Parties adversely affected by either a double deduction or double inclusion may attempt to seek relief by lifting the statute of limitations through the provisions of IRC Secs. 1311 through 1315. Where these provisions cannot be met, they may still seek relief by use of the judicial doctrine of equitable recoupment. Unfortunately, court decisions have left many unanswered questions in both areas.

IRC Secs. 1311 through 1315 allow a taxpayer or the IRS to reopen the statute of limitations in certain circumstances. The intent of these mitigation provisions is to provide a statutory remedy for the party who is adversely affected by a double deduction or double inclusion. The requirements for relief, however, do not allow for subjective judgments as to what is equitable. Despite these provisions, a taxpayer may not be able to balance the scales of justice. The recent Hall case is a good illustration.

Mr. Hall, his wife, and other family members owned a five percent overriding royalty interest in a federal oil and gas lease in Wyoming that was subject to the windfall profit tax. The operator, Amoco, withheld the tax from the royalties due the Halls and paid it to the IRS. However, a retroactive downward allocation of the Halls' interest by the Bureau of Land Management forced Amoco to recalculate the amounts the Halls were entitled to for 1980-85. The result was that Amoco had overpaid royalties to the Halls and withheld too much tax. Amoco took care of its own problem by subtracting the overpaid royalties from the amounts it owed the Halls. But Amoco did not correct the overwithheld amounts with the IRS except for filing an information return showing an overpayment of the tax.

The Halls filed claims in 1987 and were granted refunds for the open years 1983, 1984, and 1985. But the IRS disallowed the claims on the 1980-82 closed years. The Halls then sued and were granted refunds on the closed years by the District Court in Utah. The court said windfall profits were an item of gross income and fit under the category of "double inclusion of an item of gross income" in IRC Sec. 1312. Thus, the doctrine of mitigation applied, but the government appealed.

On appeal, the Tenth Circuit said a taxpayer can sue the government only if the government has waived its sovereign immunity. The Court then commented that IRC Secs. 1311 through 1315 are in Subtitle A of Title 26 of the U.S. Code. The windfall profit tax before its 1988 repeal, was in Subtitle D of Title 26, dealing with excise taxes. Thus, the Court held the government had only waived its sovereign immunity in regard to income tax. The regulations under IRC Sec. 1311 hold the mitigation provisions apply only to income taxes. The Tenth Circuit did not find these regulations inconsistent with the statute.

When the Appeals Court reversed and held for the IRS, it still left open the possibility the Halls could return to the District Court and use the judicial doctrine of equitable recoupment to overcome the statute of limitations. This doctrine is in some ways broader than IRC Secs. 1311- 15, but there are significant limits to its use as will be explained later.

Statutory Mitigation of the Statute of Limitations

Several requirements must be satisfied to obtain relief under IRC Secs. 1311-15. A determination for an open year must indicate the earlier time-barred treatment was erroneous. If the determination results in a refund or a deficiency, the position adopted by the IRS or the taxpayer must be inconsistent with the IRS's or taxpayer's earlier erroneous treatment. The correction must fall within one of the following circumstances: double inclusions or exclusions of gross income; double allowances or disallowances of deductions or credits; corrective deductions, credits, and inclusions involving trusts, estates, beneficiaries, and legatees; corrective deductions and credits for certain related corporations; and basis of property after an erroneous treatment in a prior transaction. The party seeking relief has the burden of proving these provisions have been met.

The application of IRC Secs. 1311-1315 has resulted in considerable litigation. Some of the questions that continue to cause problems are: 1) What is a "determination?" 2) What is an item of income? and 3) Do the mitigation statutes apply only to income taxes?

What is a "Determination"?

A determination must fit one of the following categories: 1) a final court decision, 2) a closing agreement, 3) a final disposition of a refund claim, or 4) an agreement with the IRS. The first two categories need no interpretation. As an example of the third category, the Fifth Circuit, in Rachal, required the IRS to lift the statute and make inventory adjustments consistent with those allowed in a claim for refund. The court ruled that in allowing adjustments that were not barred, the Commissioner had made a "determination" on the barred overpayments.

