[81-1 USTC ¶9136]A & A Distributors, Inc., Plaintiff v. United States of America , Defendant

U. S. District Court, Dist. Mass., Civil Action No. 75-1159-G, 12/19/80

[Code Sec. 7122]

Compromises: Execution of Compromise and Collateral Agreements: Waiver: Effect on subsequent net operating loss carryback.--A waiver contained in a collateral agreement executed between the taxpayer and the IRS in settlement of the taxpayer's disputed liability for a delinquency penalty did not prevent the taxpayer from claiming a carryback of a net operating loss to the year compromised. Even though the collateral agreement contained a waiver of the right to claim such a carryback, that agreement was clarified by a Compromise Agreement that permitted refund of amounts "in excess of the difference between the liability sought to be compromised and the amount offered". The taxpayer was, therefore, entitled to collect the refund from the carryback less the amount of the abated penalty. BACK REFERENCES: 81 FED ¶5697.025.

David R. Andelman, Jonathan J. Margolis, Lourie & Cutler, 1 State Street, Boston, Massachusetts 02109, for plaintiff. Anderson , Assistant United States Attorney, V. James Ferraro, Department of Justice, Washington , D. C. 20530, for defendants.

Memorandum of Decision

GARRITY, Jr., District Judge:

Plaintiff A & A Distributors, Inc. (the Taxpayer) ¹ brings this action for refund of its corporate income taxes paid for the fiscal year ending May 31, 1970 pursuant to IRC §7422, 26 U. S. C. §7422. The Taxpayer suffered a net operating loss for its fiscal year ending May 31, 1973 , and filed an "Application for Tentative Refund from Carryback or Net Operating Loss" on IRS form 1139 claiming a refund of $36,302 for the fiscal year ending May 31, 1970 . This application, and the Taxpayer's subsequently filed claim for refund of excessively collected taxes, IRS form 843, were denied by the IRS in letters dated November 29, 1973 and February 3, 1975 , respectively. The IRS relied upon a collateral agreement executed by the Taxpayer in which the Taxpayer waived the right to claim a refund for the year ending May 31, 1970 due to the carryback of a net operating loss.

The Taxpayer filed this suit on March 25, 1975 , claiming that a refund is due from taxes paid for the fiscal year ending May 31, 1970 . The Taxpayer bases its claim on its interpretation of the Compromise and Collateral Agreement executed for that year and on the asserted invalidity of the Collateral Agreement. Cross motions for summary judgment were filed in June, 1980, and we heard oral argument. It is ordered, for the reasons given below, that the Taxpayer's claim for a refund of the amount of its net operating loss carryback, less the amount of the delinquency penalty abated in the Offer in Compromise, be allowed for the tax year ending May 31, 1970 .

The essential facts in this case involve the execution of a Compromise Agreement, IRS form 656, and a Collateral Agreement, IRS form 2261-D, in settlement of the Taxpayer's disputed liability for a delinquency penalty assessed for the late filing of its corporate income tax return for the fiscal year ending May 31, 1970 . The return and tax were due on August 15, 1970 , but were not filed and paid with the interest due until forty-five days later.

The Taxpayer, a book distributor based in Holbrook, Massachusetts, claimed that it had "reasonable cause" for its delinquency and that accordingly the IRS had no authority to assess a delinquency penalty of $5,891.55 under IRC §6651. Based on its dispute with the IRS over liability for this penalty, the Taxpayer executed, on March 2, 1971 , an "Offer in Compromise" IRS form 656, to settle the dispute by payment of $500, a difference of $5,391.55. Form 656 provides that the Taxpayer also agreed to (1) waive any refund otherwise due through overpayment of tax, up to the amount originally sought by the government, less the amount paid in the compromise; (2) waive the right to adjudication of the compromised liability; and (3) waive the statute of limitations. The IRS further required, as a condition of its acceptance of the Offer in Compromise, that the Taxpayer execute a Collateral Agreement, IRS form 2261-D. The purpose of the Collateral Agreement "is to clarify the offer referred to above." Form 2261-D then provides:

I understand and agree that no refund will be made or claimed for any part of the tax, including additions to the tax, previously assessed and collected for the year(s) covered by the offer, by reason of a net operating loss or an investment credit for a later taxable period or year.

