Thursday, April 3, 2014

The Mitigation Provisions of the Code - An Example of How They Work to Open an Otherwise Closed Year (4/3/14)

All taxpayers facing a tax liability hope that the IRS will fail to assess within the applicable period of limitations.  For example, the IRS often requests a Form 870, Waiver of the Restrictions on Assessment, which, because it waives the notice of deficiency which, in turn, would have suspended the statute of limitations, hope that the IRS will not get around to assessing in time.  (That is vain hope in the overwhelming number of cases.)  There are a myriad of other circumstances where a similar situation occurs.

One such circumstance applied in El Paso CGP Company, L.L.C. v. United States of America, 748 F.3d 225 (5th Cir. 2014), here.  In this case, the facts are complex, but I think I can distill them for purposes of the point I want to make in this blog entry. Normally, when a year is closed, it is just closed.  If the taxpayer got a benefit he was not entitled to, that is just the IRS's tough luck; and vice versa.  However, various Code provisions and judicial doctrines may apply to mitigate the effect of the improper benefit in the closed year.  Indeed, the most beautiful such provisions are called the mitigation provisions of the Code -- Sections 1311-1314.  Essentially, the effect of those mitigation provisions in most of  the circumstances of adjustment to which they apply is to take away a double benefit to a taxpayer from achieving a tax benefit for the treatment of an item in a correct open year when the taxpayer has previously achieved a benefit in an incorrect otherwise closed year.

Without getting into the facts in too great a detail (read the opinion), the taxpayer claimed credits in 1986 which because of limits were carried forward to some later years.  After some audit activity, the parties agreed that the taxpayer had overstated the credits in question but was entitled to other credits so that, for the year 1986, the taxpayer was still entitled to a refund.  However, because the credits in question had been overstated in 1986, the carry forward of those credits to post-1986 years was wiped out, meaning that the taxpayer had deficiencies in those post-1986 years which were then closed.  This apparently was a circumstance of adjustment under the mitigation provisions.  (I have not chased down that issue, but the Court and the parties seemed to assume it.)  Under the mitigation provisions of the Code, the IRS has a one-year window from the time of the determination to assess, collect, refund or credit the tax, as appropriate for the type of adjustment.  See Section 1314(b), here.

The IRS netted the agreed upon deficiencies for the post-1986 years in the aggregate against the refund due for 1986 and refunded the difference (with appropriate interest).  But, as best I understand the opinion, the IRS did not assess the netted amount to the particular post-1986 years within the one-year period.  In other words, the IRS had collected the tax by offset but had not made the assessments for the particular years involved in that one-year period.  The taxpayer argued that, therefore, the IRS had not met the procedures required for mitigation and therefore, must treat the collection via netting as an overpayment for the post-1986 years that must be refunded.

A taxpayer making that argument or any argument that the IRS has not timely assessed does not want to launch the argument when the IRS still has time to assess.  Therefore, for example, it is common practice -- albeit perhaps not the best form -- to file a claim for refund for a year when there are not previously adjustments that would increase the tax liability near the end or after the assessment period of limitations.  (I say that is perhaps not the best form, because it may be difficult to sign a claim for refund under oath when the taxpayer knows that the unspotted adjustments wipe out the claim for refund; but that's a subject for another day.)

At any rate, this taxpayer did a mitigation variant of this timing strategy.  "A year after the Closing Agreement was executed, in August 2006, El Paso sent a precisely timed memorandum to the IRS claiming that the deficiencies for 1987-1990 must be refunded to El Paso because the IRS had failed properly to assess those deficiencies before the just-expired one-year statute of limitations."  (Bold-face supplied by JAT.) That memorandum was treated as a claim for refund.

So, the Fifth Circuit directly faced the issue of whether the IRS's failure to assess for each applicable year within the one-year period was fatal.  The Court held that it was not.

On the procedural merits, the IRS first argued that the offset authority in Section 6402 did not require an assessment.  Here is how the court framed that argument:
The IRS begins its response by arguing that the Code provides express authority for this set-off. The language of the Closing Agreement makes clear that the parties were agreeing on the amount of liabilities, and the Code allows the IRS to set off liabilities against overpayments. See I.R.C. § 6402(a) ("In the case of any overpayment, the Secretary, within the applicable period of limitations, may credit the amount of such overpayment . . . against any liability. . . ."). Because an assessment is not required to create a tax liability, the IRS asserts that the offset of the tax liability against the refund that was due El Paso was proper without an assessment. The IRS's argument, however, ignores the restriction on this power to offset liabilities for tax periods outside the statutory period of limitations. The tax years for which the deficiencies arose (1987-1990) were closed tax years.
The Fifth Circuit said, in effect, that may be lovely but the mitigation provisions of the Code were in the mix as well:  The court said:
The Code, however, does provide a particular method for the IRS to reopen closed tax years — the mitigation provisions. As they apply here, these mitigation provisions allow the IRS to reopen closed tax years following a closing agreement between the parties by assessing deficiencies or refunding overpayments within one year of the closing agreement. See I.R.C. §§ 1311-1314. If the IRS complied with the mitigation provisions, which would have reopened the statute of limitations for the barred years, then § 6402(a) could provide the IRS the statutory authority for the set-off. We now turn to the question of whether the IRS complied with the mitigation provisions.
The Court resolved the issue by saying that assessment in the period was only required when collection was necessary.  Here, because the IRS collected by netting, collection was not necessary and hence the IRS did not have to assess in the one-year period.  The guts of the reasoning is as follows (footnotes omitted):

