You Say Omit, I Say Understate

The Tax Court recently held that an understatement of gain by a partnership due to overstating its basis on a section 754 election did not result in an omission of gross income. Thus a proposed gain adjustment by the IRS was not timely, since it occurred after the expiration of the normal three-year statute of limitations period. The extended six-year limitations period of IRC §§ 6501(e)(1)(a) and 6229(c)(2) did not apply because there was no substantial omission of gross income, the court said.

Generally, the IRS must assess additional tax within three years of the later of the due date of the return or the date of its filing. A substantial omission of gross income—defined as exceeding 25% of reported gross income—extends the period to six years. (No time limit applies to a fraudulent return or failure to file.)

Bakersfield Energy Partners sold oil and gas properties in 1998, reporting a gain of nearly $5.4 million. In 2005, before the six-year statute of limitations period had expired, the IRS issued a Notice of Final Partnership Administrative Adjustment reducing the basis of the property to zero, thereby increasing Bakersfield’s gain by more than $16 million. The IRS claimed the understated gain was a substantial omission of Bakersfield’s gross income, which permitted the application of the six-year period.

Bakersfield argued the 1998 tax year was closed, based on Colony Inc. v. Commissioner, 357 U.S. 28 (1958), in which the Supreme Court held that the longer statute of limitations period did not apply when a taxpayer in the land development business understated its income from the sale of lots in a subdivision by overstating their basis. In that case, the Court held that gross income was not omitted, since the word omission implies “left out,” not understated. When income is omitted, it is much more difficult for the IRS to detect errors, since nothing is reported, and the additional three years helps the IRS overcome that difficulty. The Court reasoned that the additional time is unnecessary for an understated amount, since the IRS has something to question and examine.

The IRS argued that the holding in Colony applies only to situations involving the sale of goods or services during the ordinary course of business and does not apply to Bakersfield, since it sold business property used to sell goods or services. The Tax Court disagreed with that limitation, adopted Colony ’s reasoning on the statute of limitations period and granted summary judgment against the IRS.

After the Bakersfield decision, the Court of Federal Claims ruled on a ­similar fact pattern in Grapevine Imports Ltd. v. U.S. , 100 AFTR2d 2007-5065 (7/17/07), and likewise concluded that an overstatement of basis is not an omission that triggers the six-year statute. The decision cited and closely followed the rationale of Bakersfield and also relied heavily on the Colony precedent.

Bakersfield Energy Partners LP v. Commissioner, 128 TC no. 17 .

Prepared by Charles J. Reichert , CPA, professor of accounting, University of Wisconsin, Superior.