The final category, "an agreement," needs some definition. It is clear the proper filing of Form 2259 (agreement to the tax liability of a taxpayer) will meet this requirement. However, examples of actions which have been held not to constitute "determinations" include a taxpayer election to change an inventory method, adjustments included in a revenue agent's report, and the signing of Form 870. However, even if a "determination" occurs, the bar of the statute is not lifted for a year closed by an IRC Sec. 7122 compromise agreement. The question whether a determination for another tax such as estate tax, qualifies as a determination under IRC Sec. 1313 will be considered below.

What is an Item of Income?

The mitigation provisions of IRC Secs. 1311-1315 originated in the Internal Revenue Act of 1938 because the Ways and Means Committee felt "much litigation under the revenue acts deals with the proper year in which income and deductions belong." While both the taxpayer and Commissioner may agree that an item is properly a part of gross income, they disagree as to the year in which it should be included. This income tax emphasis was not changed in the 1954 revision and is reflected in the regulations that state "the determination under IRC Sec. 1313 may be with respect to any of the taxes imposed by Subtitle A Income Taxes of the 1954 IRC...or by the corresponding provisions of any prior revenue act....IRC Sec. 1311 may be applied to correct the effect of the error, only as to the tax or taxes with respect to which the determination relates."

IRC Sec. 1312 (1), (2), and (7) provides for mitigation of the statute when an item of gross income is involved. However, the courts have not always agreed whether this phrase means only items defined as gross income under IRC Sec. 61. In an early case, the question was whether inventory would be an item of gross income even though not included in IRC Sec. 61. The court concluded inventory was indeed an item of gross income because "it is vital in the determination of gross income." The court interpreted the concern of Congress to be with "results, rather than a particular class of item," and thus believed a liberal interpretation of "item of gross income" was appropriate. This interpretation has been generally followed by subsequent cases involving inventory.

It would seem this approach would also extend to the deduction of depreciation, again a vital item in the computation of gross income. The U.S. Court of Claims drew upon the Gooch opinion in the 1958 Fine case in concluding "depreciation allowances are as much constituent elements in the determination of the cost of goods sold as the inventories." In another case, the Court of Claims concluded a divorce property settlement that increased or decreased the taxpayer's gross income was also an item of gross income because in following Gooch "...the term item was not defined or limited by Congress, and in our opinion, it should be interpreted to include any item or amount which affects gross income in more than one year, and produces as a result, double taxation or inequitable avoidance of tax." These decisions, consistent with Gooch, suggest any item vital in the computation of gross income is an item of gross income. However, the Tenth Circuit did not agree with this approach in Gardiner. The court concluded the meaning of an item of gross income includes only the specific items under IRC Sec. 61, not "...everything that results in an increase in tax. It is restricted to positive items and does not include negative elements such as deductions (like depreciation), the omission of which results in increased taxes."

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Do the Mitigation Provisions Apply Only to Income Taxes?

Will an estate or other type of tax determination qualify as a IRC Sec. 1313 determination? For example, a recipient who is taxed on income in respect of a decedent is entitled to an offsetting deduction for any estate tax attributable to the same property. A taxpayer attempting to invoke the mitigation provisions argued, therefore, that the inclusion of an asset in a gross estate would constitute an allowable determination. However, the Court, relying on the literal language of IRC Sec. 1312(5), ruled mitigation occurs only where the determination involves the deductions or inclusions in computing taxable income, not gross estate.

Will the courts reach the same conclusion when the basis of an asset is established in an estate tax situation? One court said a Tax Court decision and a collateral agreement concerning stock basis for estate tax purposes did not constitute a determination. The Court based its conclusion on the regulations and the fact that the mitigation provisions were moved from "miscellaneous provisions" in the 1939 IRC to "Subtitle A Income Tax Provisions" in the 1954 IRC.

