|IRS Is Losing the Extended Statute of Limitations Applied to Inflated Basis Case Battle
Over the last couple of months the IRS has been dealt a number of setbacks in applying the extended statute of limitations to inflated basis cases.
September 10, 2009
With the proliferation of artificially inflated basis tax shelters, the Internal Revenue Service (IRS) has been hard pressed to audit taxpayers using these shelters within the normal statute of limitations as evidenced by the IRS's reliance on the extended statute of limitations. To date the IRS has not been successful in arguing that the extended statute of limitations applies to artificially inflated basis tax shelter assessments. In the past couple of months, the Ninth Circuit and the Federal Circuit have each held that the extended statute of limitations did not apply to inflated basis cases. See Bakersfield Energy Partners, LP et al. v. Commissioner, No. 07-74275 (9th Cir., June 17, 2009); and Salman Ranch Ltd and William J. Salman v. U.S., No. 2008-5053 (CA Fed. Cir., July 30, 2009); See also Kenneth H and Susan W. Beard v. Commissioner, T.C. Memo 2009-184 (August 11, 2009) and Grapevine Imports, Ltd and T-Tech, Inc. v. U.S.,100 AFTR 2d 2007-5228 (U.S. Court of Federal Claims, July 17, 2009).
Sections 6501(a) and (e)
Section 6501(a) provides the general three-year statute of limitations with respect to assessments of income tax. Section 6501(e)(1)(A) extends the limitations period to six years if the taxpayer's return omits from gross income an includible amount that is more than 25 percent of the amount of gross income reported on the return. Section 6229(a) sets forth a minimum of three years for assessment of partnership items and Section 6229(c) incorporates language parallel to Section 6501(e)(1)(A) extending the period to six years. Because of the parallel language used in Sections 6229(c) and 6501(e), courts have generally looked to Section 6501(e) in interpreting Section 6229(c).
Sections 6501(e)(1)(A)(i) and (ii), added by the 1954 Code, provide that gross income means gross receipts with respect to a trade or business sale of goods and services and that no amount adequately disclosed in a return is considered omitted from gross income. No similar language appears in Section 6229(c).
The Colony Case
The seminal case on the issue of whether an overstated basis constitutes an omission from gross income in determining whether the extended statute of limitations applies is The Colony, Inc. v. Commissioner, 78 S. Ct. 1033 (1958). That case involved a real estate dealer who filed a return reporting understatements of gross income as a result of erroneous overstatements of the basis of the real estate sold. In Colony the Supreme Court interpreting Section 275(c) of the 1939 Code, the predecessor of Section 6501(e)(1)(A), held that the extended period of limitations applies to situations in which specific income receipts have been â€śleft outâ€? or omitted in the computations of gross income and not where the understatement of gross income resulted from the overstatement of the basis of an asset sold. Finding the statutory language ambiguous, the Supreme Court turned to the legislative history to reject the IRS's argument that the extended statute applies to any significant error that caused the amount of the gross income to be understated. In addition, the Supreme Court found the Congressional purpose of the extended statute was to give the Commissioner more time to assess where the Commissioner is at a special disadvantage in detecting errors. That would be the case, as found by the Supreme Court, where there is an omission or an item is left out, rather than where the basis of a sold asset is overstated.
Bakersfield Energy and Salman Ranch Cases
Both Circuit Courts in Bakersfield Energy and Salman Ranch felt compelled to follow Colony. The taxpayer in Bakersfield Energy had sold oil and gas property reporting a low net gain by claiming a high basis in the property as a result of making a Section 754 election to step up the basis of the property after a number of partnership transfers. The IRS had assessed the partnership relying upon the extended statute of limitations. The Ninth Circuit affirmed the Tax Court decision which had found the assessment to be untimely and that the extended statute did not apply to overstated basis adjustments. In rejecting the governments argument that the court was not bound by the Supreme Court's interpretation of Section 275(c) because Section 6501(e) was materially altered by the addition of subsections (i) and (ii), the Ninth Circuit found that those subsections were meant to merely clarify the law and not to change the law. The Ninth Circuit also rejected the government's argument that Colony be limited to cases of a trade or business as there was no support for such limitation in the Supreme Court's opinion. It was suggested that since the Supreme Court had found the language of Section 275(c) ambiguous, the IRS may have the authority to issue regulations to clear up the ambiguity, even if contrary to a Supreme Court opinion .
In Salman Ranch the taxpayer had engaged in a tax shelter transaction which had inflated the basis of certain assets to be sold. As a result, the gain reported by the taxpayer on its partnership return was reduced. More than three years after the filing of the partnership return, the IRS issued a final partnership administrative adjustment adjusting the basis and gain of the partnership upon the assets sold. The U.S. Court of Appeals for the Federal Circuit, in a split decision, found Colony controlling and held that the FPAA issued more than three years after the partnership return was filed was untimely. In addition, the Court found no grounds for limiting Colony to trade or business cases. In dealing with the legislative purpose of the extended statute, the Court found that the IRS was not at a special disadvantage in detecting errors where the erroneously overstated basis appears on the face of the taxpayer's return. The dissent found that the majority's holding that an erroneously overstated basis can never justify enlargement of the period of limitations was an unwarranted enlargement of Colony. As summarized by the dissent, courts have generally applied the rationale of Colony and the three year general statute where the overstatement of basis is reasonably identifiable from the face of the return. As found by the dissent, this was not the case in Salman Ranch, i.e. in the return there was no disclosure of the transactions that resulted in the inflated overstated basis.
The IRS is not ready to give up the issue, as evidenced by a 2006 e-mail in which the Chief Counsel advised IRS personnel that an overstatement of basis can cause a 25-percent omission from gross income. However, most courts have felt compelled to follow Colony. It is to be seen whether the legislative policy of the extended statute warrants the application of the extended statute where the IRS might not be put on notice from the face of the taxpayer's return. This may be the case where the inflated basis of the asset is the result of non-economic transactions without any business purpose not appearing on the face of the taxpayer's returns. As suggested by the Ninth Circuit in Bakersfield, the IRS may be able to counter Colony by issuing a regulation that clears up the ambiguity and redefines income omission for these purposes.
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