Mitigation Provisions Allow the IRS to Reclaim Refund from Trust Beneficiaries Even Though IRS Exam Had Originally Created the Refunds

One of the more confusing areas of the tax law involves the mitigation provisions found at IRC §§1311-1314.  The case of Costello v. Commissioner, TC Memo 2016-33 deals with the potential application of these provisions to a trust and its beneficiaries that arose when the IRS made an assessment on the examination of the trust that it later agreed was in error.

The general rule of the mitigation provisions is found in IRC §1311(a) which provides:

(a) General rule

If a determination (as defined in section 1313) is described in one or more of the paragraphs of section 1312 and, on the date of the determination, correction of the effect of the error referred to in the applicable paragraph of section 1312 is prevented by the operation of any law or rule of law, other than this part and other than section 7122 (relating to compromises), then the effect of the error shall be corrected by an adjustment made in the amount and in the manner specified in section 1314.

The idea is that certain “unfair results” (be they unfair to the government or the taxpayer) that might arise due to items such as the statute of limitations may be remedied by these rules.  However, as the provision notes, it doesn’t fix all unfair results—only those that meet the specific “problems” found in §1312 and meet other requirements give rise to the adjustment.

In this case the IRS had examined a trust that had received a distribution from an IRA and, in the same year, had made distributions of that amount to the two beneficiaries of the trust.  At the conclusion of that exam the agent determined that the trust should have paid the tax rather than the beneficiaries.  Thus tax was assessed against the trust, but refunds were issued to each of the two beneficiaries. 

The trustee of the trust, who was one of the beneficiaries, signed the Form 4549 and waived the trust’s right to appeal the determination.  As well, each beneficiary signed a Form 4549 applicable to their own return to accept the changes in their returns that resulted in a refund.  The net result of these changes was that the trust owed $38,838 more to the IRS than the IRS owed to the beneficiaries.

Just less than two years later the trust filed an amended Form 1041 claiming a refund of taxes, claiming the trust should have allowed an income distribution deduction.  Upon reviewing the claim for refund the IRS agreed with that finding and accepted the trust’s refund claim.

Of course, in the interim the statute of limitations for assessments generally under IRC §6501(a) had expired on the individual returns.  So, unless the mitigation provisions apply in this case, the IRS would be “out of luck” with regard to the refunds that had been issued to the beneficiaries—refunds that would not have been due given that the IRA income should have been carried out to the beneficiaries and taxed to them on their 2001 returns.

The taxpayers initially suggested that the provisions shouldn’t apply because, after all, the IRS had created the problem in the first place by its erroneous holding in the examination which resulted in the refunds being paid which the beneficiaries had not originally requested. 

But the Court points out that the question of “fault” is not addressed in these provisions, noting:

It appears that petitioners are advocating that where the Government caused an error to come about, then the mitigation provisions should not be made available to it. However, these provisions equally apply to whoever made the mistake, and the IRS is entitled to correction of an error, if merited. See, e.g., Chertkof v. Commissioner, 66 T.C. 496, 503 (1976) (“The Government’s ‘fault’ in taking its first view--at least if it was done in good faith--was not to prevent it from collecting the revenue or to absolve the taxpayer from all tax on the item.”), aff’d, 649 F.2d 264 (4th Cir. 1981); see also Yagoda v. Commissioner, 331 F.2d 485, 490 (2d Cir. 1964) (“[T]he nature of the mitigation of limitations provisions * * * [is] remedial, not punitive.”), aff’g 39 T.C. 170, 180 (1962).

The Court then turns to the issue of whether this situation is one that triggers the application of the mitigation provisions.  The Court addresses the initial requirements as follows:

The following requirements must be met for relief under the mitigation provisions: (1) there must have been a “determination” as defined in section 1313(a); (2) that determination caused one of the errors described in section 1312; and (3) on the date of that determination, any adjustment to correct the error is barred by operation of law (other than a section 7122 compromise or these mitigation provisions). Sec. 1311(a); see Beaudry Motor Co., 98 F.3d at 1168. Respondent, as the party asserting mitigation, has the burden of showing its applicability. See Bradford v. Commissioner, 34 T.C. 1051, 1054 (1960); see also United States v. Rushlight, 291 F.2d 508, 514 (9th Cir. 1961) (addressing predecessor section 3801 of the 1939 Internal Revenue Code).

