Overstatement Does Not Trigger Six-Year Statute of Limitations
Peter C. Barton and Clayton R. Sager
JUNE 2008 - In
Bakersfield Energy Partners v. Comm’r [129 TC No.
17 (2007)], the Tax Court ruled that an overstatement of basis is
not an omission of gross income under IRC section 6501(e)(1)(A).
The statute of limitations for assessing the partners in such a
case, therefore, is three years instead of six. This controversial
decision negatively affects the IRS’s efforts to curb tax
shelters and deal with other IRC section 6501(e)(1)(A) situations.
In a similar case, however, the Federal District Court in Florida,
in Brandon Ridge Partners v. U.S. (100 AFTR2d 2007-5347;
Middle District of Florida), reached the opposite conclusion.
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.
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
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).
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.
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”
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.
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
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.
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
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.
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.
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.
C. Barton, MBA, CPA, JD, is a professor of accounting,
and Clayton R. Sager, PhD, is an associate professor
of accounting, both at the University of Wisconsin–Whitewater.