An overstatement of basis does not constitute a substantial omission of gross income that would extend the deficiency statute of limitations to six years, the Ninth Circuit Court of Appeals ruled, upholding the Tax Court. The decision in Bakersfield Energy Partners v. Commissioner puts the Ninth Circuit in line with the Court of Federal Claims’ decision in Grapevine Imports Ltd. v. U.S. (77 Fed. Cl. 505 (2007)) and, more recently, the Federal Circuit in Salman Ranch Ltd. v. U.S. (docket no. 2008-5053, July 30, 2009). For earlier coverage of Bakersfield Energy Partners, see “Tax Matters: You Say Omit, I Say Understate,” JofA, Sept. 07, page 83. The Bakersfield, Grapevine Imports and Salman Ranch courts were guided by the 1958 Supreme Court ruling in Colony Inc. v. Commissioner (357 U.S. 28).
Generally, the limitation period on assessment and collections is three years from the date a return was due or any portion of tax paid (section 6501(a)). However, the period is six years for a taxpayer that omits from a return and fails to adequately disclose 25% or more of properly includable gross income (section 6501(e)).
Bakersfield Energy Partners sold oil and gas properties in 1998 for nearly $24 million. Shortly before that, however, four partners who together owned 76.3% of the business formed a new partnership, Bakersfield Resources, to which they sold their interests for nearly $20 million. Bakersfield Energy Partners was thereby technically terminated and another new partnership formed in which Bakersfield Resources owned a 76.3% interest. The new partnership elected under section 754 to increase its basis in partnership assets following a transfer of a partnership interest. It allocated $16.5 million of its new basis to the oil and gas property. With that and mining exploration costs of nearly $2 million, it reduced its gain on the sale to slightly less than $5.4 million.
In 2005, less than two weeks before the six-year statute of limitations would have expired, the IRS declared the transaction a sham. It reduced the basis of the property to zero, increasing the gain to nearly $22 million.
Among the IRS’ arguments was that Colony Inc. was decided under an earlier statute. But, the Ninth Circuit said, the provision’s language did not change in any relevant respect, as the Supreme Court noted at the time, since recodification occurred during those proceedings. Furthermore, the legislative intent for the extended period would appear unchanged since the Supreme Court found in Colony Inc. that Congress gave the IRS the extended period to investigate returns where there was an omission of income because of the disadvantage the IRS faces in detecting an error related to an unreported item of taxable income. Where the item giving rise to an understatement of income is plainly evident on the return—as with Bakersfield’s sale price for the properties—“the Commissioner is at no such disadvantage,” the Ninth Circuit said, quoting Colony Inc.
The Federal Circuit in Salman Ranch followed similar reasoning to overrule the Court of Federal Claims.
Bakersfield Energy Partners v. Commissioner, docket no. 07-74275 (9th Cir.)
By Tax Matters Editor Paul Bonner.