The Eighth Circuit recently addressed the effect of the I.R.C.’s mitigation provisions in the context of insurance demutualization. The case demonstrates the need for an actively maintained inconsistent position—not a mere “favorable change in, or reinterpretation of, the income tax laws.”
The taxpayer, a tax-exempt insurance trust, purchased life insurance policies issued by a mutual insurance company. In 2003, the mutual insurance company began the process of “demutualization,” which is when an insurance company converts from “insurer owned by its policyholder members to one owned by stockholders.” Consequently, the taxpayer received a liquidating distribution of nearly $1.5 million. It reported this gain on its unrelated business income tax return for fiscal year 2004 and paid capital gains tax. It received additional distributions in 2006 and 2008.
Historically, the IRS adopted the position that “a policyholder’s proprietary interest in a mutual insurance company has a tax basis of zero.” The Court of Federal Claims, however, rejected that position in Fisher v. United States, 82 Fed. Cl. 780 (2008). The taxpayer filed refund claims for the capital gains taxes paid due to the liquidating distributions in 2004, 2006, and 2008. After the Federal Circuit affirmed Fisher, the IRS allowed the 2006 and 2008 refund claims; however, it rejected the 2004 claim, noting that the claim was not filed within the three-year statute of limitations provided by I.R.C. § 6511(a).
The taxpayer filed a refund suit in federal district court. The district court denied the government’s motion to dismiss and ruled that the I.R.C.’s mitigation provisions, I.R.C. §§ 1311 to 1314, applied and thus permitted the 2004 correction notwithstanding the statute of limitations.
The issue before the Eighth Circuit on appeal was whether the mitigation provisions did, in fact, ameliorate the untimely refund action.
A timely refund claim “is a jurisdictional prerequisite to a tax refund lawsuit.” As the court noted, “[g]enerally, a taxpayer must file an administrative claim for refund with the IRS within three years of the time the tax return was filed or within two years of the time the tax was paid.” Because a harsh system of statutes of limitations could result in severe inequities, Congress passed a limited set of mitigation provisions.
Here, the court noted that there are three requirements for mitigation to apply. First, there must be a “determination,” as defined by I.R.C. § 1313(a). Second, that determination must fit within one of the “circumstances of adjustment” listed in I.R.C. § 1312. Third, “the party against whom the mitigation provisions are being invoked [here, the Secretary of the Treasury] has maintained a position inconsistent with the challenged erroneous inclusion . . . of income.”
The court focused on the relevant circumstance of adjustment; the parties agreed that I.R.C. § 1312(7) provided the only potential circumstance. This subsection regards a determination that “determines the basis of property, and in respect of any transaction on which such basis depends, or in respect of any transaction which was erroneously treated as affecting such basis . . .”
Here, the Eighth Circuit found that the denial of the 2004 claim was due to timeliness—it was not a determination that “determined the basis of property.” Indeed, “[t]he IRS disallowance correspondence noted that the claim would have been granted had it been timely filed, but that volunteered comment was not a ‘determination [of] the basis of property.’” But, whether the IRS agreeing to the timely refund claims for 2006 and 2007 was a determination that established that the taxpayer had erroneously determined its basis in 2004, was an issue that raised “conflicting judicial decisions and commentary.”
Nevertheless, the court noted that there was no inconsistent position taken by the IRS. The court emphasized that the “IRS did not actively change its longstanding position that mutual policyholders’ proprietary interests have a zero basis when an insurance company demutualizes.” Rather, it “simply acquiesced in the Federal Circuit’s rejection of that position.” The court noted Brigham v. United States, 470 F.2d 571 (Ct. Cl. 1972), which emphasized the requirement that an actively maintained inconsistent position is basic to the existence of the statutory mitigation provisions.
In sum, the court rejected a mitigation interpretation that allows “taxpayers to reopen closed tax years based upon a favorable change in, or reinterpretation of, the income tax laws.” To do so would, as the court noted, “be fundamentally inconsistent with the congressional intent in enacting the mitigation provisions to ‘preserve unimpaired the essential function of the statute of limitations.’” (quoting Taxeraas, 269 F.2d at 289, citing S. Rep. No. 75-1567). Therefore, “[f]or the mitigation provisions to apply, there must be an ‘inconsistency’ that, unless adjusted, will cause the types of unfair results in successive tax years described in § 1312.” Here, “there was no inconsistency, merely different results in successive tax years resulting from a judicially-imposed change in the tax treatment of a complex transaction.”
The case is Illinois Lumber and Material Dealers Association Health Insurance Trust v. United States, No. 14-2537 (8th Cir. July 23, 2015). The opinion is available here.
