In the case of Illinois Lumber and Material Dealers Association Health Insurance Trust v. United States, 116 AFTR 2d ¶2015-5079, reversing DC MN, 113 AFTR 2d ¶2014-1937 the appellate panel had to deal with the complex area of the law found in the statute mitigation provisions of IRC §§1311-1315. The appellate determined that the taxpayer, having failed to assert its rights before statute initially expired, could not “awaken the sleeping dog” of the statute of limitations bar on any refund.

The issue involved the question of the basis of shares received in a demutualization transaction. The entity in question received distributions related to a demutualization of an insurance company whose policies were held by the organization in 2004, 2006 and 2008. Initially the entity reported this as unrelated business income and paid the tax computed with a zero basis from the sale of those interests. The zero basis position was consistent with the IRS’s holding in Revenue Ruling 71-233 and with the letter ruling the entity was informed the insurance company had received outlining the tax treatment of the demutualization

In 2008 the Court of Federal Claims rejected the IRS “zero basis” position for such shares, holding that the shares did have basis, in the case of Fisher vs. United States, 82 Fed. Cl. 780 (2008). Illinois Lumber filed claims for refund for 2004, 2006 and 2008 following that decision. After the Federal Circuit upheld the Fisher decision the IRS issued refunds to Illinois Lumber for 2006 and 2008. However the agency denied the refund for 2004, finding that it had been filed outside the three year statute of limitations found in IRC §6511(a).

Illinois Lumber did not dispute that they had filed the claim after the end of the three year statute, but argued that the refund should be allowed due to the fact the IRS had maintained an “inconsistent position” that triggered the application of the mitigation provisions of §§1311-1315.

As the appellate panel explains:

The current mitigation provisions permit Illinois Lumber to obtain a refund of 2004 capital gains tax that would otherwise be barred by § 6511(a) if (1) there was a “determination” as defined in I.R.C. § 1313(a); (2) the determination fell within one of the “circumstances of adjustment” listed in I.R.C. § 1312; and (3) “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” in Illinois Lumber’s 2004 return. O’Brien v. United States, 766 F.2d 1038, 1042 (7th Cir. 1985); see I.R.C. § 1311; Taxeraas v. United States, 269 F.2d 283, 289 (8th Cir. 1959) (“one claiming the benefits [of mitigation] must assume the burden of proving the existence of the prerequisites to its applicability”).

The panel notes that the entire area of the mitigation provisions raises thorny and complicated issues, but in this case the parties agreed that the only potential “circumstance of adjustment” in this case is found at IRC §1312(7) which provides:

(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 . . . any of the errors described in subparagraph (C) of this paragraph.

…

(i) there was an erroneous inclusion in, or omission from, gross income, [or]

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

The Court notes that unraveling when this applies is complex, but in this case the panel found that the key problem for Illinois Lumber is that the IRS never actually made a “determination” with regard to basis that would trigger the status due to inconsistency.

As the Court notes:

The Secretary denied Illinois Lumber’s claim for refund of 2004 tax paid because the claim was untimely. Therefore, even if that ruling was a “determination,” it was not a “determination [that] determine[d] the basis of property,” as § 1312(7)(A) requires. The IRS disallowance correspondence noted that the claim would have been granted had it been timely filed, but that volunteered comment was not a “determination [of] the basis of property.” On the other hand, the Secretary’s prior allowance of Illinois Lumber’s timely claims for refund of capital gains taxes paid in 2006 and 2008 was a determination establishing that Illinois Lumber had erroneously determined the basis of its demutualized interest in 2004. However, whether that determination could qualify Illinois Lumber for adjustment of a time-barred 2004 error affecting basis under § 1312(7) is an issue — not addressed by the parties or the district court — that has produced conflicting judicial decisions and commentary. See Knickerbocker, Mysteries of Mitigation, 30 Fordham L. Rev. at 255-58; Lynch, Sixty Years of Mitigation, 51 S.C.L. Rev. at 87-92; and cases cited.

The Court notes that the IRS never maintained an inconsistent position from which it derived an advantage. The panel argues:

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.[2] It simply allowed Illinois Lumber’s timely claims for refund based upon judicial rejection of the IRS’s prior position, while asserting that the statute of limitations barred review of the issue in 2004, a closed tax year.

That is, it was Illinois that gained an advantage because the IRS decided to grant a refund request. Illinois decision to file its return using the “wrong” basis in 2004 did not represent an inconsistent position of the IRS, as the IRS had never actually ruled (or been asked to rule) on that position by Illinois Lumber.

Rather, the panel notes:

The fairness or unfairness of reopening Illinois Lumber’s closed 2004 tax year is no different than if the IRS had allowed a different GAMHC mutual policyholder’s timely claims for refunds of capital gains taxes paid in 2006 and 2008. In other words, Illinois Lumber urges us to interpret the mitigation provisions as allowing taxpayers to reopen closed tax years based upon a favorable change in, or reinterpretation of, the income tax laws. That would be fundamentally inconsistent with the congressional intent in enacting the mitigation provisions to “preserve unimpaired the essential function of the statute of limitations.” Taxeraas, 269 F.2d at 289, citing S. Rep. No. 75-1567. It would also have a potentially substantial impact on federal tax revenues that Congress clearly did not intend.

For these reasons, the district court construed the “inconsistent position” provision in § 1311(b)(1) far too broadly in concluding that “a taxpayer may claim a refund for a barred year where the correct result is given effect in an open year by a determination, and that correct result is inconsistent with the treatment of the item in a barred year.” Illinois Lumber, 2014 WL 1757861, at *15 (quotation omitted). For the mitigation provisions to apply, there must be an “inconsistency” that, unless adjusted, will cause the types of unfair results in successive tax years described in § 1312. Here, there was no inconsistency, merely different results in successive tax years resulting from a judicially-imposed change in the tax treatment of a complex transaction. 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.”