Taxpayer’s argument for $1.5 million refund fails on several grounds

A taxpayer was not entitled to a $1.5 million refund under a Sec. 1341 claim of right, the mitigation provisions of Secs. 1311 through 1314, or the doctrine of equitable recoupment.

Background

Richard O’Neill, a prominent landowner in Orange County, Calif., and political activist, established the revocable Richard J. O’Neill Trust in 1968. The trust became irrevocable upon O’Neill’s death on April 4, 2009. At the time of his death, the trust held a majority ownership interest in RMV Total Diversification LLC (RMV), which was treated for tax purposes as a partnership and subject to the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA).

RMV sold capital gain assets during 2009 and 2010, resulting in flow-through income to the trust, which the trust reported on its Forms 1041, U.S. Income Tax Return for Estates and Trusts, for 2009 and 2010.

O’Neill’s estate borrowed money from RMV through what is commonly called a Graegin loan (see Estate of Graegin, T.C. Memo. 1988-477). RMV charged the estate 9% interest on the loan note, and the interest paid to RMV by the estate resulted in flowthrough income for the trust. The trust reported this income on its returns.

In June 2010, O’Neill’s estate timely filed a Form 706, United States Estate (and Generation-Skipping Transfer) Tax Return. The IRS audited the return and proposed adjustments to it. The estate objected to the IRS’s proposed adjustments and challenged them in Tax Court.

While the case was pending, the parties reached a settlement in their dispute, and the Tax Court entered a stipulated decision in the case. As part of this decision, the court adjusted the value of the estate’s interest in RMV from $30,725,000 to $40,614,822 under Sec. 2036 and reduced the estate’s interest deduction for the Graegin loan from 9% to 6%. Subsequent to the decision, the parties rewrote the loan note, which resulted in a $500,538 reduction of accrued interest to the trust for 2010.

In October 2015, the trust timely filed a Form 1045, Application for Tentative Refund, on which the trust made a tentative claim for refund for the 2014 tax year under a claim-of-right theory. The tentative claim for refund was to recover an overpayment of income tax by the trust for the 2009 and 2010 tax years.

The IRS issued the trust a refund of $1.5 million in response to the trust’s Form 1045. On reflection, the Service determined that the trust did not have a claim of right and was not entitled to the refund it received for the 2014 tax year. Consequently, it issued the trust a notice of deficiency for $1.5 million.

The trust declined to repay the refund and challenged the IRS’s determination in Tax Court. The trust asserted in Tax Court that the Form 1045 it filed in October 2015 satisfied the Sec. 1341 claim-of-right requirements. In the alternative, the trust contended that it was entitled to the refund under the mitigation provisions of Secs. 1311 through 1314 or under a theory of equitable recoupment. Both parties moved for partial summary judgment on the issue of whether the trust was entitled to the refund it received.

The Tax Court’s decision

The Tax Court granted the IRS’s motion for summary judgment, holding that the trust was not entitled to a refund for the 2014 tax year under any of the three theories it advanced.

Claim of right: Sec. 1341 applies where a taxpayer included an item in gross income for a prior tax year because it appeared that the taxpayer had an unrestricted right (a claim of right) to the item of income. Under the claim-of-right doctrine, a taxpayer is allowed a deduction after the close of the prior tax year if it is established that the taxpayer did not have an unrestricted right to that item of income. In certain circumstances, a taxpayer with a claim of right under Sec. 1341 may be entitled to a refund. For purposes of Sec. 1341, the original “circumstances, terms, and conditions” of the payment of an income item determine whether the taxpayer has an unrestricted right to it. A taxpayer’s unrestricted right to an income item that is not subject to contingent repayment cannot be altered by subsequent agreements.

The Tax Court found both procedural and substantive reasons why Sec. 1341 would not apply to the trust. Procedurally, the court concluded that the trust was not the proper taxpayer to file a claim for refund. It found that both the capital gain and interest income that were the basis of the refund claim were partnership items and that, under TEFRA, these items must be decided at the partnership level, not at the partner level.

Regarding whether it met the substantive requirements of Sec. 1341, the trust argued that it met these requirements in two ways. First, in 2009 and 2010, RMV sold capital assets that generated capital gains that were allocable to the trust. According to the trust, RMV understated its basis in the capital assets, which effectively caused the trust to overstate its capital gain. Thus, the basis adjustment (which arose out of the adjustment of the partnership’s value in the stipulated decision in the trust’s earlier Tax Court case) created a claim of right with respect to the overstated capital gain.

