The Mitigation Provisions of the Code Are Hard (10/18/19)

In Whitesell v. Commissioner, T.C. Memo. 2019-126, here, the facts are somewhat complex but for present purposes are fairly presented in the Court's opening summary:

P-H owned a 100% interest in WIC, an S corporation. In 2008, a Michigan trial court entered a civil monetary judgment against WIC. For tax years 2008, 2009, and 2010, R allowed WIC $10,982,856 in deductions for the judgment and interest thereon. In 2011, the Michigan Court of Appeals reversed the trial court and remanded the case. In 2015, R determined deficiencies for 2010 and 2011. The deficiency for 2011 was premised in part on R’s determination that WIC must include $10,982,856 in income for tax year 2011 because 2011 was the year in which the Michigan Court of Appeals reversed the judgment. Ps filed a petition in this Court in October 2015 and filed an amended petition in December 2015. In neither pleading did Ps challenge R’s determination of the amount of income inclusion ($10,982,856) or the year of inclusion (2011). Three years later, in October 2018, Ps moved to file an amendment to the amended petition to assert that WIC had settled the Michigan lawsuit in 2013 and that the income inclusion had to be made for the 2013 tax year. By the time Ps filed their October 2018 motion, the three-year period for assessing tax for Ps’ 2013 tax year had expired. 

My simplified summary of key facts (with assumptions):

1.  In 2008, through WIC, taxpayers' S corporation, Whitesell deducted approximately $11 million (rounded down to the nearest million) based upon a judgment in a lawsuit.  The validity and timing of this claimed deduction was not in issue.

2.  In 2011, the deficiency year, the judgment was reversed.

3.  In 2013, the parties settled the suit.  I could not find what that settlement amount was, but let's assume for purposes of this discussion that WIC paid a net of $5 million.

Just on these bare facts, from an economic perspective, WIC (and thus the shareholders) are entitled to a net $5 million for their actual expenses.  But, because of the timing of the events and the annual accounting system, there are alternative possibilities in getting to the right net amount.

There are at least 3 ways to do it.

1.  Say that no deduction is allowable until 2013 (when the settlement occurred), then only $5 million would be deductible.  Under this choice, in the final analysis, "the pot is right."

2.  But, as happened, say $11 million is claimed as a deduction in the year of the judgment (2008), then we know that, by the end (2013), $6 million in deductions are excessive and, on a tax benefit theory, that $6 million has to come back into income.  That could happen in 2013 when the final settlement occurs.  Under this choice, in the final analysis, "the pot is right" (the net quantum of income inclusion is right).

3.  As a variation, the taxpayer (at the insistence of the IRS) must include the $11 million as income when the judgment is reversed in 2011.  If this choice happened, then when the liability was settled in 2013, the taxpayer would have a $5 million deduction in  2013 because there would then be no excess deductions taken in earlier years.  Under this choice, in the final analysis, "the pot is right" (the net quantum of income inclusion is right).
In Whitesell, the IRS, by notice of deficiency, chose #3, and asserted a deficiency in 2011, although it apparently did not address any deduction the taxpayer might be entitled to in 2013 (to get the pot right), nor did it attempt to assert an alternative protective position for 2013 consistent with choice #2 that the $6 million net excessive deductions claimed in 2008 is income in 2013.

The 2011 deficiency case was filed in 2015 (according to the Tax Court docket number).  During most of the time that the deficiency case was proceeding, although at significant times the taxpayer had legal representation, the only questions the taxpayer put in issue regarding the income inclusion in 2011 were "that the period of limitation for assessment had expired for WIC’s 2011 tax year and that the IRS had accepted their $3 million offer-in-compromise." Slip Op.  p. 25.  The taxpayers lost those issues in a previously reported opinion, Whitesell v. Commissioner, T.C. Memo. 2017-84, here.

The taxpayers then sought to snatch victory from the jaws of defeat, as the saying goes.  On October 12, 2018, facing what appeared to be a certain loss, the Whitesells filed the present motion for leave to file an amendment to the amended petition. The Court described (Slip Op., p. 21):

The motion explained that the Michigan case was not settled until 2013, and that under section 1.461-2(a)(3), Income Tax Regs., refunds of contested liabilities are included in gross income “when the contest is settled.” The amendment the Whitesells wish to file would allege that the Michigan case was not resolved until 2013, when WIC and Whitaker settled the Michigan case. The amendment would also allege: “The amounts WIC previously paid for the Whitaker [j]udgment and related interest amounts do not constitute gross income to WIC in 2011 or 2012”.

