On Appeal From the Decision of the United States Tax Court, No. 26234-92
Before BAUER, MANION, and KANNE, Circuit Judges.
In 1966 a predecessor to Fruit of the Loom sold assets to a purchaser that ultimately failed to pay $19 million. The loss justified a tax deduction. The problem here is that the IRS claims the company, due partly to procedural mishaps, was able to realize the full deduction twice, resulting in a "double counting." We consider whether the Internal Revenue Service can invoke the mitigation provisions of the Internal Revenue Code to collect additional taxes from taxpayer to rectify this "double counting" by assessing a tax deficiency which otherwise would be barred by the applicable statute of limitations. Because the Commissioner has not met her burden of proof to invoke the mitigation provisions as an exception to the statute of limitations, we affirm the decision of the tax court.
A. Factual and Procedural Background
Some thirty years ago the Philadelphia & Reading Corporation originally claimed the tax deduction at issue in this case. *fn1 In 1966, one of taxpayer's subsidiaries, Extoy Corporation, sold its operating assets. As part of that sale the buyer gave the taxpayer a $19 million note. In 1967, because of the buyer's financial problems, the note was cancelled. Taxpayer subsequently prepared its 1966 tax return on which it reduced the amount realized on the Extoy sale by the face amount of the cancelled $19 million note.
In fall 1972 the Commissioner of Internal Revenue completed an audit of taxpayer's 1964-68 taxable years. A principal issue in the audit was the $19 million reduction in sale price claimed for Extoy for 1966. The facts surrounding this audit are developed in detail in the tax court's opinion, Fruit-Of-The-Loom, Inc. v. Commissioner, 68 T.C.M. (CCH) 867, 868 (1994), with which this opinion assumes familiarity.
During the audit one of Commissioner's examining agents disallowed the Extoy loss deduction for 1966 on the ground that the reduction in sale price did not occur until 1967 and therefore was not properly deductible until that tax year. After a series of discussions, the parties agreed to resolve the issues raised in the audit, including the Extoy loss issue. The parties memorialized the terms of this resolution in an IRS Form 870, which listed deficiencies for tax years ending 1965, 1966, and 1968, and overassessments for tax years ending 1964 and 1967. Specifically with regard to the Extoy loss, taxpayer and the Commissioner agreed that the $19 million deduction should be disallowed for 1966, but that $15.2 million of the reduction in sale price could be deducted in 1967 and the remaining $3.8 million would be allocated to a warrant taxpayer received to purchase stock.
Because taxpayer did not want Commissioner to assess the deficiencies until the Joint Committee on Internal Revenue Taxation ("Joint Committee") approved the over-assessments, the Form 870 expressly delayed the assessments until the IRS authorized the overassessments. The parties executed the Form 870 in December 1972.
As a result of an internal communication problem certain qualifying language in the Form 870 was overlooked. One of Commissioner's employees assessed deficiencies in February 1973 without issuing taxpayer a notice of deficiency and while the Joint Committee was still reviewing the overassessments. After taxpayer complained about a bill for the premature assessments, the Commissioner's employee abated them and sent notice of such to the taxpayer. In the meantime the Joint Committee approved a refund of the overassessments in June 1973. The Commissioner then secured an extension of the limitations period for the deficiency years 1965, 1966, and 1968 to September 30, 1973.
In June 1973 a second, more serious communication breakdown occurred. Unaware that the limitations period had been extended, the same employee of Commissioner reassessed deficiencies for the years 1965, 1966, and 1968. Despite being informed of the error, Commissioner refused to abate the assessment, although she did stay any collection until the overassessments had been credited. The taxpayer must receive notice of such a deficiency before any assessment becomes final. However, Commissioner failed to issue a notice of deficiency for the 1965, 1966, and 1968 tax years before the extended statute of limitations expired on September 30, 1973.
