Basis Overstatement Does Not Trigger Six-Year Statute of Limitations

By Peter C. Barton and Clayton R. Sager

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Background

Enacted in 1954, IRC section 6501(a) states that “the amount of any tax imposed by this title shall be assessed within three years after the return is filed.” This means it covers all federal taxes and all assessments unless otherwise indicated. In 1997, Congress clarified that the statute of limitations under IRC section 6501(a) is not affected by the filing of a return by any pass-through entity, even if the taxpayer has received an item of income, loss, gain, deduction, or credit from the entity. This puts the filing of a partner’s return at issue.

One exception to IRC section 6501(a) is section 6501(e)(1)(A), which states that if a taxpayer “omits from gross income an amount properly includable therein” which exceeds 25% of the gross income reported on the return, the three-year statute of limitations becomes six. IRC section 6501(e)(1)(A)(i) adds that for a trade or business, gross income means gross receipts before they are reduced by the cost of goods or services. The statute does not address the meaning of gross income for sales other than goods and services, an omission that has resulted in several court cases. Finally, under IRC section 6501(e)(1)(A)(ii), any amount omitted from gross income that is disclosed on or with the return that adequately advises the IRS “of the nature and amount of such item” shall not be considered in applying the six-year rule.

In 1982, Congress enacted the Tax Equity and Fiscal Responsibility Act (TEFRA), which includes IRC sections 6221–6234. These IRC sections are complex statutes enacting unified partnership audit rules. They require that the IRS make tax adjustments to partnership items, including items of income, loss, deductions, credits, or liabilities at the partnership level [Treasury Regulations section 301.6231(a)(3)-1(a)(1)(i)]. If the IRS makes adjustments to the partnership items, it must send the partners the final partnership administrative adjustment (FPAA). The partners have appeal rights in the federal courts before being assessed (IRC sections 6223, 6225, and 6226).

IRC section 6229(a) imposes a minimum period for assessing federal income tax on any person that is attributable to any partnership item. The minimum period is three years after the later of the date on which the partnership return is filed or the due date for filing the partnership return (without extensions). IRC section 6229 is not a separate statute of limitations: IRC section 6501(n)(2) indicates that IRC section 6229 may extend the IRC section 6501(a) statute of limitations for the IRS to assess partners regarding partnership items (see AD Global Fund v. U.S. [481 F.3d 1351 (Fed. Cir. 2007)]). IRC section 6229(c)(2) substitutes six years for three years in IRC section 6229(a) if the partnership “omits from gross income an amount properly includable therein” that exceeds 25% of the gross income reported on the partnership return. IRC section 6229(d) suspends the running of the period specified in IRC section 6229(a) for at least 90 days plus one year if and when the IRS mails an FPAA to a partner.

The 1939 IRC had provisions for a statute of limitations somewhat similar to the 1954 IRC, but lacked the provision stipulating that, for a trade or business, gross income means gross receipts before reduction for the cost of goods or services sold. In Colony v. Comm’r [357 U.S. 28 (1958)], the Supreme Court interpreted “omits from gross income an amount properly includable therein” in section 275(c) of the 1939 IRC to mean that gross receipts must be understated, meaning that an overstatement of basis did not increase the statute of limitations beyond three years. Colony involved an overstatement of inventory basis. The Supreme Court reasoned that the IRS needed more time if an item of gross receipts were missing, but would not need more time if the amount of basis were on the return but overstated. The Court also emphasized that the statute uses “omits,” not “reduces” or “understates.”

Bakersfield

In Bakersfield, the IRS sent an FPAA in October 2005, determining that Bakersfield had overstated its basis in gas reserves sold in 1998 by the reported basis of $16,515,194, which the IRS adjusted to $0. The gas reserves were IRC section 1231 property. The IRS claimed the reported basis resulted from a sham transaction, and the six-year statute of limitations applied under IRC section 6501(e)(1)(A). The Bakersfield partners argued that, unlike an understatement of gross receipts, an overstatement of basis is not an omission of gross income. They argued that the three-year statute of limitations applied, and none of the partners could be assessed, assuming they filed their 1998 individual returns more than three years before the FPAA was issued.

The IRS argued that, although overstating deductions is not an omission of gross income under IRC section 6501(e)(1)(A) and IRC section 6229(c)(2), overstating basis on the sale of IRC section 1231 or investment property is an omission of gross income, using IRC section 61’s definition of “gross income.” This interpretation is implied in IRC section 6501(e)(1)(A) by carving out an exception for goods and services in IRC section 6501(e)(1)(A)(i), which requires the understatement of gross receipts. The IRS concluded that Colony is irrelevant.

In rejecting the IRS’s reasoning, the Tax Court, relying on Colony, ruled that IRC section 6501(e) does not apply in Bakersfield because “omits” from gross income means something “left out,” not something (i.e., basis) overstated. Therefore, it ruled that the normal three-year statute of limitations applied.

Brandon Ridge

In Brandon Ridge, Nelson and Carolyn Jefferson engaged in several transactions in 1998 to reduce their gain on S corporation stock by increasing its basis. After these transactions, they owned Brandon Ridge Partners, which sold the S corporation stock with its basis increased by more than $3.2 million. The IRS argued that the transactions constituted a “Son of Boss” tax shelter, which incorrectly increased the stock’s basis.

The Brandon Ridge partners claimed that the IRS had issued the FPAA after the three-year statute of limitations expired. The IRS argued that because IRC section 6501(e)(1)(A)(i) states that the gross receipts test applies to the trade or business sales of goods and services, it does not apply to all other transactions. It claimed that interpreting IRC section 6501(e)(1)(A)(i) otherwise would render this subsection superfluous. The IRS argued that therefore the six-year statute of limitations applied to the stock sale.

As stated in Insulglass Corp. v. Comm’r [84 TC 203 (1985)], except for sales of goods and services, the definition of “gross income” as it applies to the six-year statute means those items listed in IRC section 61(a), which includes “gains derived from dealings in property.” More recently, in CC&F Western [273 F.3d 402 (2001)], the First Circuit noted that IRC section 6501(e)(1)(A)(i) adopts Colony’s gross receipts test for sales of goods and services only, implying that Colony should not apply to other sources of income.

In Brandon Ridge, the Federal District Court ruled that the gross receipts rule in IRC section 6501(e)(1)(A)(i) did not apply, because stock sales are not sales of goods or services. Overstating the stock’s basis, resulting in an understatement of gross income, allowed the IRS to correctly apply the six-year rule under IRC section 6501(e)(1)(A). Brandon Ridge arguably limits Colony to sales of goods or services by a trade or business.

Interpreting the Decisions

The meaning of “omits from gross income” in IRC section 6501(e)(1)(A) is the issue at stake in the cases discussed above. The Tax Court in Bakersfield required gross receipts to be overstated for the six-year statute of limitations to apply, but the Federal District Court in Brandon Ridge would limit this requirement for the sale of goods and services only, as specified in IRC section 6501(e)(1)(A)(i). For sales of other property, the overstatement of basis also triggers the six-year rule. The taxpayer in Brandon Ridge appeared to have the better argument, based on a statutory analysis and a policy of reducing tax shelters. The IRS will likely appeal Bakersfield to the Ninth Circuit Court of Appeals. If the decision in Brandon Ridge is appealed, it will be to the Eleventh Circuit Court of Appeals. Alternatively, Congress could clarify the provisions and intent of IRC section 6501(e)(1)(A). Meanwhile, taxpayers who would benefit from Bakersfield should petition the Tax Court.

©2008 The New York State Society of CPAs. Legal Notices