Generally, when it comes to civil matters, state and Federal law includes various “statutes of limitations” and “discovery rules.”
The statute of limitations rules say that a claim has to be filed within a certain time period. The discovery rules say that the time period for the statute starts to run when the claim is discovered or discoverable. There are nuances to these rules–many of which extend or limit the applicability of the discovery rule.
When it comes to civil tax matters, our Federal tax laws include various statutes of limitations rules, but they do not include a comparable discovery rule. Instead of providing a discovery rule, our tax laws set out a strict deadline and then have claim or right, collateral estoppel, and mitigation rules that are exceptions to the strict statute of limitation rules.
These tax rules are much more complex and often fail to work as well as the discovery rules that apply outside of the tax realm. The recent Richard J. O’Neill Trust v. Commissioner, T.C. Memo. 2022-108, provides an example of this in the context of a settlement agreement with the IRS. The case shows how important it is to think through related adjustments in reaching settlements with the IRS.
Facts & Procedural History
The taxpayer was a revocable trust that owned a majority interest in an LLC.
The trust became irrevocable when the settlor died. After becoming irrevocable, the LLC sold assets and triggered income tax on the capital gain that the trust reported and paid.
The IRS audited the settlor’s Federal estate tax return. The IRS Office of Appeals settled the case by agreeing that the value of the LLC was $10 million more than reported on the estate tax return. It is hard to tell from the court case, but because the LLC was contributed to the trust during the settlor’s lifetime, it appears that the taxpayer was arguing that the increase in value impacted the LLC’s basis in the assets it sold. Thus, the trust reported a larger capital gain than it should have.
Eight months after the IRS settlement, the taxpayer filed a tentative claim for refund on Form 1045 for the 2014 tax year under a claim of right theory. The tentative claim for refund was to recover an overpayment of income tax paid by the trust for the 2009 and 2010 tax years.
The LLC did not file an amended partnership income tax return for 2009, 2010, 2014, or 2015. The trust did not file Form 8082, Notice of Inconsistent Treatment or Administrative Adjustment Request (AAR), with respect to RMV for 2009, 2010, 2014, or 2015.
The question for the court was whether the taxpayer, i.e., the trust, was entitled to a refund.
The Statute of Limitations
In this case, presumably, the taxpayer trust paid the income tax in 2010 and 2011. The decedent’s estate did not settle the estate tax issue with the IRS until 2014. Thus, by the time the taxpayer trust discovered the potential claim (which resulted from the IRS settlement), the statute of limitations would have expired. As noted above, a discovery rule would say that the statute of limitations did not start running until 2014.
Our tax laws are not as generous. Our tax laws provide a strict statute of limitations for filing a refund claim. The date the tax is paid is the triggering event–not the discovery of the overpayment. The tax law says that a claim generally has to be filed within two years of the later of the date of the original payment of tax or the date the tax is paid.
Our tax laws go on to provide other rules that can help avoid the harsh result created by these rules.
About the Claim of Right, Mitigation, & Equitable Recoupment
This brings us to the claim of right, mitigation, and equitable recoupment rules. Here is a summary of these rules from this court case:
- Claim of Right: instances in which a taxpayer includes an item in gross income for a prior taxable year because it appeared that the taxpayer had an unrestricted right to the item of income. A deduction is allowed after the close of the prior taxable year if it is established that the taxpayer did not have an unrestricted right to that item.
- Mitigation: allows for filing of a refund claim within one year from the date a proper determination becomes final. To claim the benefits of the mitigation provisions, a taxpayer must show that (1) there was a determination as defined by section 1313(a); (2) the determination falls within specified circumstances of adjustment set forth in section 1312; and (3) the party against whom the mitigation provisions are being invoked has maintained a position inconsistent with the challenged erroneous inclusion, exclusion, recognition, or nonrecognition of income as described by section 1311(b).
- Equitable Recoupment: for situations where the government has taxed a single transaction, item, or taxable event under two inconsistent theories. A claim of equitable recoupment requires that (1) the refund for which recoupment is sought by way of offset be barred by time; (2) the time-barred offset arises out of the same transaction, item, or taxable event as the overpayment or deficiency before the Court; (3) the transaction, item, or taxable event have been inconsistently subject to two taxes; and (4) if the subject transaction, item, or taxable event involves two or more taxpayers, there be sufficiency of interest between the taxpayers so that the taxpayers should be treated as one.
As one can imagine given the nuances noted above, each set of rules has its own set of rules. These rules dictate whether a taxpayer can use these provisions to obtain a refund.
These rules have to be applied to each fact pattern separately.
When It All Fails
In the present case, the court concluded that none of the rules allow the taxpayer to recover the taxes it overpaid.
The claim of right did not work as the partnership, not the trust, would have been the taxpayer that needed to file the refund claim. The court also noted that none of the capital gain proceeds had to be paid back by the trust, which would be required for a claim of right.
The mitigation rules did not work because the trust did not file an amended return for 2009 or 2010. It filed a refund claim for 2014. The court concluded that this was fatal as it could not allow a refund absent a claim being filed for the earlier years.
The equitable recoupment rules did not work as the estate’s estate tax is different than the trust’s income tax (if you want to read an example of equitable recoupment that was successful, you can find one here).
Problems with the claim of right, mitigation, and equitable recoupment rules often come up in cases like this one–i.e., cases where the taxpayer settles one or more issues with the IRS. Those settling cases with the IRS have to carefully consider collateral and other adjustments. As this case shows, this is particularly true if there are related parties and/or related taxes. These issues usually have to be anticipated and filed as protective claims with the IRS or factored into the settlement and/or reflected in a binding closing agreement. This is one area where advance tax planning can help.
The taxpayer, i.e., the trust