Analysis of and reflections on recent cases and rulings.

• Author: Beavers, James A.

Gross Income

Taxpayer's argument for $1.5 million refund fails on several grounds

A taxpayer was not entitled to a $1.5 million refund under a Sec. 1341 claim of right, the mitigation provisions of Secs. 1311 through 1314, or the doctrine of equitable recoupment.

Background

Richard O'Neill, a prominent landowner in Orange County, Calif., and political activist, established the revocable Richard J. O'Neill Trust in 1968. The trust became irrevocable upon O'Neill's death on April 4, 2009. At the time of his death, the trust held a majority ownership interest in RMV Total Diversification LLC (RMV), which was treated for tax purposes as a partnership and subject to the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA).

RMV sold capital gain assets during 2009 and 2010, resulting in flowthrough income to the trust, which the trust reported on its Forms 1041, U.S. Income Tax Return for Estates and Trusts, for 2009 and 2010.

O'Neill's estate borrowed money from RMV through what is commonly called a Graegin loan (see Estate of Graegin, T.C. Memo. 1988-477). RMV charged the estate 9% interest on the loan note, and the interest paid to RMV by the estate resulted in flowthrough income for the trust. The trust reported this income on its returns.

In June 2010, O'Neill's estate timely filed a Form 706, United States Estate (and Generation-Skipping Transfer) Tax Return. The IRS audited the return and proposed adjustments to it. The estate objected to the IRS's proposed adjustments and challenged them in Tax Court.

While the case was pending, the parties reached a settlement in their dispute, and the Tax Court entered a stipulated decision in the case. As part of this decision, the court adjusted the value of the estate's interest in RMV from $30,725,000 to $40,614,822 under Sec. 2036 and reduced the estate's interest deduction for the Graegin loan from 9% to 6%. Subsequent to the decision, the parties rewrote the loan note, which resulted in a $500,538 reduction of accrued interest to the trust for 2010.

In October 2015, the trust timely filed a Form 1045, Application for Tentative Refund, on which the trust made a tentative claim for 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 by the trust for the 2009 and 2010 tax years.

The IRS issued the trust a refund of $1.5 million in response to the trust's Form 1045. On reflection, the Service determined that the trust did not have a claim of right and was not entitled to the refund it received for the 2014 tax year. Consequently, it issued the trust a notice of deficiency for $1.5 million.

The trust declined to repay the refund and challenged the IRS's determination in Tax Court. The trust asserted in Tax Court that the Form 1045 it filed in October 2015 satisfied the Sec. 1341 claim-of-right requirements. In the alternative, the trust contended that it was entitled to the refund under the mitigation provisions of Secs. 1311 through 1314 or under a theory of equitable recoupment. Both parties moved for partial summary judgment on the issue of whether the trust was entitled to the refund it received.

The Tax Court's decision

The Tax Court granted the IRS's motion for summary judgment, holding that the trust was not entitled to a refund for the 2014 tax year under any of the three theories it advanced.

Claim of right Sec. 1341 applies where a taxpayer included an item in gross income for a prior tax year because it appeared that the taxpayer had an unrestricted right (a claim of right) to the item of income. Under the claim-of-right doctrine, a taxpayer is allowed a deduction after the close of the prior tax year if it is established that the taxpayer did not have an unrestricted right to that item of income. In certain circumstances, a taxpayer with a claim of right under Sec. 1341 may be entitled to a refund. For purposes of Sec. 1341, the original "circumstances, terms, and conditions" of the payment of an income item determine whether the taxpayer has an unrestricted right to it. A taxpayer's unrestricted right to an income item that is not subject to contingent repayment cannot be altered by subsequent agreements.

The Tax Court found both procedural and substantive reasons why Sec. 1341 would not apply to the trust. Procedurally, the court concluded that the trust was not the proper taxpayer to file a claim for refund. It found that both the capital gain and interest income that were the basis of the refund claim were partnership items and that, under TEFRA, these items must be...