Another District Court reached the same conclusion in a similar case, holding a determination must be made solely and exclusively in connection with income taxes. However, on appeal, the Fourth Circuit contended this was an unrealistically narrow view, especially in light of the fact the phrase "a determination under the income tax laws" was removed during the revision of the IRC in 1954. Moreover, the Fourth Circuit pointed out the District Court was only concerned with income taxes, but that the determination of estate tax values is essential in ascertaining the correct income tax liability.

The Fourth Circuit also relied upon the existence of IRC Sec. 1314(e) as a further indication the mitigation provisions may utilize more than income tax determinations. It would seemingly be superfluous to include this section stating the mitigation provisions are inapplicable to employment taxes if no taxes except income taxes are covered by these provisions.

The initial decision of the District Court in Hall underlined the Chertkof conclusion that a determination can involve other code sections that are not income tax provisions but which affect income taxes. However, Hall differed from Chertkof in the sense the taxpayer sought a refund of windfall profit taxes rather than income taxes. Thus, the court was not faced with a situation where a non-income tax determination affects income tax, but with a refund claim of a non-IRC Sec. 61 tax. Although the District Court was willing to apply the mitigation provisions because of the similarity of "windfall profits" and the items listed in IRC Sec. 61(a), on appeal the Tenth Circuit was unwilling to broadly interpret the statute and reversed.

Judicial Mitigation of the Statute (Equitable Recoupment)

The doctrine of equitable recoupment is a judicial remedy for mitigating the harsh effects of closed tax years. The intended purpose is to prevent "unjust enrichment" by either the taxpayer or the government. The taxpayer (IRS) is allowed the right of offset of time-barred overpayments (deficiencies) against deficiencies (overpayments) assessed (claimed) by the IRS (taxpayer). The party raising equitable recoupment as a defense must be able to answer the following three questions in the affirmative: Does the overpayment or deficiency arise from the same transaction? Is the transaction subjected to two taxes based on inconsistent legal theories? Is the main action timely? These criteria were developed in early Supreme Court decisions but continue to be refined in recent cases.

Early Cases

The doctrine of equitable recoupment originated in the 1935 Bull decision where the Supreme Court drew upon common law to prevent the unjust enrichment of the government because of an assessment of both an income and estate tax on the same transaction. The court allowed a timely assessment of income tax to be offset by a time-barred estate tax. Although the Court thereby opened up the possibility of recoupment, it was careful to make limits to the doctrine. Equitable recoupment should only be a defense; it cannot be used as an independent ground for a suit, according to the Court.

The decision in Stone underlined the necessity for unjust enrichment of one party. The trustees of an estate brought a suit to recover taxes erroneously paid. The Supreme Court ruled, however, that equitable recoupment was inappropriate because the government had not been unjustly enriched (only one tax had been paid). The tax should have been paid by the beneficiaries but in equity the beneficiaries and trustees were the same person, according to the Court.

The Supreme Court, in Rothensies v. Electric Storage Battery Co., resisted the temptation to broaden recoupment despite three dissents. The majority warned that the "equity-minded judge" may be tempted to search for means of relief in individual situations and forget the unfairness of requiring the other party to litigate a time-barred claim. The Court felt the doctrine should be limited in scope and denied recoupment where two separate transactions occurred.

Do the Overpayment and Deficiency Arise from the Same Transaction?

The Electric Storage Battery case is a good place to begin the discussion of the "single transaction" requirement. The taxpayer paid excise taxes on the sale of batteries from 1919 to 1926. The taxpayer was able to get a refund for the open years (1922-1926) after it was determined the sales were not subject to excise taxes. However, the government taxed these refunds as income under the tax benefit doctrine since the company had deducted the excise taxes on its income tax returns. The taxpayer attempted to offset the time-barred excise tax payments (1919-1921) against the income tax deficiency assessed on the refunds. The Supreme Court denied the taxpayer's request on the basis there were two transactions. The excise taxes were based on the sale of batteries but the refund was based on a prior deduction under the tax benefit rule.

