IRS Was Correct to Use Deficiency Procedures in Collecting Erroneous Refund

(Parker Tax Publishing March 2026)

The Tax Court held that the erroneous portion of a refund that the IRS issued to a taxpayer was a rebate refund, and not a nonrebate refund as argued by the taxpayer, and thus could be collected from the taxpayer through deficiency procedures. The court found that both the IRS and the taxpayer were fundamentally wrong in focusing on whether the error by the IRS was a "substantive recalculation" instead of whether the error led to a substantive recalculation of the tax imposed on taxpayer. El v. Comm'r, T.C. Memo. 2026-17.

Background

In 2021, Juliet El timely filed her 2020 Form 1040. Her 2020 income consisted of $6,881 of wages or similar income and $16,623 of unemployment compensation. El has one son, K.C., and she properly claimed a child tax credit (CTC) for him. Using Schedule 8812, Additional Child Tax Credit (ACTC), El determined that she was eligible for an ACTC of $1,400 with respect to K.C. On her return, El calculated an initial amount of federal income tax due of $488. This was reduced to zero on the basis of her entitlement to the nonrefundable portion of the CTC.

Altogether, El reported an overpayment of $5,271 (consisting of refundable credits of $1,400 (ACTC) and $2,913 (Earned Income Credit), and $958 of excess federal income tax withheld). She requested a refund of that amount by direct deposit. El instead received a refund of $21,035 via direct deposit.

El's IRS transcript showed that while processing her Schedule 8812, the IRS's computer system adjusted the amount of ACTC calculated on the Schedule 8812. The computer determined that the amount of the ACTC that El was entitled to was $17,164 (which corresponded to the amount of earned income El reported on her Schedule 8812). On the basis of this adjustment, the IRS increased El's total refundable credits to $20,077 and total overpayments to $21,035. Of that amount, $15,764 was issued by the IRS in error.

In July of 2023, the IRS mailed a Notice of Deficiency to El showing that she owed $15,764. Included was Form 4549, Report of Income Tax Examination Changes, showing a negative adjustment related to the ACTC of $15,764 that resulted in a balance due from El in that amount. El subsequently filed a Tax Court petition asserting that the IRS erred in issuing a deficiency notice. El argued that because a mere computer or clerical error caused the adjustment, there was no substantive recalculation of her ACTC and, therefore, the refund she received was a nonrebate refund.

The IRS filed a motion for summary judgment arguing that it adjusted El's ACTC causing the issuance of an erroneous rebate refund to her. Both sides agreed that the only issue for the court to decide was whether, as a matter of law, the erroneous portion of the refund the IRS issued was a rebate refund or a nonrebate refund.

Rebate Refunds and Nonrebate Refunds

A refund issued by the IRS can take one of two forms: a rebate refund or a nonrebate refund. Because a deficiency is defined as including any rebates issued, but not other refunds, that definition is the basis of the distinction between the two types of refunds. When the IRS mistakenly issues a rebate by misinterpreting the tax imposed on a taxpayer under the Code (i.e., the IRS mistakenly believes the taxpayer owes less), the IRS has issued an erroneous rebate.

The IRS has two methods in which it can recover erroneous rebate refunds: (1) file a refund suit in court pursuant to Code Sec. 7405, or (2) pursue a supplemental assessment by following the deficiency procedures. The latter is available because the erroneous rebate refund gives rise to a deficiency that revives a tax liability, thereby permitting a supplemental assessment. In contrast, since nonrebate refunds don't fit within the definition of a deficiency provided by Code Sec. 6211, the IRS is limited to a refund suit to recover those refunds. The IRS cannot use deficiency procedures to recover a nonrebate refund.

In Thomas v. Comm'r, T.C. Memo. 2014-18, the Tax Court held that the IRS issued a rebate refund when it mistakenly shifted the amount a married couple reported as their taxable Social Security benefit into a different box on their Form 1040 designated for reporting gross Social Security benefits received. The court reasoned that the refund was a rebate refund because it was based on a "substantive recalculation" of the taxpayers' tax imposed. This resulted in a deficiency equal to the amount of the IRS's erroneous rebate, and that deficiency was recoverable by the IRS through its deficiency procedures.

Both El and the IRS relied on Thomas for support of their respective positions. El argued that a simple substitution error does not involve any calculation and therefore cannot be a "substantive recalculation." The IRS, on the other hand, defended its mistake as a "recalculation" that was in essence a mistaken transposition of numbers on the return (i.e., the $17,164 being listed elsewhere by El as her earned income).

Analysis

The Tax Court held that the IRS was correct in using its deficiency procedures to recoup the $15,764 that El owed. The court said there was no disputing that the IRS substantively recalculated, albeit erroneously, El's tax for the 2020 tax year resulting in the issuance of a rebate refund to El of the difference between the IRS's mistaken calculation and the amount El reported.

The court analyzed the formula for calculating a deficiency. The court explained that under Code Sec. 6211(a), a deficiency is defined with the following formula: Deficiency = Tax Imposed - (Tax Reported + Prior Deficiency Assessments - Rebates). The court added that, where there is no prior deficiency, as in El's case, the formula is Deficiency = Tax Imposed - Tax Reported + Rebates. Citing Code Sec. 6211(a) and Code Sec. 6211(b)(1), the court observed that the "Tax Imposed" generally means the amount of tax required to be paid under the income tax provisions of the Code, while the "Tax Reported" reflects the amount calculated and reported by taxpayers on the face of their returns. The term "Rebate" describes an adjustment made by the IRS when it finds (or believes it has found) a mismatch between the tax imposed and the tax reported that favors the taxpayer.

According to the court, both the IRS and El made a fundamental error in analyzing whether a "substantive recalculation" occurred. The court found that both parties incorrectly directed their attention to whether the error (substituting El's earned income of $17,164 for the ACTC) was a "substantive recalculation" instead of whether the error led to a substantive recalculation of the tax imposed on El. Without reaching the question of whether a transposition or substitution error is a "substantive recalculation," the court found that the record amply supported the position that the IRS substantively recalculated El's overall tax. The court said this was the only correct place to direct the analysis: whether the taxpayer's tax imposed was recalculated. The court agreed with the IRS that the mechanism of the error does not resolve the issue. All erroneous refunds are issued because of some mistake, computation, clerical, or otherwise. But the court found that before the IRS may invoke the deficiency procedures, the critical question is whether there was a substantive recalculation of the tax imposed that gave rise to a rebate.

For a discussion of tax refunds and credits, see Parker Tax ¶261,100.

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