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Demutualization and the Mitigation Provisions — Part II

Posted on June 3, 2016

Yesterday, I posted the first part of this post, discussing the Illinois Lumber case, and the differing opinions on the treatment of basis in stock received from demutualized insurance companies.  Today’s post will focus on how the taxpayer attempted to use the mitigation provisions to get around the statute of limitations when it requested a refund of tax paid on a sale prior to the IRS changing its position on the treatment of the basis.

Mitigation – Reducing harm—in just a few situations.

As our readers know, Section 6511(a) imposes a three year statute of limitations.  It is a somewhat arbitrary cutoff, notions of fairness be damned, but useful for the administration of the tax system.  There are some statutory provisions in the Code that address unfair results of double taxation, or double non-taxation, in very specific stated circumstances outside of the limitations period.  The income tax mitigation provisions, found in Sections 1311 to 1314, have not been heavily covered in PT before.  Aspects of these provisions can be complicated (and the new edition of SaltzBook will have an updated Chapter 5 covering the material in depth),  but the general idea is that neither a taxpayer nor the government should be able to take opposite positions before and after the statute of limitations closes to their benefit.  Inconsistency is the key, and that allows the aggrieved party to potentially open a closed year.

Specifically, for the case at hand, Illinois Lumber argued that under Section 1313(a) there was a determination that fell within one of the circumstances listed under Section 1312, and the “party against whom the mitigation provisions are being invoked [here, the Secretary of the Treasury] has maintained a position inconsistent with the challenged erroneous inclusion of income”.  These would be the requirements for Section 1311(a) and (b) to apply, which would allow Illinois Lumber to open the time-barred year and obtain a refund for the tax it paid pursuant to the Service’s incorrect position. In addition, though, one of the paragraphs in Section 1312 would also have to apply, and the Service and the taxpayer agreed that only Section 1312(7) could apply in Illinois Lumber, which states:

(7)  Basis of property after erroneous treatment of a prior transaction.

(A)  General rule. The determination determines the basis of property, and in respect of any transaction on which such basis depends, or in respect of any transaction which was erroneously treated as affecting such basis, there occurred, with respect to a taxpayer described in subparagraph (B) of this paragraph , any of the errors described in subparagraph (C) of this paragraph .

(B)  …

(i)  the taxpayer with respect to whom the determination is made,…

(C)  Prior erroneous treatment. …

(ii)  there was an erroneous recognition, or nonrecognition, of gain or loss, …

Seems so simple.   Here, the taxpayer paid tax in a prior year based on the IRS’s published guidance that no basis was allocated to the stock.  Subsequently, the IRS reversed its position, and stated basis could be allocated to the stock, and the taxpayer attempted to obtain a refund, which the IRS denied because it was outside of the statute of limitations.  The only real issue was whether the IRS had been inconsistent, otherwise the Section would have applied.

Inconsistency – Inconsistent Court Cases, but here the 8th Says no

At the District Court level, the taxpayer prevailed, finding the Service had taken an inconsistent position by allocating no basis to the shares and then subsequently acquiescing to the Fischer holding.  The 8th Circuit didn’t view these clearly different positions as being “inconsistent” as required by the statute.

The Court did note that many commentators have indicated Section 1313(7) is the most problematic of the mitigation provisions (which are all fairly confusing).  That language was not really what the holding was about though.

In reviewing the “determination” relating to 2004 by the Service, the Eighth Circuit held that the determination had nothing to do with the basis of the property, how it was allocated, or who was taxed, as required under Section 1312(7)(A).  Instead, that determination was that the claim was untimely under the statute of limitations.  Further, as stated by the Court:

In our view, the answer to the mitigation question in this case becomes clear when we focus on the third prerequisite, an “inconsistency” that provides the party invoking the statute of limitations an advantage by “assum[ing] a position diametrically opposed to that taken prior to the running of the statute.” S. Rep. No. 75-1567, at 49, codified in § 1311(b)(1). There was no such inconsistency by the government in this case. First, the IRS did not actively change its longstanding position that mutual policyholders’ proprietary interests have a zero basis when an insurance company demutualizes. The Secretary simply acquiesced in the Federal Circuit’s rejection of that position. Second, focusing on the basis issue, the government gained no “unfair tax advantage by taking one position at the time of the acquisition of property and an inconsistent position at the time of its disposition.” S. Rep. No. 75-1567, at 50.

The Court looked to Brigham v. United States, 470 F2d 571 (Ct. Cl. 1972), which held:

The Revenue Ruling was, in effect, an acquiescence with the Brown decision of the United States Supreme Court…. The function of the ruling was acquiescence, not command…. The Commissioner has not attempted to exploit the statute of limitations by adopting an inconsistent stance for an open year. The Commissioner, to the contrary, has merely acceded to the plaintiffs’ demand for the open year. … In the factual pattern before us, adjustments for one year do not have a consequential effect on other years …. After a change in the interpretation of the law, the taxpayers are attempting to reopen closed years ….

The Court concludes with the following:

Had Illinois Lumber timely challenged the IRS’s position, as the taxpayer did in Fisher, it would have obtained a refund of the capital gains tax in 2004, as well as in 2006 and 2008. Having slept on its rights in 2004 beyond the applicable statute of limitations, it may not use the mitigation provisions to “awaken the sleeping dog.”

Although the conclusion by the 8th Circuit may be correct, I dislike somewhat the closing lines, although I am probably being too picky about the language. The part that bothers me is the reference to having to handle this like Fischer.  In this instance, the taxpayer is attempting to use the mitigation provisions to open the period after the statute, but the IRS had not changed its position as regard the specific taxpayer (it was not timely given the opportunity).  The refund request relating to 2004 essentially stated, “the law has changed, so I want my money back (especially because you gave it back for other years).”  There was no subsequent transaction. Or, as Prof. Timothy Todd phrased it in his post for Forbes, “[t]he case demonstrates the need for an actively maintained inconsistent position – not a mere ‘favorable change in, or reinterpretation of, the income tax laws.’”

For the mitigation provisions to apply, however, the taxpayer did not have to challenge the case to SCOTUS (which Fischer was willing to do), and they could have “slept” on these rights, but still used the mitigation provisions if the facts fell within the statute.  For instance, the taxpayer paid tax on the capital gains related to the sale of the interests in the shares. What if the taxpayer then sold the life insurance policy, which would generally result in capital gain for the difference of the basis and the sale price, and the IRS took the position that the basis should have been allocated to the shares and could not now be allocated to the policy?  That, I believe, would allow for mitigation.

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