While a payment and a refund of that same payment is not a "single transaction," one payment taxed twice is a single transaction. In Dalm, an administratrix of an estate had been a long-time employee of the decedent. The decedent's brother caused one-third of the estate to be transferred to the administratrix. The IRS said the transferred amounts were in the nature of additional administrative fees and assessed an income tax on Dalm. After a Tax Court trial, Dalm settled the case for one-half the claimed deficiency. Dalm paid this amount, but then claimed equitable recoupment on gift taxes she had paid on the same amount in a statute-barred year. There was obviously only a single payment or single transaction involved. She had paid both gift taxes and income taxes on the same amount. On this basis, the Sixth Circuit allowed recoupment but the decision was overturned by the Supreme Court (see later discussion).

In some cases this requirement of a single transaction has been slightly relaxed so that two taxes levied on one fund has been treated as the equivalent of a single transaction. In Boyle, at issue was whether a dividend arrearage taxed as part of an estate for estate tax purposes was the same transaction as the subsequent dividend distribution taxed as income to the beneficiaries. The Third Circuit allowed recoupment because both taxes had been levied on one fund, despite the fact that, loosely speaking, two transactions occurred under two different statutes. But why did this "one fund" rationale not work in Electric Storage Battery where the refunded excise tax could be construed as being from the same "fund" of tax that was paid? Interestingly, the Third Circuit saw time as the key difference between the two cases. The Electric Storage Battery Company waited 20 years to get its refund, whereas only a short time elapsed between the estate tax and the income tax in Boyle. Thus, a considerable time lapse between two taxes may make it more difficult to argue both taxes spring from the same fund.

In Boyle the court decided the "practical effect" of an estate tax and an income tax on the same fund was to tax a single transaction twice. However, other courts have favored a more limited application of the single transaction criterion. For example, a bad debt deduction creating a refund for income tax purposes coupled with the failure to include the refund as an asset on an estate tax return did not constitute a single transaction. Also, a refund of excise taxes on sale of gasoline to a partnership in which the taxpayer was a 50% partner followed by a sale of the gasoline by the partnership to customers was not a single transaction.

A single transaction criterion implies the party claiming recoupment must be the same party as the original taxpayer. Otherwise, recoupment would not promote equity. In Hall, equitable recoupment may not apply because the government collected taxes from both the holders of an interest and the lease operator on the same items of windfall profits. Thus, the requirement that there be one party taxed twice would not appear to be satisfied. The Appeals Court did not deal with equitable recoupment. However, the Halls could return to the District Court and raise the issue.

Is a Transaction Subjected to Two Taxes Based on Inconsistent Legal Theories?

For recoupment to apply, two taxes must have been assessed based on inconsistent legal theories. In Bull, recoupment was allowed by the Supreme Court when both estate and income taxes were assessed on the same sum. However, in Gulf Oil Corp. recoupment was denied because two taxes had not been collected. There had been only a single erroneous collection of tax. It may be easier to argue two taxes were paid if the taxes are different types of taxes as in Bull. However, even where two types of taxes are clearly involved, the IRS may attempt to show two taxes were levied under different statutes rather than under inconsistent legal theories. In Boyle, two taxes were clearly assessed: an estate tax on a dividend arrearage and an income tax on the dividend distribution. The IRS argued and the District Court agreed that two separate statutes gave it the right to tax both the accumulation and the distribution. But the Third Circuit held for the taxpayer because both taxes were levied on a definite fund.