However, the part of the Offer in Compromise that form 2261-D purports to clarify provides in clause 3(b) as follows:

3. In making this offer, and as part consideration thereof, the proponents agree . . . (b) that any and all amounts to which the proponents may be entitled under the Internal Revenue laws, due through overpayments of any tax or other liability, including interest and penalties, made for periods ending prior to or during the calendar year in which the offer is accepted, (and which are not in excess of the difference between the liability sought to be compromised and the amount herein offered) shall also be retained by the United States. (Emphasis supplied.)

Counsel for the IRS indicated that its usual practice is to delete the parenthetical in clause 3(b) when it conditions acceptance of the Taxpayer's Offer in Compromise on the execution of Collateral Agreement form 2261-D. However, the IRS did not delete the parenthetical in this case, and accepted the Offer in Compromise with the clause and the Collateral Agreement by letter dated March 22, 1972 .

The Taxpayer suffered a net operating loss for the fiscal year ending May 31, 1973 in the amount of $71,781. ² An "Application for Tentative Refund from Carryback of Net Operating Loss", form 1139, was filed in August and October of 1973, claiming the §172 carryback of the net loss to the third preceding year, i. e., the year compromised, 1970. A carryback to 1970 would have reduced taxable income for 1970 from $91,707 to $19,926, and would have reduced the tax due from $40,496 to $4,731. Hence the carryback to 1970 would absorb the entire net operating loss and result in a claim for refund of $36,302. IRS denied the application by letter dated November 29, 1973 . The tentative carryback allowance was denied because "of the waiver signed when this account was compromised, so no refund may be claimed or issued for this period. Since your loss is completely absorbed by May 31, 1970 income, there is no carryforward available."

Counsel for the Taxpayer consequently filed, on July 12, 1974 , IRS form 843, a claim for "Refund of Taxes Illegally, Erroneously, or Excessively Collected." The IRS denied this claim by letter dated February 3, 1975 . The Taxpayer thereafter instituted this action on March 25, 1975 .

It is not disputed that an agreement compromising a tax liability is a contract. United States v. Lane [62-1 USTC ¶9467], 5 Cir., 1962, 303 F. 2d 1; Cooper Agency v. United States, D. S. C., 1969 [69-2 USTC ¶9560], 301 F. Supp. 871, aff'd per curiam [70-1 USTC ¶9321], 4 Cir., 422 F. 2d 1331, cert. denied, 1970, 400 U. S. 904. The Compromise and Collateral Agreement at issue here, therefore "is governed by the rules applicable to contracts generally." United States v. Lane, supra, at 4. In applying the rules of contract interpretation to the disputed terms of this Agreement, we conclude as a matter of law that the waiver contained in form 2261-D of the right to claim a carryback of a net operating loss to the compromised year is limited by provision 3(b) of the Compromise Agreement, form 656, which permits refund of amounts "in excess of the difference between the liability sought to be compromised and the amount herein offered." The Taxpayer therefore agreed to relinquish only $5,391.55 of a refund it was otherwise entitled to claim for the compromised year.

This is the only construction of the agreement that gives effect to both of the disputed provisions. "It is elementary that a construction which comports with the Agreement as a whole is to be preferred even if it be thought that certain language, viewed only by itself, more readily suggests something else." Spartans Indus., Inc. v. John Pilling Shoe Co., 1 Cir., 1967, 385 F. 2d 495, 499; see Ucello v. Consentino, 1968, 354 Mass. 48, 51. The construction of the Agreement urged by the government would read the contract as though clause 3(b) on form 656 did not exist. It takes this position in spite of the explicit statement on the Collateral Agreement that its purpose is to "clarify" the original offer. Especially in the light of the circumstances of this case, where the compromise resulted from the Taxpayer's ability to establish facts calling for abatement ³ in full rather than a reduction in the amount of the delinquency penalty, we believe it would be unreasonable to construe the Agreement to provide that the taxpayer relinquished the right to claim a refund of an amount seven times greater than the penalty originally compromised. Since we find that the "language of the instrument is not clear beyond peradventure," c. f. Over the Road Drivers, Inc. v. Transport Insurance Co., 1 Cir., Dec. 10, 1980 , No. 79-1094, slip op. at 4, our construction must, and does "effectuate a reasonable and enforceable purpose to accomplish a practical and straightforward end." Agricultural Nat'l Bank v. Brennan, 1936, 295 Mass. 325, 328. ⁴ That is, the government collects the full amount of the penalty originally assessed, $5,891.55, without the necessity of litigating the claim, and the Taxpayer collects the refund from the carryback, $36,302, less the amount of the abated penalty, $5,391.55--or $30,910.45.

