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By Joan L. Rood
Buchanan Ingersoll & Rooney PC, Washington, D.C.
Legislation, signed by the President on July 31, 2015, broadens the scope of the extended six-year statute of limitations on assessment ("six-year statute") in §6501(e)1 to ensnare taxpayers selling property. Specifically, to generate revenue to pay for provisions in the Surface Transportation and Veterans Health Care Choice Improvement Act of 2015, Pub. L. No. 114-41 (the "Act"), Congress has applied this six-year statute to situations in which a taxpayer has overstated, in its federal tax return, the basis of property sold.
The IRS normally must assess a tax deficiency within three years of the date a tax return is filed.2 However, if a taxpayer omits a substantial amount of gross income from a filed return, §6501(e) extends the statute of limitations on assessment to six years. A substantial amount of gross income is defined as an amount in excess of 25% of the gross income stated on the return. Prior to the Act, gross income was defined for these purposes as "the total of the amounts received or accrued from the sale of goods or services (if such amounts are required to be shown on the return) prior to diminution by the cost of such sales or services."3 This definition of gross income applies to income earned in a trade or business; it does not apply to capital gain income.
Despite IRS arguments to the contrary, the Supreme Court had twice determined that the above language prohibits the extended six-year statute from being applied when a taxpayer has overstated the basis of property sold on its tax return. In the first case, Colony, Inc. v. Commissioner,4 the Court ruled that the six-year statute did not apply to an understatement of reported gross profits resulting from errors in calculating the basis of the property sold. In that case, the taxpayer had overstated the basis of residential lots it had sold by including unallowable items of development expense in the basis. The Court reasoned that the plain language of the statute requires an omission of gross income from the return, not the reporting of less income than required from a particular transaction, and that the legislative history did not indicate otherwise. It also noted that the purpose of the extended limitations period was to give the IRS additional time to determine a taxpayer's tax liability when "the return on its face provides no clue as to the existence of the omitted item." In contrast, in Colony, the return did provide a clue as to the existence of the omitted item because it reported a sale of the property.
In response to the Colony decision, the Treasury department promulgated Reg. §1.6501(e)-1(a)(1)(iii), which provides:In the case of amounts received or accrued that relate to the disposition of property, and except as provided in paragraph (a)(1)(ii) of this section, gross income means the excess of the amount realized from the disposition of the property over the unrecovered cost or other basis of the property. Consequently, … an understated amount of gross income resulting from an overstatement of unrecovered cost or other basis constitutes an omission from gross income for purposes of section 6501(e)(1)(A)(i).
The validity of this regulation was the issue in a second Supreme Court case, United States v. Home Concrete & Supply, LLC.5 The Court in this case invalidated the regulation, reasoning that the regulation was inconsistent with the Colony decision and with congressional intent. Thus, the Court ruled again that an overstatement of an asset's basis is not an omission from gross income that triggers the extended six-year statute.
Home Concrete, a 2012 decision, did not settle this lingering issue until 2015, when Congress was looking for ways to increase federal revenues without raising taxes to fund spending provisions in the Act. Despite the fact that the IRS has fair notice of a basis overstatement and merely needs to audit a tax return with such an overstatement within the normal three-year statute, Congress decided to broaden the six-year statute to include basis overstatement situations. Specifically, the Act added to the definition of omission from gross income "an understatement of gross income by reason of an overstatement of unrecovered cost or other basis."6 This expanded six-year statute applies to federal income tax returns filed after July 31, 2015.7
This amendment to §6501(e) raises the question of whether an amount of gross income attributable to a basis overstatement must be trade or business income or whether it may be a capital gain. Specifically, the amended statute reads, in relevant part, as follows:
In the case of a trade or business, the term "gross income" means the total of the amounts received or accrued from the sale of goods or services (if such amounts are required to be shown on the return) prior to diminution by the cost of such sales or services;
An understatement of gross income by reason of an overstatement of unrecovered cost or other basis is an omission from gross income;
It is clear that §6501(e)(1)(B)(i) applies only to trade or business income. However, the insertion of the new basis overstatement provision in §6501(e)(1)(B)(ii) introduces ambiguity into the statute. The statute could be interpreted as §6501(e)(1)(B)(ii) amplifying the term "gross income" as it is defined in §6501(e)(1)(B)(i) and thereby applying the basis overstatement provision to only transactions entered into in the ordinary course of a trade or business or as adding a second definition that is independent of §6501(e)(1)(B)(i) and thereby not limited to only trade or business transactions. Moreover, §6501(e)(1)(B)(i) could be viewed to preclude consideration of basis overstatements in trade or business transactions, thereby effectively limiting §6501(e)(1)(B)(ii) to only capital transactions. Unfortunately, the Act does not contain any legislative history to help answer these questions. Nevertheless, it is likely that the IRS will not limit its enforcement of this new provision to trade or business income because, in Home Concrete, the IRS attempted to apply the six-year statute to the returns of a pass-through entity and its partners, alleging that the parties under reported the gain on the sale of the partners' business.8
Additionally, in amending §6501(e), Congress excluded a basis overstatement from an important disclosure exception in the six-year statute. Specifically, omitted amounts of income that are disclosed in the return (or in a statement attached to the return) are not taken into account when determining whether there has been a substantial omission of income that triggers the six-year statute.9 However, as amended, the six-year statute of limitations can apply to a basis overstatement even if the taxpayer fully discloses the underlying tax issue on its return. Specifically, the disclosure exception now reads:In determining the amount omitted from gross income (other than in the case of an overstatement of unrecovered cost or other basis), there shall not be taken into account any amount which is omitted from gross income stated in the return if such amount is disclosed in the return, or in a statement attached to the return, in a manner adequate to apprise the Secretary of the nature and amount of such item. [emphasis added]10
As noted previously, the Act does not contain legislative history on the six-year statute provision providing any tax policy reason for Congress not including basis overstatements in this disclosure exception. Moreover, there does not appear to be any good tax policy reason for excluding basis overstatements from the disclosure exception since disclosure would put the IRS on notice of the need to examine the taxpayer's claimed basis. However, the legislation's revenue scoring may provide the real reason for excluding basis overstatements from the disclosure exception. The Joint Committee estimated that amending the six-year statute to include basis overstatements will lead to $1.2 billion of increased collections by the IRS over the next 10 years.11 This number likely reflects the fact that once the six-year statute is triggered for a particular tax year, the taxpayer's entire tax liability for that year is subject to the extended statute, not just an adjustment for the basis overstatement.12
If Congress had not excluded basis overstatements from the disclosure exception this revenue number would have been much less given today's emphasis on disclosure, which is driven by the complex system of penalties. Thus, even though disclosing a tax issue that could produce a basis overstatement is fruitless in avoiding the six-year statute, such a disclosure may still be advisable, depending on the facts and circumstances, to avoid penalties, most notably the understatement of income tax penalties in §6662 and reportable transaction penalties in §6662A.
For more information, in the Tax Management Portfolios, see Peyser, 627 T.M., Limitations Periods, Interest on Underpayments and Overpayments, and Mitigation, and in Tax Practice Series, see ¶3860, Statute of Limitations.
11 Joint Committee on Taxation, JCX-105-15, Estimated Revenue Effects of the Revenue Provisions Contained in Titles II and IV of H.R. 3236, The "Surface Transportation and Veterans Health Care Choice Improvement Act of 2015," Scheduled for Consideration by the House of Representatives on July 29, 2015 (July 29, 2015).
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