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Taxpayer Uses Mitigation Rules to Obtain Refund from Closed Tax Year.
(Parker Tax Publishing May 9, 2014)

Courts are generally quite rigid in applying the statute of limitations provisions in Code Sec. 6511. However, in some situations, a taxpayer may fall into a trap where the statute of limitations expires before a subsequent determination leads to a change in tax liability. This is where the mitigation provisions can come into play. The IRS can, and does, use the mitigation provisions of Code Sec. 1311 through Code Sec. 1314 to reopen a taxpayer's closed tax year and assesses tax deficiencies. The IRS is not so quick, however, to allow taxpayers to use those provisions when seeking a refund from a closed year.

This was the situation in Illinois Lumber v. U.S., 2014 PTC 212 (D. Minn. 4/30/14), where a tax-exempt organization incorrectly filed a tax return and paid over $200,000 in taxes on income from the demutualization of a company of which it was a member. Until recently, the correct tax treatment of demutualization proceeds was a subject of contention between taxpayers and the IRS. In 2008, the Federal Circuit settled the issue and, as a result, the tax-exempt organization concluded that it did not owe the tax it paid on the demutualization income. When it applied for a refund, the IRS said the statute of limitations prevented any refund. However, a district court held otherwise concluding that the taxpayer was indeed entitled to a refund under the mitigation provisions. The decision involves the unique intersection of the law on mitigation and recent legal precedent on the tax treatment of demutualization proceeds.


Illinois Lumber and Material Dealers Association Health Insurance Trust is a tax-exempt voluntary employees' beneficiary association (VEBA) insurance trust. In light of its status as a VEBA trust, the IRS informed Illinois Lumber in a May 1989 letter that it was not required to file federal income tax returns unless it is subject to the tax on unrelated business income under Code Sec. 511.

At some point before 2003, Illinois Lumber obtained a membership interest in the Great American Mutual Holding Company. Around September 2003, Great American was involved in a "demutualization" process. The process involved the conversion of the mutually owned insurance company to a stock-ownership based insurance company. When demutualization occurs, the insurance company's policyholders are typically offered stock or cash in exchange for their ownership rights.

In September 2003, the liquidator of Great American sent a letter to Illinois Lumber along with a payment of almost $1.5 million. According to the letter, the payment represented Illinois Lumber's initial distribution for its membership interest in Great American. In addition to noting that the payment would not affect the benefits of any Great American policies held by Illinois Lumber, Great American also provided guidance on the tax consequences of the distribution. Great American advised that the liquidator had obtained a private letter ruling from the IRS confirming that Illinois Lumber's membership interest qualified as a capital asset and the entire amount of the initial distribution was long-term capital gain. As reflected in Rev. Rul. 71-233, the IRS considered the demutualization payments to be taxable income to the policyholders, for which the policyholders were to report a long-term capital gain with zero basis.

On its fiscal year end 2004 tax return, Illinois Lumber reported the demutualization payment on Form 990 T, Unrelated Business Income Return, and paid approximately $200,000 of tax on the payment. Illinois Lumber received at least two subsequent demutualization proceeds which it reported on its 2006 and 2008 tax returns.

The Fisher Decision

In August 2008, the Federal Claims Court issued a decision in Fisher v. U.S., 2008 PTC 2 (Fed. Cl. 2008), in which the court ruled against the IRS's position of assigning zero income tax basis to stock received in the demutualization of an insurance company. Under the circumstances of Fisher, the court concluded that the sale proceeds of the demutualized stock were to be treated as a return of capital up to the amount of the cost basis in the insurance policy (i.e., the open transaction doctrine). Any taxable gain would be limited to amounts received in excess of the cost basis. The IRS appealed.

In late 2009, the Court of Appeals for the Federal Circuit affirmed the Federal Claims Court's decision in Fisher, issuing an affirmance without a published opinion.

Amended Returns and Refund Claim

On October 31, 2008, shortly after the Federal Claims Court decision in Fisher, Illinois Lumber filed an amended return for its 2006 and 2008 tax years. Within a few weeks, on November 23, 2008, Illinois Lumber also filed a claim for refund of its 2004 taxes.

On December 16, 2009, the IRS disallowed Illinois Lumber's 2004 refund claim. Illinois Lumber sought an administrative appeal. On July 5, 2010, the IRS approved Illinois Lumber's claims for refunds for 2006 and 2008. In the IRS's "Explanation of Items" with respect to both the 2006 and 2008 refunds, the IRS noted that the final resolution of the appeal in Fisher "dictated how to move forward on these issues." Finding that Illinois Lumber's claim for refund for 2006 and 2008 involved the same issue, the IRS said that its claim for refund for taxes for proceeds from insurance demutualization should be allowed in full pursuant to the outcome of the appellate decision.