In November 1973 Commissioner initiated proceedings against taxpayer to collect the June 1973 deficiency assessments. Taxpayer filed suit in the United States District Court for the Northern District of Illinois to enjoin Commissioner from collecting these taxes, alleging that Commissioner had neither issued a notice of deficiency nor complied with the conditions in the Form 870 waiver. The district court ruled Commissioner's assessment illegal and enjoined the Commissioner from collecting any amount in excess of the net deficiency (i.e., the deficiency amount less the over-assessment amount, an offset total of $4,060,184). Philadelphia & Reading Corp. v. Beck, 81-1 U.S.T.C. para. 9180 (CCH). But the district court also ruled that taxpayer had failed to establish the requisite harm for injunctive relief to stay collection of the net deficiency. Id. This court affirmed that ruling. Philadelphia & Reading Corp. v. Beck, 676 F.2d 1159 (7th Cir. 1982) ("P & R I").
Commissioner collected the net deficiency in 1983 by levying taxpayer's bank account in Chicago. Taxpayer sued the United States in the United States District Court for the District of Delaware in November 1983 for a refund of the 1966 and 1968 deficiencies and later amended that complaint to request a refund of the 1965 deficiencies as well. The U.S. district court in Delaware found the June 1973 assessments illegal and invalid but denied relief to taxpayer on the ground that it had previously obtained the benefits of the overassessments without suffering any material detriment. Philadelphia & Reading Corp. v. United States, 738 F. Supp. 143, 149 (D. Del. 1990). The Third Circuit reversed, 944 F.2d 1063 (3d Cir. 1991) ("P & R II"), holding that all amounts collected pursuant to the illegal and invalid assessments for taxpayer's 1965, 1966, and 1968 tax years must be refunded to the taxpayer. The Third Circuit noted that while this court's decision in P & R I was correct because equitable considerations must apply in an injunction proceeding, such considerations did not apply in a purely legal refund suit. 944 F.2d at 1073-75. On remand, the district court ordered Commissioner to refund to taxpayer federal income taxes, penalties, and interest totaling $59,897,232.68.
After P & R II, Commissioner issued a notice of deficiency to taxpayer for the 1966 tax year, asserting that the mitigation provisions of the Internal Revenue Code allowed it to reopen the closed 1966 tax year to determine a tax deficiency. Commissioner asserted that P & R II had allowed taxpayer a "deduction" for a loss taxpayer took in 1967, thus permitting the IRS to use the mitigation provisions to prevent a "double deduction" of that loss in 1966 and 1967. Taxpayer challenged this notice of deficiency in the tax court. The "double deduction" is at the core of this case.
B. The Mitigation Provisions of the Internal Revenue Code
The mitigation provisions of the Internal Revenue Code, 26 U.S.C. secs. 1311-1314, "allow both the Commissioner and the taxpayer to correct an error made in a prior closed tax year and to obtain an adjustment to tax liability despite the running of the ordinary period of limitations." O'Brien v. United States, 766 F.2d 1038, 1041 (7th Cir. 1985). This court has noted, however, that "Congress did not intend to provide relief in all situations in which just claims are precluded by statutes of limitations" and has recognized the need for limitations statutes despite the harsh results they sometimes cause to taxpayers and the government alike. Olin Mathieson Chem. Corp. v. United States, 265 F.2d 293, 296 (7th Cir. 1959). The relief provided by the mitigation statutes "is limited to defined circumstances, and 'does not purport to permit the correction of all errors and inequities.' " Provident Nat. Bank v. United States, 507 F. Supp. 1197, 1200 (E.D. Pa. 1981) (quoting Brennen v. Commissioner, 20 T.C. 495, 500 (1953)).
The party who attempts to invoke the mitigation provisions, in this case the Commissioner, bears the burden to prove that their specific requirements have been met. O'Brien, 766 F.2d at 1042. As the tax court noted below, for the mitigation provisions to apply:
1. An error must have occurred in a taxable year which cannot otherwise be corrected by operation ...