Allowing the Taxpayer to collect a limited refund from the taxes paid in the compromised year due to the carryback of a net operating loss of a later year, as done in this Agreement, does not reopen the question of the Taxpayer's liability for the compromised year. Although a compromise under IRC §7122, even of the delinquency penalty alone, forecloses relitigation of the Taxpayer's liability for tax, penalty, and interest together, see 26 C. F. R. §301.7122-1(c); 38 Op. Att'y Gen. 94 (1934), the carryback of a net loss from a future year under §172 does not reopen the compromised year's liability since "the facts giving rise to the deficiency of refund [did not] exist at the time of the acceptance of the offer." Internal Revenue Manual [hereinafter IRM ] ( 10-1-73 ) §5755.71(2); see Blackmon & Assoc., Inc. v. United States [76-1 USTC ¶9199], D. C. Tex., 1976, 409 F. Supp. 1264, 1265. No right, nor liability, existed on the part of either of the proponents of this Agreement under §172 at the time it was completed, so the question of a claim for refund due to carryback was not opened in the first instance until 1973, the year in which the net loss was incurred.

Since the provision of the Internal Revenue Code of 1954 authorizing net operating loss carrybacks (§172) does so on the basis of the taxpayer's experience for a taxable year, the right to a loss carryback refund does not arise until the end of the taxable year in which the loss occurs. . . . Therefore no claim, but only a prospect or expectation of a claim, to a net loss carryback refund can arise until the end of a taxable year, and the prospect, hope or expectation of a claim is not a right of action.

Fournier v. Rosenblum [63-2 USTC ¶9536], 1 Cir., 1963, 318 F. 2d 525, 527.

Thus, the execution of an Offer in Compromise relating to a delinquency penalty does not by itself preclude a claim for a refund due to a net loss carryback. United States v. Lane, supra; Blackmon & Assoc., supra.

The Chief Counsel of the IRS , however, has long taken the carryback of a net operating loss to be a reopening of the liability of the compromised year. Hence, to avoid the nullification of Offers in Compromise due to taxpayers' failure to understand that a compromise of a delinquency penalty compromised the entire tax liability for the year in question, the IRS required Taxpayers to execute Collateral Agreement 2261-D in conjunction with the deletion of the parenthetical in clause 3(b) in the Offer in Compromise, form 656. ⁵ The Chief Counsel's rationale is outlined in IRM ( 10-1-73 ) §5755.72:

Refunds Based on Net Operating Loss Carrybacks

The Chief Counsel in the memorandum of February 10, 19 61 , pointed out that the question involved in refunds for the period compromised is basically one of contract construction and the intent of the parties must be considered. In each of several suits for refund arising out of claims based on the carryback of a net operating loss to a year involving an accepted offer in compromise of a delinquency penalty, it was the opinion of the Chief Counsel that there was no defense to the suit. The offers had been solicited by the Service, and it was clear from an examination of the relevant facts the offeror had apparently considered the compromise as one only of the delinquency penalty. It was concluded therefore that such a compromise was a nullity, since the tax liability (tax penalty and interest) is one inseparable unit for the purpose of compromise, and there was no authority in the law for compromising less than the entire tax liability. Where the offer is considered a nullity, there is no rescission of the offer; it simply never legally took place; it had no legal force or effect.

However, the IRS here confuses the question of the intention of the parties to the Agreement with the separate issue of whether a carryback loss necessarily involves a reopening of the question of tax liability of the compromised year. ⁶

We agree with the Taxpayer that a net operating loss carryback under IRC §172 is a separate issue, not involving the reopening of issues of liability for the compromised year. The application of the net loss to a compromised year is a fortuitous circumstance depending only upon the Taxpayer's income for the year of the loss and a statutorily prescribed carryback period. This net loss is carried back and applied to the tax liability agreed to by the government and the taxpayer for the compromised year.

