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Peoria and Pekin Union Railway Co. v. Department of Revenue

December 18, 1998


Appeal from the Circuit Court of the 10th Judicial Circuit, Tazewell County, Illinois No. 96--MR--69 Honorable Donald C. Courson, Judge Presiding.

The opinion of the court was delivered by: Justice Breslin


A.D., 1998

On this appeal, the plaintiff, Peoria & Pekin Union Railway Company (railway), argues that the Illinois Department of Revenue (Department) unlawfully sought to recover taxes and penalties for a deficiency from 1988 by employing the federal change provisions of the Illinois Income Tax Act (Act) (35 ILCS 5/101 et seq. (West 1996)) after adjustments were made to its return by the Internal Revenue Service (IRS). We hold that because of the IRS's upward adjustment of the railway's 1988 taxable income, the Department could properly assess the railway for resulting deficiencies. We therefore reverse and reinstate the Department's decision.


The railway is a railroad operating in Illinois from its principal place of business in Creve Couer. In 1980 the railway entered into an agreement to borrow federal funds for improvements as permitted under the Railroad Revitalization and Regulatory Reform Act (45 U.S.C. §801 et seq. (1982)). Ultimately, $3.49 million was borrowed and the projects were completed by 1982. By 1988, when the funds had not been paid back, the railway reached an agreement with the federal railroad administrator to pay $1.54 million in full satisfaction of the indebtedness. The amount forgiven was $1.95 million.

A 1992 IRS audit determined that the forgiveness constituted taxable income under the Internal Revenue Code (Code) (26 U.S.C. §101 et seq. (1982)). The IRS also concluded that beginning in 1982 the railway improperly deducted interest totaling $324,804. Since none of the interest had actually been paid, the IRS found that it too constituted taxable income.

Because of these determinations, adjustments were made to the railway's 1988 federal return. The effect of the adjustment was to increase the railway's income for that year by $2,274,804 ($1,950,000 $324,804). The difference resulted in a modification to its 1988 "taxable income" from the reported -$879,261 to $1,395,543. Regardless of the change, the IRS was unable to assess the railway for taxes due from 1988 because the three-year statute of limitations in section 6501(a) of the Code (26 U.S.C.A. §6501(a) (West Supp. 1998)) had expired. An affidavit from IRS agent Donald Blair confirmed that although the railway's taxable income increased as a result of the audit, no federal assessment followed due to the expiration of the limitations period. The railway did not, however, escape federal assessments entirely. It was required to recalculate net operating loss and investment tax credit carryforwards for tax years 1989-91.

Information regarding the audit was subsequently disclosed to the Illinois Department of Revenue pursuant to section 6103(d) of the Code (26 U.S.C.A. §6103(d) (West Supp. 1998)). The railway filed amended Illinois returns reflecting changes in its federal taxable income for tax years 1989-91. On May 13, 1994, an amended Illinois return for 1988 was also filed . It did not reflect changes in income but noted in part VI that it was "being filed as a result of a 1988 RAR which affected the NOL C/F. No change in taxable income results due to the expiration of the statute." A Department audit concluded that there had been a change in federal taxable income which necessitated an amended return required by section 506(b) of the Act (35 ILCS 5/506(b) (West 1994)). A recalculation led the Department to conclude that the railway's base income for 1988 was $1,359,483 rather than $0, as it had claimed. *fn1 A notice of deficiency for tax year 1988 was issued on October 12, 1994, for $132,831 plus $42,559 in interest. Due to recomputation, the amount was later reduced to $158,215, which included a penalty of $28,941. The statement in the notice explained the deficiency as follows: "As a result of the Internal Revenue Service audit changes for the taxable year ending December 31, 1988 and your filing of the IL-1120-X dated May 13, 1994, it is necessary to reduce the allowable subtraction modification for Pre-86 Federal Net Operating Loss to zero. (Illinois Income Tax Act, Sections 203(b) and 506(b)."

The railway disputed its tax liability, claiming that the Department had no greater power to tax than the IRS and, since the limitations period expired for 1988, no assessment was possible. A hearing followed before an administrative law Judge (ALJ). The ALJ rejected the railway's arguments. She concluded that although the limitations period expires three years from the date a return is filed, the Department may issue a notice of deficiency within two years of notice to the Department of a change to taxable income under section 905(a) of the Act (35 ILCS 5/905(a) (West 1996)). Because there was a change, the ALJ determined that the Department had an additional two years and that it had properly filed the notice within that period. Ultimately the ALJ concluded that the assessment was proper and that the railway's failure to exercise ordinary business care under the circumstances warranted a penalty.The railway sought administrative review in the circuit court. Without elaboration, the court found that the Department's action was "contrary to law" and reversed. The Department appeals.


An appellate court's role in an appeal from an administrative decision is to review the agency's determination, not the circuit court decision. Jackson v. Board of Review, 105 Ill. 2d 501, 475 N.E.2d 879 (1985). Judicial review of administrative decisions extends to all questions of law and fact presented by the record. 735 ILCS 5/3-110 (West 1996); Sandburg Faculty Ass'n v. Illinois Educational Labor Relations Board, 248 Ill. App. 3d 1028, 618 N.E.2d 989 (1983). An agency's findings of fact are considered prima facie true and correct. 735 ILCS 5/3-110 (West 1996); Strube v. Pollution Control Board, 242 Ill. App. 3d 822, 610 N.E.2d 717 (1993). The court reviews the agency's factual findings only to determine if they are against the manifest weight of the evidence. Jones v. Peoria County Sheriff's Merit Comm'n, 249 Ill. App. 3d 883, 619 N.E.2d 830 (1993). The court may not reweigh the evidence or substitute its judgment for that of the administrative agency. Strube, 242 Ill. App. 3d at 826, 610 N.E.2d at 720; Farmers State Bank v. Department of Employment Security, 216 Ill. App. 3d 633, 576 N.E.2d 532 (1991). As for questions relating to the interpretation of a statute that an agency is charged with enforcing, the agency's interpretation is entitled to substantial weight and deference, but it does not bind the court and will be rejected when erroneous. Village of Downers Grove v. Illinois State Labor Relations Board, 221 Ill. App. 3d 47, 581 N.E.2d 824 (1991).


The Act imposes a tax on the net income of every corporation. 35 ILCS 5/201(a) (West 1996). Net income is a taxpayer's base income less the standard exemption and a deduction that is not relevant here. 35 ILCS 5/202 (West 1996). A corporation's base income is equal to its "taxable income" as modified by the Act. 35 ILCS 5/203(b)(1) (West 1996). A taxpayer's taxable income is defined as that individual's "taxable income properly reportable for federal income tax purposes for the taxable year under the provisions of the Internal Revenue Code." 35 ILCS 5/203(e)(1) (West 1996). Thus, federal taxable income is the starting point when determining a corporation's state income tax liability. See generally Searle Pharmaceuticals, Inc. v. Department of Revenue, 117 Ill. 2d ...

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