Tax Court Determines that Mitigation Applies to Correct an Exclusion of Income at the Beneficiary Level of a Trust

Deloitte’s Tax Insights for May 2016 discusses the case of Costello v. Commissioner, in which petitioners Sally and Brian Costello were beneficiaries of a 1993 Trust created by their father. The pair challenged proposed deficiencies asserted by the IRS, arguing that the assessment statue of limitations had expired in their 2001 tax years. The article states,

The IRS asserted that this situation properly fell under mitigation to allow it to reopen the Beneficiaries’ 2001 tax year and assess deficiencies related to the exclusion of distributions the Beneficiaries received from the Trust. The Beneficiaries asserted that mitigation did not apply as the IRS created the issue, they did not maintain an inconsistent position and the proper relationship did not exist to utilize mitigation between the Trust and Beneficiaries.

The Tax Court dismissed the Beneficiaries’ argument that mitigation was not applicable as the IRS examination caused the change in tax position. The Tax Court noted the mitigation provisions applied equally regardless of how the situation was created, thus the IRS could utilize mitigation to correct the error if the requirements for mitigation were met.

Next, the Tax Court examined the following mitigation requirements: (1) a determination, (2) a circumstance of adjustment, and (3) whether the correction was barred at the time of the determination, to evaluate whether the IRS could utilize mitigation. Under Section 1313, a determination includes a decision by the Tax Court, closing agreement under Section 7121 and a final disposition by the Secretary of a claim for refund. In this instance, the Tax Court held that the IRS acceptance of the Trust’s refund for the tax year 2001 constituted a determination for mitigation purposes.

Section 1312 contains seven circumstances of adjustment to which the mitigation provisions can apply. The Tax Court noted that the relevant circumstance of adjustment in this case was Section 1312(5), which provides:

The determination allows or disallows any of the additional deductions allowable in computing the taxable income of estates or trusts, or requires or denies any of the inclusions in the computation of taxable income of beneficiaries, heirs, or legatees, specified in subparts A to E, inclusive (secs. 641 and following, relating to estates, trusts, and beneficiaries) of part I of subchapter J of this chapter, or corresponding provisions of prior internal revenue laws, and the correlative inclusion or deduction, as the case may be, has been erroneously excluded, omitted, or included, or disallowed, omitted, or allowed, as the case may be, in respect of the related taxpayer.

The Tax Court held that this situation fell under the above, as the Trust was granted a refund for the tax year 2001based on the deduction for the JH distributions it had received, but there was no correlative inclusion of income at the Beneficiaries.

Lastly, the Tax Court noted that the Beneficiaries’ 2001 returns were closed for purposes of assessment on August 8, 2008, the date that the Trust’s refund claim was granted, i.e., the determination. Accordingly, the Tax Court concluded that the IRS met the standards for mitigation.

Read the full post here: IRS Insights

Posted by Allison Trupp, Associate Editor, Wealth Strategies Journal