Acceptance of the government's construction of IRC §172 net loss carrybacks as reopening the issues of a compromised year's tax liability as proscribed by IRC §7122 would contravene the purpose of §172 and advance no end of §7122. The purpose of IRC §172 is to mitigate the harshness and rigidity of the annual accounting system and progressive income tax rates on taxpayers with fluctuating incomes. Foster Lumber Co. v. United States [74-2 USTC ¶9611], 8 Cir., 1974, 500 F. 2d 1230, 1232, rev'd on other grounds [76-2 USTC ¶9740], 429 U. S. 32; Commissioner v. VanBergh [54-1 USTC ¶9151], 2 Cir., 1954, 209 F. 2d 23, 25. Contrary to the policy of §172, the IRS practice of requiring the execution of Collateral Agreement 2261-D and deletion of clause 3(b) in form 656 increases the difference between the originally assessed penalty and the amount accepted in the Offer in Compromise. The Taxpayer's cross motion for summary judgment is granted and the government's motion is hereby denied. Judgment shall enter for the plaintiff in the sum of $30,910.45 plus interest determined pursuant to 26 U. S. C. §6611 and costs, as per 28 U. S. C. §2412.

¹ The Taxpayer A & A Distributors, Inc., has been in bankruptcy since 1976, a date approximately one year after this suit was filed. The trustee in bankruptcy, Peter Zimmerman, was substituted for A & A as party plaintiff on July 15, 1980 . For simplicity we refer to the plaintiff as the "Taxpayer."

² IRC §172(b)(2) provides that:

"the entire amount of the net operating loss for any taxable year . . . shall be carried to the earliest of the taxable years to which such loss may be carried. The portion of such loss which shall be carried to each of the other taxable years shall be the excess, if any, of the amount of such loss over the sum of the taxable income for each of the prior taxable years to which such loss may be carried."

³ Under IRC §6651, if the taxpayer had "reasonable cause" for the delinquency, the penalty is to be abated. Of course, if there is doubt as to the existence of reasonable cause, the IRS can compromise the sum of the penalty assessed depending "upon the degree of doubt found in the particular case." Revenue Proc. 64-44, 1964-2 C. B. 974, 978.

⁴ Much of the incentive to execute an Offer in Compromise when there is a dispute as to liability is the saving of time and expense of a lawsuit and mitigation of the risk of losing the disputed issue. In re Prudence Co. [38-2 USTC ¶9447], 2 Cir., 1938, 98 F. 2d 559. It would be inconsistent with the presumption that a compromise agreement is a "rational business instrument", see McMahon v. Monarch Life Ins. Co., 1962, 345 Mass. 261, 264; Berkal v. DeMatteo Constr. Co., 1951, 327 Mass. 329, 333, to interpret the disputed provisions in this Agreement to grant the IRS an opportunity to recover amounts greatly in excess of the liability reduced in the compromise. Adoption of the government's construction of the Agreement would amount to a forfeiture of approximately $36,000 more than the IRS ever claimed that the Taxpayer owed. Such a forfeiture may itself be contrary to public policy. United States v. Lane, supra, at 4.

⁵ See IRM (5-80) §5794.1(3), which provides:

"To avoid the problem, Form 2261-D, Collateral Agreement--Delinquency Penalty Offer--Income Tax--Carryback of Net Operating Loss or Investment Credit (Exhibit 5700-42) should be used. This form clarifies the waiver provisions of the Form 656 and precludes the subsequent allowance of a refund due to a net operating loss or investment credit carryback to periods closed by a penalty compromise. It should always be executed by taxpayers before acceptance of an offer to compromise a delinquency penalty involving an income tax return."

⁶ Many of the problems arising from the carryback of a net operating loss to a compromised year have been eliminated for taxpayers incurring losses after December 31, 1975 . Congress added IRC §172(b)(3)(C) in 1976 (originally enacted as §172(b)(3)(E)) to permit taxpayers to elect to relinquish the carryback in favor of the carryover. Section 172(b)(3)(C) provides that "Any taxpayer entitled to a carryback period under paragraph (1) may elect to relinquish the entire carryback period with respect to a net operating loss for any taxable year ending after December 31, 1975 ."