The IRS asserted that it met the tests, as the Court notes:

Respondent therefore asserts that the above requirements have been met, offering this frame of reference: (1) JVC Trust, through petitioner as a trustee, filed a claim for refund for which the IRS made a determination on August 8, 2008, that allowed the refund; (2) because that IRS determination accepted the income distribution deduction for JVC Trust (thereby eliminating the JH distributions as taxable income at the trust level), the correlating inclusion of the JVC Trust distributions (as taxable income at the beneficiarylevel) had been erroneously excluded by petitioners who had accepted refunds; and (3) as of August 8, 2008, petitioners’ 2001 returns, as modified by respondent’s examination, could not be adjusted by operation of law because the three-year period of limitations for assessment had expired.

The situation in question (inconsistent treatment of a trust and its beneficiaries) is one described in IRC §1312(5):

(5) Correlative deductions and inclusions for trusts or estates and legatees, beneficiaries, or heirs

The determination allows or disallows any of the additional deductions allowable in computing the taxable income of estates or trusts, or requires or denies any of the inclusions in the computation of taxable income of beneficiaries, heirs, or legatees, specified in subparts A to E, inclusive (secs. 641 and following, relating to estates, trusts, and beneficiaries) of part I of subchapter J of this chapter, or corresponding provisions of prior internal revenue laws, and the correlative inclusion or deduction, as the case may be, has been erroneously excluded, omitted, or included, or disallowed, omitted, or allowed, as the case may be, in respect of the related taxpayer.

However, the taxpayer argued that, in addition to the above, two additional conditions found in IRC §1311(b) must be me.  First, pursuant to IRC §1311(b)(1) there must be the maintenance of an inconsistent position and, second, the trust and beneficiaries must have a relationship of the type described in IRC §1311(b)(2). 

Or, more directly, the Court explains:

Thus, to succeed respondent must also show that (1) JVC Trust (the taxpayer with respect to whom the determination was made) maintained a position that it was not liable for tax on the 2001 distribution income, as adopted in the IRS determination, which was inconsistent with the tax treatments (i.e., erroneous exclusions) of the JVC Trust distribution income for petitioners’ 2001 tax years; and (2) petitioners were related to JVC Trust at the time it first maintained its inconsistent claim for refund position in 2006, as well as in 2001

The taxpayers note that the amended return merely corrected an erroneous position forced upon the trust by the IRS, and the parties never actively maintained an inconsistent position.  The Court, however, argued that the question of an inconsistent position depends on the relationship of the parties and if they were related when the trust filed the amended return, creating the inconsistent position.

The Court notes:

Under the mitigation provisions a “related taxpayer” is, as relevant here, a taxpayer who stood in a fiduciary-beneficiary relationship with the taxpayer with respect to whom a determination was made. Sec. 1313(c)(3). A beneficiary of a trust satisfies this definition. See Lovering v. United States, 49 F. Supp. 1, 2 (D. Mass. 1943) (determining, under predecessor section 3801 of the 1939 Internal Revenue Code, a relationship between a fiduciary trust and its beneficiary—even where the trust was treated as a corporation for tax purposes).

However, as the Court notes, this relationship had to exist both at the time the error was made (in tax year 2001 in this case) and when the trust first took its inconsistent position (when the claim for refund was filed in 2006).  The taxpayers argued that, as the trust’s final year of activity was 2003, no relationship could have existed in 2006 as the trust itself did not exist.

The Court did not accept this, noting that they had taken the position the trust had standing to request and receive a refund of taxes, but now were trying to argue that it simultaneously did not exist for purposes of the relationship test.  The Court noted that one of the beneficiary was acting in her capacity as trustee of the trust when she filed the refund claim and when she cashed the refund checks the IRS issued.

As the Court continues:

Petitioners therefore would have retained their status as beneficiaries at least up to 2009 in order for them to receive, at that time, trust distributions of the refund (an event, as it appears, that would have wound up the last outstanding affair of JVC Trust). As there is no evidence that their beneficiary status had been interrupted at any time since the creation of JVC Trust, we conclude that there was an extant fiduciary-beneficiary relationship between JVC Trust and petitioners at the time JVC Trust first maintained its inconsistent position on or around November 13, 2006.