A recent Tax Court case illustrates how the IRS was able to assess income taxes against two trust beneficiaries even though the statute of limitations for assessment had expired, via the mitigation provisions of the Internal Revenue Code.
FACTS: A father established a revocable trust during his lifetime. Several IRAs of father named the trust as beneficiary. Father then died on June 21, 1998. In 2001, $228,530.44 was distributed to the trust from the IRAs. In the same year, the trust distributed the same amount to two beneficiaries of the trust (who were children of the father).
On its timely Form 1041 for 2001, the trust reported $228,530 in gross income, and also deducted that amount as an income distribution, so that it had no net income. It reported the distributions to the beneficiaries on Schedules K-1. The two beneficiaries each reported $114,265 in income from the distributions on their Forms 1040 for 2001.
The Form 1041 was selected for audit, and in 2004 the IRS disallowed the income distribution deductions, and determined an $80,302 deficiency for the trust for 2001. The IRS also adjusted the beneficiaries’ Forms 1040 by removing the trust distributions from gross income. The beneficiaries paid the additional tax due that the trust owed 2001, and they received refunds for their 2001 taxes.
In 2006, the trust amended its 2001 Form 1041 and sought a refund of the taxes paid under the audit by again claiming a distribution deduction. In 2008, the IRS accepted the refund claim, and refunded the taxes that had been paid on behalf of the trust based on the 2004 disallowance. In 2008, the IRS sent notices of deficiency to the beneficiaries for 2001 that included the distributed amounts in the gross income of the beneficiaries.
The 2008 assessments against the beneficiaries were barred by the statute of limitations, which expired for the 2001 tax years of the beneficiaries on April 15, 2005. The IRS sought to uphold their assessments using the mitigation provisions of the Code (Sections 1311 through 1314). If applicable, the provisions allow for the correction of an error made in a closed tax year by effectively extending the limitations period up to one year from the date a final determination is made. Their intent is to take "the profit out of inconsistency, whether exhibited by taxpayers or revenue officials, and whether fortuitous or the result of design", and their purpose is to prevent the Government or a taxpayer from obtaining "an unfair benefit *** by assuming an inconsistent position and then taking shelter behind the protective barrier of the *** [period] of limitations." S. Rept. No. 75-1567, at 49 (1938), 1939-1 C.B. (Part 2) 779, 815.
More particularly, Code Section 1311(a) provides that if (1) there is a determination of tax (as defined in Section 1313), (2) that determination causes an error described in Section 1312, and (3) on the determination date an adjustment to correct the error is barred by operation of law, then mitigation applies. Code Section 1311(b) generally also requires, in the case of an allowed refund, an inconsistent treatment as to the erroneous income exclusion.
Requirement 1 was met with the IRS’ determination to allow the refund claim of the trust. Requirement 2 was met per Section 1312(5) which provides as one of the Section 1312 errors the circumstance when “[t]he determination allows... deductions allowable in computing the taxable income of...trusts...and the correlative inclusion...has been erroneously excluded...in respect of the related taxpayer.” Here, the refund claim determination allowed a deduction to the trust but the correlative inclusion of income of the distribution income was erroneously excluded from the gross income of the beneficiaries (the related taxpayers). Requirement 3 was met per the statute of limitations bar that prevented the income from being assessed to the beneficiaries. Lastly, there existed an inconsistency between the allowed deduction/refund to the trust and the erroneous non-taxation of the beneficiaries. Thus, the Tax Court applied the mitigation provisions to allow for the assessment of the beneficiaries.
COMMENT: This case is interesting for at least two reasons. First, it illustrates the application of the mitigation provision of the Code to a mismatching of income and deduction between a trust and its beneficiaries. Such cases are rare, and often difficult to imagine how they can come about. Second, it reminds practitioners that in examining statute of limitation issues, if it appears the statute has run one still has to ask the question whether the mitigation provisions may act to extend the statute. I would venture to say that there are likely many practitioners who have little, if any, passing knowledge or awareness of the mitigation provisions.
As a personal aside, when I earned my Masters in Tax Law many years ago, our tax procedure professor was enamored with terrorizing our class with the mitigation provisions. These provisions are difficult to follow and employ, especially for students first learning the basics of tax procedure. That experience left me with a special non-fondness for the mitigation provisions.
A key preliminary question to ask in determining whether one should look further at the mitigation provisions is whether the IRS and the taxpayer have adopted inconsistent positions that injure (or provide a windfall to) one or the other, and are typically reliant on a closed statute of limitations. Examples include multiple deductions for the same item, multiple income inclusions for the same item, or mismatched income and deduction between trusts and beneficiaries like in this case. An alternate phraseology is to ask whether the result is too good to be true for either the IRS or the taxpayer, and arises in part from statute of limitations provisions.
As the case illustrates, the mitigation provisions apply even if the problem arose from government behavior or error. The provisions can operate to the benefit of the IRS or the taxpayer, depending on the circumstances.
CITES: Sally M. Costello, et vir. v. Commissioner, TC Memo 2016-33; Code Sections 1311-13