IRS Issues Regs on Six-Year Limitations on Basis Overstatement

The IRS issued proposed and temporary regulations (TD 9466, REG-108045-08) Thursday to clarify that an overstatement of basis can create a substantial omission of gross income under IRC §§ 6229(c)(2) and 6501(e) for purposes of the six-year extended period for assessments and collections of tax attributable to partnership items. In so doing, the Service sought to strengthen its position, which has been rejected in the Tax Court and two circuit courts this year.

The regulations, which are effective upon their release, add new Treas. Reg. § 301.6229(c)(2)-1T, which clarifies that, outside the trade or business context, “gross income,” as used in section 6229, has the same meaning as in section 61(a), the general definition that includes under paragraph (3) “gains derived from dealings in property.” They also replace Treas. Reg. § 301.6501(e)-1 with a temporary regulation of the same number to specify that gross income can include “the excess of the amount realized from the disposition of the property over the unrecovered cost or other basis of the property.” Accordingly, outside the context of a trade or business, any basis overstatement that leads to an understatement of gross income under section 61(a) constitutes an omission from gross income for purposes of sections 6501(e)(1)(A) and 6229(c)(2) under the temporary regulations.

Section 6229(c)(2) substitutes six years for the ordinary three-year period in which the IRS may make assessments, where there is a substantial omission of gross income, defined as more than 25% of gross income properly includible on the return. Section 6501(e) provides an exception where the item is disclosed on the return with sufficient information to indicate its nature and amount.

In June 2009, the Ninth Circuit Court of Appeals, affirming the Tax Court, held that no understatement of gross income had occurred where an assessment arose from an overstatement of basis (Bakersfield Energy Partners LP (128 TC 207, aff’d, 9th Cir., June 2009)). The following month, the Federal Circuit held similarly in Salman Ranch Ltd. v. U.S. (docket no. 2008-5053). The Tax Court also ruled in favor of the taxpayers on the issue in Kenneth and Susan Beard v. Commissioner (TC Memo 2009-184) and Intermountain Insurance Service of Vail v. Commissioner (TC Memo 2009-195). The courts held that the 1958 Supreme Court ruling in Colony Inc. v. Commissioner (357 U.S. 28) controlled, despite its having been decided under a predecessor statute to section 6229 of the 1939 Internal Revenue Code. The IRS has maintained throughout these cases that Congress intended in section 6229, part of its 1954 overhaul of the IRC, to limit the holding in Colony Inc. to cases arising under the earlier statute.

In its preamble to the temporary regulations, the IRS noted that the Ninth and Federal circuits had acknowledged the current statute to be ambiguous, and that the Ninth Circuit suggested the Service could clarify the matter by regulation.

The temporary regulations also serve as the text of the proposed regulations, on which written or electronic comments and requests for a public hearing must be submitted by Dec. 28, 2009. Comments may be sent by mail to the IRS at P.O. Box 7604, Ben Franklin Station, Washington, D.C. 20044, or by electronically via the Web portal at regulations.gov.