Can an auditor adjust a corporation's Texas earned surplus based on a federal Form 1139 tentative-refund application carrying back an NOL?

Plain-English summary

This internal Tax Policy memo answers an auditor's question about adjusting a corporation's net taxable earned surplus after the taxpayer filed a federal Form 1139 (Application for Tentative Refund). (The STAR index mislabels the document as "Form 1130"; the letter itself addresses Form 1139.)

• The facts. The taxpayer carried back NOLs on a Form 1139, which reduced a prior-year charitable deduction and thereby increased that year's federal taxable income. The auditor believed a matching adjustment to net taxable earned surplus was warranted. The taxpayer objected that (1) a Form 1139 is not an amended return, and (2) a federal NOL is not deductible for earned surplus, so no adjustment should follow.
• Second argument rejected. Rule 3.555(f) provides that a corporation may take items in computing earned surplus only to the extent each item is included in reportable federal taxable income - which disposes of the taxpayer's NOL-deductibility argument.
• The "amended return" question is sidestepped. Rule 3.544(d)(4) requires an amended franchise report within 120 days of filing an amended federal return that changes net taxable earned surplus. Whether a Form 1139 (used instead of a Form 1120X, and which by itself may not be a claim for refund under 26 C.F.R. 1.6411-1(b)(2)) is such an amended return need not be decided here.
• Why it doesn't matter - the records rule. Tax Code Sec. 171.211 authorizes the Comptroller to investigate/examine a corporation's records, and Rule 3.544(e) lets the Comptroller examine financial statements, working papers, and other business papers. Because the Form 1139 and supporting schedules are "records of the corporation," an auditor may adjust net taxable earned surplus if those documents support the adjustment.
• A caution on the charitable deduction. The taxpayer's recalculation of its charitable deduction for the carryback year appears to conflict with IRC Sec. 170(b)(2)(C), which requires computing the charitable deduction without regard to an NOL - something the auditor may want to explore, though it would not change the conclusion that Form 1139 is a usable record.

Currency note: This letter describes the pre-2008 franchise tax (replaced by the margin tax effective January 1, 2008 under House Bills 3 and 3928). Treat it as historical.

What this means for you

Corporations filing federal carryback applications

Filing a Form 1139 instead of a Form 1120X does not shield the resulting figures from Texas review. Even if the Form 1139 is not itself an "amended return," its schedules are your business records, and the Comptroller can use them to adjust earned surplus. Reconcile any NOL-driven change to a prior-year deduction with the Texas earned-surplus computation.

Auditors

You do not have to win the "is Form 1139 an amended return" debate to make the adjustment - Sec. 171.211 and Rule 3.544(e) let you rely on the corporation's own records, including the Form 1139 and its schedules.

Common questions

Q: Is a Form 1139 an 'amended return' that triggers the 120-day amended-report rule?
A: The Comptroller found it unnecessary to decide, because the records-examination authority independently supports the adjustment.

Q: Does the NOL being non-deductible for earned surplus prevent the adjustment?
A: No. Rule 3.555(f) ties earned-surplus items to what is included in reportable federal taxable income, which disposes of that argument.

Q: What was the concern about the charitable deduction?
A: The taxpayer's recalculation appears to conflict with IRC Sec. 170(b)(2)(C), which computes the charitable deduction without regard to an NOL.

Citations and references

Statutes, rules, and regulations:

• Franchise Tax Rule 3.555(f), 34 Tex. Admin. Code - earned-surplus items allowed only to the extent included in reportable federal taxable income
• Franchise Tax Rule 3.544(d)(4), 34 Tex. Admin. Code - amended franchise report due within 120 days of an amended federal return changing net taxable earned surplus
• Franchise Tax Rule 3.544(e), 34 Tex. Admin. Code - Comptroller may examine the corporation's business records
• Texas Tax Code Sec. 171.211 - Comptroller may investigate/examine records to determine franchise tax liability
• 26 C.F.R. 1.6411-1(b)(2) - a Form 1139 by itself may not constitute a claim for credit or refund
• Internal Revenue Code Sec. 170(b)(2)(C) - charitable deduction computed without regard to an NOL

Source

• STAR search: https://star.comptroller.texas.gov/search?doc_type_code=L&tax_type_code=FIT
• Opinion: https://star.comptroller.texas.gov/view/200204921L

Original ruling text

April 3, 2002

Subject: Form 1139 - Is it an amended return?

Question: Taxpayer filed a federal Application for Tentative Refund (Form
1139). Taxpayer carried back net operating losses ("NOL"), which resulted in
the reduction of a charitable contribution deduction taken by Taxpayer in a
prior year. This reduction had the effect of increasing Taxpayer's line 28
federal taxable income for that prior year. The auditor believes a
corresponding adjustment to net taxable earned surplus should be made for the
applicable tax year, but Taxpayer opposes the adjustment on two grounds: (1)
filing a Form 1139 is not the filing of an amended return; and (2) because a
federal net operating loss is not deductible for earned surplus, there should
be no adjustment to earned surplus resulting from the carryback of an NOL.

Answer: Franchise Tax Rule 3.555(f) provides that "a corporation may take ...
items deducted in computing earned surplus only to the extent each item is
included in computing reportable federal taxable income." This disposes of
Taxpayer's second argument.

Franchise Tax Rule 3.544(d)(4) requires a corporation to file an amended
franchise tax report within 120 days after filing an amended federal income tax
return that changes the corporation's net taxable earned surplus." Therefore,
the issue of whether the filing of a Form 1139 constitutes a filing of an
amended return warrants further consideration.

Form 1139 is used to carryback a net operating loss, capital loss or certain
unused tax credits. Use of Form 1139 instead of Form 1120X is optional. As a
practical matter, filing Form 1139 usually results in a faster refund than the
filing of a Form 1120X. Generally, the Internal Revenue Service (IRS) must act
on an application within 90 days of its filing. In contrast, the IRS has 6
months to act upon the filing of a Form 1120X. If the IRS fails to act within
the 6 months, the taxpayer may then file a suit for refund.

Unlike the filing of a Form 1120X, the filing of a Form 1139 by itself may not
constitute a claim for credit or refund. See 26 C.F.R. 1.6411-1(b)(2).
However, a timely definitive analysis of whether filing a Form 1139 is the
filing of an amended federal income tax return for franchise tax, may be
unnecessary in this instance since another provision of the Texas Tax Code
appears capable of resolving the matter.

Texas Tax Code Section 171.211 authorizes the Comptroller to investigate or
examine a corporation's records to determine the franchise tax liability of the
corporation. Similarly, Rule 3.544(e) provides that the Comptroller "may
examine financial statements, working papers, registers, memoranda, contracts,
corporate minutes, and any other business papers used in connection with its
accounting system." Because a taxpayer's Form 1139 and supporting schedules
are "records of the corporation," an auditor may adjust a taxpayer's net
taxable earned surplus if those documents support the adjustment.

Taxpayer's recalculation of its charitable deduction for the year to which the
NOL was carried back appears to conflict with the provisions of IRC Section
170(b)(2)(C) which requires the computation of a total charitable deduction
without regard to NOL. The auditor may want to further explore with Taxpayer
this apparent conflict, which may affect the adjustment at issue, but it would
not change the conclusion that Form 1139 is a record that may be used to adjust
a taxpayer's net taxable earned surplus.

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