Tax Court in Brief | Richard J. O’Neill Trust v. Comm’r | Application for Tentative Refund, Claim of Right, Mitigation, and Equitable Recoupment

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Tax Litigation:  The Week of October 24th, 2022, through October 28th, 2022

Richard J. O’Neill Trust v. Comm’r, T.C. Memo. 2022-108 | October 27, 2022 | Kerrigan, J. | Dkt. No. 20840-17

Summary: The Richard J. O’Neill Trust (“trust”) was established as a revocable trust, but it became an irrevocable trust upon the death of decedent, its creator. At the time of his death, the trust held an 86.12% ownership interest in RMV Total Diversification, LLC (RMV). RMV is a limited liability company and is a partnership pursuant to the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA). (TEFRA was repealed for returns filed for partnership tax years beginning after December 31, 2017.) RMV sold capital gain assets during 2009 and 2010, which resulted in flowthrough income to the trust. The trust reported this income on its Forms 1041, U.S. Income Tax Return for Estates and Trusts, for 2009 and 2010. Following decedent’s death, his estate borrowed money from RMV and was charged a 9% interest rate. The interest paid to RMV by the estate resulted in flowthrough income for the trust, which the trust reported as income.

The estate timely filed Form 706, United States Estate (and Generation-Skipping Transfer) Tax Return. The IRS proposed adjustments, the estate objected and filed a petition with the U.S. Tax Court, a settlement was reached, and a decision was entered in Estate of Richard J. O’Neill, Deceased, Anthony R. Moiso, Executor v. Commissioner, Docket No. 19822-13 (related case). This decision resulted in two adjustments relevant to this case: (1) the value of the estate’s interest in RMV was adjusted from $30,725,000 to $40,614,822 under 26 U.S.C. § 2036 and (2) the estate was limited to a deduction of 6% on the note. The note was rewritten, resulting in a $500,538 reduction of accrued interest to the trust for 2010. In 2015 the trust filed a timely tentative claim for refund on Form 1045, Application for Tentative 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 paid by the trust for the 2009 and 2010 tax years. RMV did not file an amended partnership income tax return for 2009, 2010, 2014, or 2015. The trust did not file Form 8082, Notice of Inconsistent Treatment or Administrative Adjustment Request (AAR), with respect to RMV for 2009, 2010, 2014, or 2015.

On July 17, 2017, the IRS issued to the trust a notice of deficiency in which the IRS determined a deficiency of $1,554,917 for tax year 2014. The IRS determined that the trust was not entitled to the refund of $1,537,780 it received for the year and must return the refund. The trust asserted that its Form 1045, Application for Tentative Refund satisfied the claim of right requirements under 26 U.S.C. § 1341 and thereby entitles the trust to retain the refund. The trust also asserted that it is entitled to the refund under the mitigation provisions of 26 U.S.C. §§ 1311-1314 or, alternatively, under a theory of equitable recoupment.

Key Issue: Whether, as a matter of law, the IRS was entitled to judgment as to its determination that the trust was not entitled to the refund and must return the refund, notwithstanding the trust’s assertion of the claim of right requirements under 26 U.S.C. § 1341, mitigation under 26 U.S.C. §§ 1311-1314, and claim for equitable recoupment.

Primary Holdings: The IRS was entitled to judgment. The trust was not a proper party to assert a claim of right under section 1341. RMV had an unrestricted right to the interest income under the note, and the trust did not have a claim of right upon which to base its claim for refund. The trust’s reliance on the mitigation provisions failed for both procedural and substantive reasons.  The trust’s claim of equitable recoupment failed because the trust is not the appropriate party to seek a refund. The deficiency upon which the trust based its claim for recoupment arose from deficiencies directly related to the estate’s taxes, not the trust’s. And, the trust did not prove all elements of an equitable recoupment.

Key Points of Law:

Claim of Right. 26 U.S.C. § 1341 addresses instances in which a taxpayer includes an item in gross income for a prior taxable year because it appeared that the taxpayer had an unrestricted right to the item of income. A deduction is allowed after the close of the prior taxable year if it is established that the taxpayer did not have an unrestricted right to that item. 26 U.S.C. § 1341(a). For the purposes of a refund claim under section 1341, the original “circumstances, terms, and conditions” of the payment of an income item determine whether the taxpayer has an unrestricted right to it. Blanton v. Commissioner, 46 T.C. 527, 530 (1966), aff’d, 379 F.2d 558 (5th Cir. 1967). A taxpayer’s unrestricted right to an income item that is not subject to contingent repayment cannot be altered by subsequent agreements. Id. Claim of right under section 1341 may not be an appropriate procedural tool if the claiming taxpayer was not the appropriate taxpayer to file a claim for refund.

Mitigation Provisions. 26 U.S.C. §§ 1311-1314 (mitigation provisions) allow for filing of a refund claim within one year from the date a proper determination becomes final. To claim the benefits of the mitigation provisions, a taxpayer must show that (1) there was a determination as defined by section 1313(a); (2) the determination falls within specified circumstances of adjustment set forth in section 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 section 1311(b).

Equitable Recoupment. Equitable recoupment is an equitable solution for situations “where the Government has taxed a single transaction, item, or taxable event under two inconsistent theories.” United States v. Dalm, 494 U.S. 596, 605 n.5 (1990). It is not an “independent ground for reopening years now closed by the statute of limitations.” Evans Tr. v. United States, 462 F.2d 521, 526 (Ct. Cl. 1972). A claim of equitable recoupment requires that (1) the refund for which recoupment is sought by way of offset be barred by time; (2) the time-barred offset arise out of the same transaction, item, or taxable event as the overpayment or deficiency before the Court; (3) the transaction, item, or taxable event have been inconsistently subject to two taxes; and (4) if the subject transaction, item, or taxable event involves two or more taxpayers, there be sufficiency of interest between the taxpayers so that the taxpayers should be treated as one. Estate of Branson v. Commissioner, 113 T.C. 6, 15 (1999), aff’d, 264 F.3d 904 (9th Cir. 2001).

Insights: For a taxpayer to seek relief pursuant to a claim of right under section 1341, mitigation under sections 1311 through 1314, or equitable recoupment, the taxpayer must meet the applicable procedural and substantive requirements under each theory. In this case, the trust was not the proper party to assert a claim of right under section 1341 and the trust failed to satisfy the requirements for mitigation and equitable recoupment.