A statute's meaning begins with its plain language. See Carder v. Continental Airlines, Inc., 636 F.3d 172, 175 (5th Cir. 2011). The relevant portion of § 1314(b) states: 
The adjustment authorized in section 1311(a) shall be made by assessing and collecting, or refunding or crediting, the amount thereof in the same manner as if it were a deficiency determined by the Secretary with respect to the taxpayer as to whom the error was made or an overpayment claimed by such taxpayer, as the case may be, for the taxable year or years with respect to which an amount is ascertained under subsection (a). . . . 
(Emphasis added.) In our view, this language allows an adjustment covering multiple tax years. We reach this conclusion acknowledging that the amount of the adjustment must be determined for each individual taxable year. See I.R.C. § 1314(a) ("In computing the amount of an adjustment under this part there shall first be ascertained the tax previously determined for the taxable year with respect to which the error was made.") (emphasis added). In our view, the language of  [*18] § 1314(b) allows the IRS to make one total adjustment, covering multiple tax years; but the one adjustment amount first must be determined on the basis of each tax year separately. This is precisely what occurred here. The Closing Agreement lays out the adjustment amounts for each individual tax year, and the IRS implemented the adjustment for all the years by refunding to El Paso the amount of the net overpayment. 
That the plain language of § 1314(b) calls for deficiencies to be "assess[ed] and collect[ed]" further supports the IRS's position by tying together an assessment and collection. This connection suggests that the assessment is meant to occur in cases where collection activities might be required. If the Closing Agreement contains a net overpayment — as it does here — the IRS will not have to collect the deficiencies for the individual years because the IRS already holds the taxpayer's money to cover the deficiency. 
This connection between an assessment and the IRS's collection powers is apparent throughout the Code, including in the regulations related to closing agreements. See Treas. Reg. § 301.7121-1(d)(2) ("Any tax or deficiency in tax determined pursuant to a closing agreement shall be assessed and collected, and any overpayment determined pursuant thereto shall be credited or refunded. . . ."). This connection has also been recognized by courts. See Philadelphia & Reading Corp. v. United States, 944 F.2d 1063, 1064 n.1 (3d Cir. 1991) ("[I]t is the assessment, and only the assessment, that sets in motion the collection powers of the IRS. . . ."). From these authorities,it is clear that a primary function of an assessment is to lay the necessary groundwork for the IRS to exercise its collection authority. That is not to say, dogmatically, that an assessment is only required when the IRS uses its formal collection powers. It does, however, fully support the IRS's argument that an assessment is unnecessary when the IRS, as here, already holds adequate money from the taxpayer to cover the deficiencies. 
El Paso argues against this reading of the statute, contending that it violates the established norm that tax years must be treated as insular units. This insulation prevents the IRS from commingling overpayments and deficiencies across tax years to arrive at a net amount due to the taxpayer or owed to the IRS. See id. at 1066 ("Under the relevant tax laws, however, the IRS is not empowered to arrive at a net deficiency or overpayment and send the taxpayer a bill or refund for the net amount. Instead, the IRS must separately assess each year's deficiency and separately refund each year's overpayment."). 
We have already recognized the general rule that each individual tax year must be treated individually. When the Government finds deficiencies in one tax year and overpayments in another, it may not, on its own initiative and without proper assessment, send the tax payer a single bill for the net deficiency. In holding that the IRS acted permissibly in this case, we are not casting doubt on this principle, or on the opinion of the Third Circuit in Philadelphia & Reading. To be sure, however, this case fits within an exception to the broad principle that the Third Circuit recognized: "[T]he taxpayer and the IRS can reach an agreement that permits the IRS to pay out or recover only the net overpayment or deficiency." Id. Here, the Closing Agreement permitted the IRS to pay out only the net overpayment. The Closing Agreement did not require the IRS to refund the entire overpayment to El Paso, then require the IRS to engage in a separate effort to collect the deficiencies through formal collection procedures. El Paso acknowledges this point. It only argues that the IRS did not take the necessary steps, i.e. assessing year-by-year the tax deficiencies, prior to refunding to El Paso its overpayment, an overpayment which had been reduced by the set-off deficiencies. This agreement fits this case into the exception recognized by the Third Circuit.
Lights out for El Paso!

I do encourage readers who want to pursue this type of logic further to read  Principal Life Ins. Co. v. United States, 95 Fed. Cl. 786 (Fed. Cl. 2010), here.  See also my blog, Principal Life -- A Masterpiece of Tax Procedure (Federal Tax Procedure 11/29/13), here.  The principal, so to speak, paragraph in that blog for present purposes is (cut and pasted):
Nevertheless, even if the taxpayer's argument were correct that the 1/28/05 operated to transform the deposit into a payment which, along with its first argument would mean that the assessment was not timely, the taxpayer is still not entitled to have the "payment" refunded.  It is true that Section 6401)(b) states that ""[t]he term 'overpayment' includes that part of the amount of the payment of any internal revenue tax which is assessed or collected after the expiration of the period of limitations properly applicable thereto." Continuing, Judge Allegra says, "Read in isolation this subsection supports plaintiff's claim that, assuming arguendo the assessment here was untimely, an 'overpayment' occurred."  The argument is that a payment within the assessment statute of limitations which is not assessed until after assessment statute has expired creates a overpayment that must be refunded.  Judge Allegra concludes that the argument flies in the face of contextual statutory analysis, the legislative history and many decided cases.  Students need to read his analysis to see how a great mind with hard work gets it right.

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