Taxing Lessons From Court Decisions

Decisions — Pushing the limit

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Extensions and exceptions aside, the IRS generally has three years from the date of the filing of a return to assess tax. (See internal revenue code sec. 6501(a)). Well – that’s true as long as the mitigation provisions in code sections 1311 through 1314 don’t apply. In seven specific circumstances, these provisions allow for the correction of an error that might otherwise be prevented by operation of law (such as the statute of limitations).

The mitigation provisions were first enacted as section 820 of the Revenue Act of 1938, and were included in the 1939 code as section 3801 and in the 1954 and 1986 code as sections 1311-1314.4. The provisions currently in effect reflect amendments to the 1938 provisions, but are substantially the same, and they apply to both the IRS and taxpayers. To qualify for relief, a “determination” (as defined in section1313(a)) must be made, the determination must have caused an error (as described in section 1312), any adjustment to correct the error must be barred by operation of law on the date of the determination, and the determination must adopt a position maintained by a party that is inconsistent with the error.

Essentially, when the mitigation rules apply, neither you nor the IRS can enjoy a “windfall” caused by currently treating an item inconsistently with its erroneous treatment in a closed year. For example, the provisions allow you to correct an error in the closed year where the same item was erroneously included or excluded from income or where the same item was allowed or disallowed as a deduction. The idea is to provide a remedy that puts you (or the IRS) in the position you would have been in if the item had been properly and consistently treated.

In T.C. Memo. 2016-33 (Costello), the taxpayer was a trustee for a trust established by her father. The trust was the beneficiary of the father’s individual retirement accounts, and those accounts were distributed to the trust in 2001. The trust, in turn, distributed the IRA funds to the beneficiaries of the trust.

The trust reported the IRA funds received as income on its 2001 federal income tax return. The return was filed prior to the due date of April 2002. Because the income was distributed to the beneficiaries, the trust paid no income tax. Instead, the beneficiaries reported the income on their personal returns and paid the resulting tax.

In 2004, the IRS audited the trust’s 2001 return. The taxpayer agreed to an extension of the statute of limitations for the return from April 2005 to April 2006. The IRS auditor determined that the tax on the distributions was owed by the trust rather than the beneficiaries. The auditor said the trust owed $80,302. The auditor also adjusted the 2001 individual returns of the beneficiaries to reflect refunds for the tax they had paid.

In November 2004, the taxpayer signed a form agreeing with the determination and waiving the trust’s right to appeal.

In January 2005, the taxpayer sent a personal check to the IRS as partial payment toward the trust’s 2001 tax liability. In March 2005, the IRS issued refunds to the beneficiaries. The beneficiaries then sent the refunds to IRS to pay the balance of the trust’s liability.

In November 2006, the taxpayer filed an amended tax return for the trust, claiming a refund of $80,302 for the 2001 tax year. The amended return reversed the IRS auditor’s determination that the trust owed the tax on the distributions, and reiterated the trust’s original position that the beneficiaries owed the income tax.

In August 2008, the IRS sent the taxpayer a letter accepting the trust’s refund claim. In August 2009, the IRS issued a refund check to the trust. The taxpayer endorsed and deposited the check in November 2009.

In September 2008, the IRS sent a notice of deficiency to each of the beneficiaries explaining that their gross incomes had been adjusted to once again include the trust distributions.

The beneficiaries (including the taxpayer) said the IRS could not adjust their individual tax returns because the statute of limitations had expired on those returns in April 2005. In addition, while not denying they received a windfall, the beneficiaries said the mitigation provisions did not apply. They argued that they did not maintain any active inconsistent position and that they did not change their positions since they originally filed their returns.

The IRS says the trust did not have to pay tax on the distributions on account of its successful claim for refund and the beneficiaries also received individual refunds that resulted from those same distribution items for the same tax year. The IRS argued the inconsistent tax treatment of those items resulted in an error that could not be corrected without applying the mitigation provisions and that the requirements for applying those provisions were met.


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Sorry, wrong answer :(
Right answer!

For the IRS.

We hold that:

(1) the IRS issued a determination regarding the trust’s claim for refund, which satisfies section 1313(a)(3)(A);

(2) because the IRS determination accepted the claim for refund of the trust, the correlating inclusion of taxable income had been erroneously excluded by the beneficiaries as described in section 1312(5);

(3) the beneficiaries’ 2001 returns, as of August 2008, could not be adjusted by operation of law;

(4) the trust maintained a position adopted by the IRS determination and that position was inconsistent with the erroneous exclusions of the beneficiaries’ 2001 returns as modified*; and

(5) the beneficiaries were related to the trust in 2001, the year of the error, and in 2006 when the trust first maintained its inconsistent position.

The IRS has satisfied all requirements and conditions of the mitigation provisions, and the period of limitations for assessment is thereby extended up to one year from August 2008, the date of the final determination.

Consequently, the notices of deficiency the IRS sent to the beneficiaries in September 2008, were timely, and the beneficiaries’ 2001 tax years are reopened for the limited purpose of correcting the section 1312(5) error.

*Editorial note: The court said that by signing a form agreeing with the determination (Form 4549) in January 2005, and accepting the refunds in March 2005, the taxpayer adopted a position that tax on the distribution income should be paid at the entity (trust) level. The trust first maintained its inconsistent position, tax treatment of the distribution income at the beneficiary level, when it filed its claim for refund in November 2006.

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