IRS may not assess a deficiency 9 years after a failed tax-free merger for predecessor company's failure to file

The new company's return with the old company's pro forma short-year return attached was sufficient to run the statute of limitation, the Tax Court finds.
By David W. Clark, CPA, and Darlene Pulliam, CPA, Ph.D.

Even though the successor corporation in an attempted tax-free merger filed a single tax return in the year of reorganization that only included a pro forma attachment for the activity of the predecessor corporation, the Tax Court held that the filing was sufficient to trigger the running of the statute of limitation, thereby barring the IRS from assessing a deficiency for the predecessor corporation's failure to file under Sec. 6501(c)(3).

Facts: On Dec. 4, 2002, Capital Fire Insurance Co. (Old Capital) merged into New Capital Fire Inc. (New Capital) in an intended reorganization under Sec. 368(a)(1)(F) (an F reorganization). For the 2002 tax year, New Capital filed a single Form 1120, U.S. Corporation Income Tax Return, with an attached pro forma Form 1120-PC, U.S. Property and Casualty Insurance Company Income Tax Return. The pro forma return listed Old Capital's employer identification number and reported the 2002 operating activity of Old Capital. New Capital also attached a statement to its return that the taxable operating activity of Old Capital was included in the 2002 filing on the Form 1120. On the return, New Capital reported Old Capital's federal tax payments and checked the box stating that it was the "final return" for Old Capital.

Almost nine years after New Capital filed its 2002 corporate tax return, on July 25, 2012, the IRS issued Old Capital a notice of deficiency for failing to file a tax return for its short tax year ending Dec. 4, 2002.

Issues: The IRS contended that the Old Capital merger failed to meet the applicable requirements to qualify for a tax-free F reorganization into New Capital. An F reorganization involves "a mere change in identity, form, or place of organization of one corporation, however effected" (Sec. 368(a)(1)(F)). The IRS argued that the two entities remained separate taxpayers, each with a duty to file a return for 2002. In addition, the IRS asserted that New Capital's 2002 tax return with the attached pro forma return was "purposefully misleading" and did not constitute a valid tax return in reporting the short-tax-year activity of Old Capital. Relying on Sec. 6501(c)(3), which authorizes an exception to the three-year statute of limitation when a taxpayer does not file a return, the IRS issued a notice of deficiency to Old Capital for failure to file.

New Capital maintained that the merger was designed to be a tax-free, F reorganization and, therefore, its 2002 timely filed tax return represented the continuation of Old Capital under Sec. 368(a)(1)(F).

Holding: Finding in favor of New Capital, the Tax Court held that the exception to the statute of limitation in Sec. 6501(c)(3) did not apply; therefore, the IRS was barred from imposing a deficiency notice and associated tax penalty assessment. The court noted that the primary question was not whether the reorganization qualified under Sec. 368, but rather, whether the running of the statute of limitation began with the filing of the return, regardless of whether the return was erroneous in any respect. The court relied on the rationale applied in Mabel Elevator Co., 2 B.T.A. 517 (1925), that in the absence of any evidence that a return was false or fraudulent with the intent to evade tax, it becomes the duty of the IRS to determine any deficiencies within the period of limitation provided by statute. Having reviewed New Capital's return, the court determined that it was not false or fraudulent, nor was it filed with intent to evade taxes with respect to Old Capital, the court held, and in fact, it contained sufficient information to calculate Old Capital's tax liability.

  • New Capital Fire, Inc., T.C. Memo. 2017-177

—By David W. Clark, CPA, instructor of accounting and health care management, and Darlene Pulliam, CPA, Ph.D., Regents Professor and McCray Professor of Accounting, both of West Texas A&M University, Canyon, Texas.

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