The IRS has also attempted to demonstrate that even though two taxes were literally assessed, a settlement had in retrospect the effect of producing a one-tax situation. The taxpayer in Dalm paid both gift taxes and income taxes on a portion of the property transferred to her. The taxpayer and the IRS settled the income tax for one-half the original assessment. The IRS argued and the district court agreed that only one tax had been assessed because the settlement amount took into account the previously paid gift tax. However, the Sixth Circuit interpreted the settlement as an income tax matter only. Thus, the earlier gift tax stood independently. Care should be exercised when entering into settlement agreements where recoupment may subsequently be raised. Whether two taxes were assessed may depend on something as vague as the understanding of the parties involved. In Dalm, the Court of Appeals gave the taxpayer the benefit of the doubt when it heard conflicting testimony concerning whether the income tax settlement took into account any previously paid gift taxes.

Is There a Timely Deficiency Claim By the Government?

At first glance, this requirement does not seem to be a barrier because a taxpayer would usually raise recoupment only if the government assessed a deficiency that resulted in a double tax. But this requirement has caused problems for taxpayers because the word deficiency has been narrowly interpreted and the IRS uses this requirement to defeat so-called separate or independent actions.

In O'Brien the taxpayer reported a gain on inherited stock using as his basis the value in his father's estate tax return. The Tax Court later entered a stipulated order raising the stock value for estate tax valuation purposes. Since the increased value would decrease his reported gain, the taxpayer filed a claim for refund after the statute had run. The Seventh Circuit did not uphold the refund because the double tax did not result from a "deficiency action." Thus, unless the government actually makes a deficiency claim, recoupment is not available to remedy the closed year problem.

Interestingly, the district court in holding for the taxpayer, had interpreted O'Brien as a situation where the government had taken inconsistent positions in the collection of separate taxes arising out of a single triggering event--the death of the taxpayer's father. But the Seventh Circuit reversed by stressing the taxpayer's refund claim was a separate action and recoupment can only be used as a defense. The action was separate, said the court, because the taxpayer filing the refund suit was not the same taxpayer as the one to whom the erroneous determination had been made. Apparently inheriting and selling stock are two separate transactions despite the fact both are rooted in the death of the taxpayer's father. The district court was trying hard to correct an inequitable situation but the Court of Appeals overturned the attempt because the taxpayer was in effect seeking to reopen a closed year. The main action must be timely. The basic methodology of equitable recoupment is to make an open year wrong to correct the closed year. In O'Brien, the taxpayer was trying to make a closed year wrong to correct another closed year.

This same rationale was stretched in Dalm where the Supreme Court would not allow recoupment for a taxpayer in a district court action because the deficiency had been litigated in an earlier Tax Court proceeding. Thus, even litigation of the same transaction is a separate untimely action unless it is being used as a defense in the original trial.

The requirement of a timely deficiency claim may work in favor of the taxpayer. The courts have acted to prevent the IRS from offsetting a current overpayment against a time-barred deficiency the IRS had failed to assess. In the 1986 Kolom case, the IRS had not noticed the incorrect treatment of a sale of stock options until the statute had run. The IRS attempted to offset a current overpayment against the deficiency, but was rebuffed by the Ninth Circuit. It may be important to note in this case the taxpayer had "clean hands," i.e., the sale of the stock options was clearly identified, though incorrect.

Many Unsettled Questions

Taxpayers attempting to bypass the statute of limitations should pay careful attention to the unsettled questions which abound in this area. One measure of the uncertainty taxpayers face is the frequency with which trial court decisions are reversed. Taxpayers who seek statutory relief must navigate the intricacies of IRC Secs. 1311-1315 as well as be aware of the unresolved judicial questions such as whether these provisions apply only to income taxes. Because equitable recoupment was developed by the courts to do equity in cases where the statute does not apply, it is tempting to believe the courts will focus on equity rather than narrow requirements. However, the cases reveal the courts' reluctance to bypass the statute of limitations except in restricted circumstances.

Robet C. Elmore, PhD, CPA, is assistant professor of accounting and Larry Maples, PhD, CPA, professor of accounting, both at Tennessee Technological University.