The Tax Court denied the request to amend to assert 2013 as the proper year.  In doing so, the Tax Court noted in footnote 29 (on Slip Op. 29):  "The Whitesells do not suggest that mitigation under sec. 1311 would be available, so we do not address it."  For those who have avoided the mitigation provisions so far, they are in Code §§ 1311 - 1314.  Those provisions are titled and linked as follows:

§ 1311. Correction of error, here§ 1312. Circumstances of adjustment, here§ 1313. Definitions, here§ 1314. Amount and method of adjustment, here

For the full drill-down for the placement of the mitigation provisions in the Code structure, it is: 

Subtitle A. Income Taxes,
Chapter 1. Normal Taxes and Surtaxes,
Subchapter Q. Readjustment of Tax Between Years and Special Limitations,
Part II. Mitigation of Effect of Limitations and Other Provisions.

Being a mitigation fan, I thought I would address the mitigation issues in the case (actually there are two--(i) could the IRS assert mitigation if the taxpayers prevailed in the 2011 deficiency proceeding on a theory that the income was not includable in 2011; and (ii) could the taxpayers assert mitigation to claim as a deduction the net $5 paid in 2013 if they are required to include the income in 2011.  The Court's footnote quoted above is addressed to the latter issue.

Before moving to the mitigation issues, I do want to address whether it was necessary for the taxpayers to amend their petition to assert that the income is taxable in 2013 rather than 2011.  I have not looked at the petition or the amended petition, so I don't know whether the taxpayers made a general claim that the income was not taxable in 2011 or was silent (thus not properly raising that issue).  If they raised only the procedural issues noted above, then they probably would need to amend the petition.  (The wording quoted above suggests that they had not made the general claim about the income not being includable in 2013.)  But, if they raised a general claim that it was not taxable in 2011, albeit without asserting 2013 as the proper year, then I would think that issue would be in play based on the pleadings and the only thing that might prevent it from being asserted is that it is just raised as an issue for trial too late in the proceedings.  I can't resolve that issue now on what I know and really don't plan to dig into it, so I just raise it for others to pursue if they wish.

Another issue is whether, if the taxpayers are foreclosed from claiming that the income is not includable in 2011, they could at least reduce the amount includable by the amount that they ultimately paid in 2013 (which I have assumed in this discussion to be $5,000,000).  At least that would get the pot right if the taxpayers did not claim that amount as deductions in 2013, but from the tenor of the Court's opinion, I am not sure the Court will allow that to happen, nor am I sure that the reduction in 2011 for an amount not known in 2011 would be proper (however "just" it might be.)

Now, moving to mitigation:

1.  Let's assume that the taxpayers were allowed to assert the timing issue and, based on it, avoided the $11 million tax benefit income in 2011 and that the taxpayers had not included the income 2013, the year for inclusion of the net $6 million tax benefit income.  This would be a circumstance of adjustment called a double exclusion of income.  (I think it is the same income, the tax benefit income arising from the excessive deduction claim in 2008, with the amounts different solely because it is net in the year 2013; or it might be conceptualized as $11 million tax benefit income in 2013 with $5 million deduction.)  Then, I think the IRS could open up the 2013 statute of limitations under the mitigation provisions if the statute were otherwise closed.  I won't dig into the weeds on this one, but I do discuss the issue beginning on p. 305 of my 2019 edition of Federal Tax Procedure (Practitioner's Edition), which may be downloaded on the page here.

2.  The next question is whether, if the taxpayers are forced in the Tax Court proceeding to include the $11 million income in 2011 without any adjustment for the $5 million paid in 2013, they can open up 2013 to get the benefit of the $5 million payment as a deduction via claim for refund for 2013 even if it were otherwise barred.  That gets a bit dicier.  The logical mitigation category for deductions not claimed in the correct year is where deductions were claimed in the incorrect year.  This would be double disallowance of deductions.  (See the FTPB Practitioner's Edition, starting on p. 301.)  The problem is that there was no deduction claimed in 2011, so technically, the deduction that taxpayers would like to claim for 2013 do not represent a double disallowance.  Maybe economically it is economically a double disallowance.

So, I don't offer definitive answers, simply because doing so would require more time than I have to spend on the matter.  For those wanting to pursue the mitigation issues, please do so and make comments or even draft a Guest Blog that I can post.