However, with respect to its refund claim for 2004, the IRS said that, had Illinois Lumber's claim been timely filed, the IRS would have granted the claim; however, since it was filed late, the refund claim could not be granted.

Illinois Lumber hired Charles Ulrich, a CPA, to help it appeal the IRS's decision. Mr. Ulrich noted that under Code Sec. 6511, an administrative claim for a tax refund must be filed with the IRS within either: (1) three years from the date on which the return giving rise to the refund claim was filed; or (2) two years from the date on which the tax was paid, whichever is later. According to Mr. Ulrich, the three-year statute of limitations in Code Sec. 6511 did not apply to Illinois Lumber because the statute applies only to persons or entities required to pay tax. He emphasized Illinois Lumber's status as a tax-exempt entity, noting that Illinois Lumber was not required to file any Form 990-T for unrelated business income. Moreover, even if the statute of limitations was applicable to Illinois Lumber, Mr. Ulrich argued that the organization met the requirements for mitigation under Code Secs. 1311-14, and could, thus, avoid the effect of the statute of limitations.

Mitigation Provisions

The mitigation provisions of Code Secs. 1311-14 provide a form of statutory relief and may apply in certain limited circumstances to claims that are otherwise barred by the statute of limitations. The mitigation provisions are intended to ensure that if certain prerequisites are met, either the government or the taxpayer can secure relief. The goal of the mitigation provisions is to leave the parties in as near as possible the position they would have been in if the item had been properly treated through the years. The party invoking mitigation bears the burden of establishing the following requirements:

(1) there must be a "determination" as defined by Code Sec. 1313(a);

(2) the "determination" must be a specified circumstance of adjustment listed in Code 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.

IRS Arguments

According to Charles Fisher, Team Manager of the IRS Appeals Office, the statute of limitations applied to Illinois Lumber's 2004 tax refund claim and the mitigation provisions of Code Secs. 1311-14 failed to overcome the effect of the statute on Illinois Lumber's claim. Observing that Code Sec. 1312 lists seven limited circumstances of adjustment, Fisher found that none applied to Illinois Lumber's refund claim. Of the seven enumerated circumstances, Mr. Fisher opined that the only one that might apply was Code Sec. 1312(1), applicable to the double inclusion of an item of gross income, i.e., the inclusion in gross income of the same item for more than one tax year. However, Mr. Fisher found this circumstance inapplicable because Illinois Lumber did not report a double inclusion of income in 2004. Mr. Fisher further stated that the mitigation provisions did not apply because the IRS had not taken an inconsistent position that caused a double inclusion of income.

Mr. Fisher did not address the possible applicability of the circumstance of adjustment found in Code Sec. 1312(7), which applies to the basis of property after erroneous treatment of a prior transaction. Mr. Ulrich had previously identified this circumstance as the applicable provision supporting Illinois Lumber's claim for mitigation in a letter to the IRS Appeals Office.

District Court's Decision

The district court began its analysis by looking at whether the statue of limitations applied to Illinois Lumber. The court noted that, while the Eighth Circuit, the circuit to which this case is appealable, does not appear to have addressed this issue, several courts have considered this very argument and rejected it. The court said that Illinois Lumber's interpretation of Code Sec. 6511 was inconsistent with Code Sec. 7422(a), which makes filing a claim for refund or credit a prerequisite to any suit for the recovery of any wrongfully assessed tax, or of any sum alleged to have been excessive or in any manner wrongfully collected. The court cited an analogous case in which the taxpayer argued that refund claims brought by a tax-exempt organization were subject to no administrative limitations period whatsoever. The district court concluded that such a reading of the Code made little sense. Thus, it rejected the argument that Illinois Lumber, as a tax-exempt organization, was not subject to the statute of limitations provisions.

The court then turned to the mitigation provisions and said Illinois Lumber met all the applicable requirements for applying the provisions. The court said there had been a final determination because the facts demonstrated that Illinois Lumber's refund claim was unqualifiedly disallowed.

With respect to the fact that the determination must fall into one of the seven specified circumstances listed in Code Sec. 1312, the court determined that Code Sec. 1312(7) applied to Illinois Lumber. A party seeking mitigation under this basis-related circumstance of adjustment, the court observed, must prove the following elements:

(1) the relevant "determination" determines the basis of property;

(2) there exists a transaction on which such basis depends;

(3) with respect to the transaction there occurred a described error which includes, for example, erroneous recognition and nonrecognition of gain or loss and erroneous inclusion or exclusion of gross income; and

(4) the described error occurred with respect to a the taxpayer.

The district court acknowledged that the Fisher decision and other subsequent demutualization cases were not binding precedent; however, in the absence of Eighth Circuit and Supreme Court authority, the district court found these cases persuasive and relevant. The court also noted the fact that the letter from the IRS to Illinois Lumber expressly cited the Fisher decision and stated that demutualization proceeds were not taxable. (Staff Editor Parker Tax Publishing)

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