Application of Six-Year Statute of Limitations Denied Again
The Tax Court, whose denial of a six-year statute of limitations in Bakersfield Energy Partners had been recently upheld by the Ninth Circuit, held in two more cases that an overstatement of basis did not allow the extended assessment period for a substantial omission of gross income under IRC § 6501(e). In one, two S corporations did not reduce their basis in Treasury notes by the amount of their liability to close a short sale of the securities. The other involved stepped-up basis on a sale of business assets by a limited liability company.
Generally, the IRS must assess additional tax within three years of the later of the due date of the return or the date of filing. IRC § 6501(e)(1)(A) extends the assessment period to six years when there is a substantial omission of gross income, defined as exceeding 25% of reported gross income. For a trade or business, section 6501(e)(1)(A)(i) states that gross income is the amount received from the sale of goods or services before any reduction for the cost of those goods or services. Under the safe harbor of section 6501(e)(1)(A)(ii), omitted income does not include any amount adequately disclosed on the tax return or on an attached statement. In Colony Inc v. Commissioner (357 U.S. 28), the Supreme Court differentiated an omission from an understatement when it held that a land development company had not omitted income when it overstated the basis and understated the gain from its sale of real estate.
In 1999, Kenneth Beard sold shares in two S corporations in which he was a majority owner and reported total gain of $1,406,336 from the sales on his and his wife’s 1999 joint tax return filed on April 11, 2000. Earlier in 1999, the Beards purchased Treasury notes for $12,160,000 and transferred them to the S corporations, along with an obligation of $12,160,000 to cover their short position related to the notes. They did not reduce their stock basis by the short position obligation assumed by the corporation, which the IRS did after examining their return. The Service sent a deficiency notice dated April 13, 2006. The taxpayers argued before the Tax Court that the statute of limitations for tax year 1999 had expired.
In 2007, the Tax Court, in Bakersfield Energy Partners LP (128 TC 207, aff’d,9th Cir. , June 2009), held that the principles of Colony applied and no omission of gross income had occurred when a partnership understated its gain from the sale of oil and gas property due to the overstatement of the property’s basis. In the current case, the IRS stated Bakersfield Energy Partners had not been decided correctly and advanced the same arguments rejected by the Ninth Circuit in its holding on appeal of Bakersfield. It argued the Colony decision was not binding because Colony was based on section 275(c) of the 1934 Revenue Act, and that its successor, the current section 6501(e)(1)(A), is materially different. The Tax Court, citing the Ninth Circuit in Bakersfield, rejected that argument, stating that Congress used the identical language in the current section 6501(e)(1)(A) as in its predecessor.
Three weeks after its holding in Beard, the Tax Court again cited Bakersfield in denying the IRS a six-year limitations period in Intermountain Insurance Service of Vail v. Commissioner. Intermountain realized $1.9 million on a sale of business assets, which it reported in a September 2000 return filing as a loss of $87,680, stemming from a stepped-up basis of more than $2 million. The IRS issued a notice of partnership administration adjustment nearly six years later, claiming Intermountain overstated its capital contributions and outside partnership basis.
Recently, the IRS has met with more failures than successes in a string of taxpayer challenges on this issue (see “Tax Matters: Ninth, Federal Circuits: Basis Overstatement Not Income Omission,” JofA, Sept. 09, page 78).
Intermountain Insurance Service of Vail v. Commissioner, TC Memo 2009-195
By Charles J. Reichert, CPA, professor of accounting, University of Wisconsin–Superior.