The Tax Court found that this was not the case. It noted that the trust through RMV had an unrestricted right in the capital assets sales proceeds and that no portion of this item had been repaid or restored as a result of the disputes surrounding RMV’s right to the item. Consequently, the court found that RMV’s unrestricted right to the sales proceeds had never ceased to exist, so the trust’s right to the income was also unrestricted. Because the trust’s right to the income items was at all times unrestricted, Sec. 1341 did not apply.

Further, the Tax Court stated that an adjustment to basis related to the value of an income item is independent from a taxpayer’s right to the income item. Thus, the adjustment to basis did not affect the trust’s unrestricted right to the income item in question — the capital gain — and, as a result, the court again determined that Sec. 1341 did not apply.

The trust also argued in its refund claim that the Tax Court’s earlier decision regarding the interest income from the Graegin loan created a claim of right for the interest income paid by RMV to the estate. The Tax Court also rejected this argument, observing that RMV’s voluntary renegotiation of the note’s terms to reflect the Tax Court’s previous decision with respect to the rate of interest income did not retroactively restrict RMV’s right to the interest income reported for the prior tax year. The court reasoned that RMV and, by extension, the trust had an unrestricted right to the interest income at all relevant times; therefore, the decision regarding the interest income did not give the trust a claim of right.

Mitigation provisions: The trust’s first alternative to its claim-of-right argument was that it was entitled to a refund under the mitigation provisions (Secs. 1311 through 1314), which allow for filing a refund claim within one year from the date a proper determination becomes final.

Three requirements must be met for the mitigation provisions to apply. A taxpayer must show that (1) there was a determination as defined by Sec. 1313(a); (2) the determination falls within specified circumstances of adjustment set forth in Sec. 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 Sec. 1311(b).

The Tax Court held that, for procedural reasons, the mitigation provisions did not apply. Under Sec. 1314(b), the mitigation provisions require that a refund claim be filed with respect to a specific year. In the trust’s case, it claimed it overpaid for the 2009 and 2010 tax years, so its refund claim should have been filed for those years. The trust, however, filed its claim for the 2014 tax year. The court found that this procedural defect was fatal to the trust’s position.

Equitable recoupment: The trust’s second alternative argument was that the doctrine of equitable recoupment would entitle it to the claimed refund. Equitable recoupment is an equitable remedy for situations in which a single transaction, item, or taxable event has been taxed under two inconsistent theories. The Tax Court has held that a claim of equitable recoupment requires that (1) the refund for which recoupment is sought by way of offset is 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 has been inconsistently subject to two taxes; and (4) if the subject transaction, item, or taxable event involves two or more taxpayers, there is a sufficiency of interest between the taxpayers so that the taxpayers should be treated as one.

The Tax Court found that the trust’s equitable recoupment argument failed procedurally again because the trust was not the proper party to seek the refund. It was not the proper party because the deficiency upon which the trust based its claim for recoupment arose from deficiencies directly related to the O’Neill estate’s taxes, not the trust’s.

In addition, the Tax Court determined that the substantive requirements of equitable recoupment were not met. The court found that the IRS’s determination in the notice of deficiency that the trust was not due a refund was based on the disallowance of the trust’s claimed reduction of tax liability pursuant to Sec. 1341 and was not inconsistent with the trust’s time-barred liabilities for 2009 and 2010. Also, those liabilities had no transactional connection with the IRS’s denial of the trust’s claim for refund under Sec. 1341.

Reflections

The Tax Court rejected the trust’s mitigation argument on procedural grounds: The refund claim was filed for the 2014 tax year instead of 2009 and 2010, the years in which it claimed it overpaid its tax liability. Absent that defect, could the trust have prevailed on its mitigation argument? Regarding the mitigation provisions of Secs. 1311 through 1314, the Tax Court stated in Bolten, 95 T.C. 397 (1990), that they were:

designed to prevent a windfall, in specified circumstances, either to the taxpayer or to the Government arising out of the treatment of the same item in a manner inconsistent with its erroneous treatment in a closed year. Thus, provision is made to correct an error in the closed year where, for example, the same item was erroneously included or excluded from income or where the same item was allowed or disallowed as a deduction in a barred year.

Richard J. O’Neill Trust, T.C. Memo. 2022-108

Contributor

James A. Beavers, CPA, CGMA, J.D., LL.M., is The Tax Adviser’s tax technical content manager. For more information about this column, contact thetaxadviser@aicpa.org