is deductible in the year of repayment and not by amending the return for the year of receipt. After the decision in American Oil, Congress enacted Section 1341. It permits taxpayers, who would not be adequately compensated from a deduction allowable in a later year, to recompute their taxes for the year of receipt if they choose to do so. If the Section 1341 requirements are met, the taxpayer has two choices: he can deduct the item from the current year’s taxes or he can claim a tax credit for the amount his tax was increased in the prior year by including the erroneous item.
Norwich did not elect the alternative computation of taxes for the year of the deduction because its tax rates for 2007 through 2013 were not different from those for 2014. The IRS took the position Norwich’s payments in 2014 were repayments of loans rather than a deductible expense under the claim of right doctrine. The Tax Court, however, held Norwich’s prior years’ overreported income were subject to a claim of right deduction because they were income in the prior years rather than loans. The court ruled Norwich’s 2014 and 2015 repayments were deductible because they were erroneously reported items of income rather than repayment of loans.
The court also ruled, as an accrual basis taxpayer, Norwich was entitled to a 2014 deduction for amounts it repaid to its lender in 2015, as well as in 2014. Under both the claim of right doctrine and Section 461(h), economic performance occurred when Norwich entered into the repayment agreement with its lender. The court stated Reg. §1.1341-1(e) can be harmonized with Section 461(h) such that the proper year of the deduction is the one in which the obligation to restore an accrual basis taxpayer’s overstated income is secured by providing cash or collateral.
Keith Wood is an attorney with Carruthers & Roth, P.A. in Greensboro.