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By Theodore D. Peyser, Esq.Roberts & Holland LLP, Washington, DC and New York, NY
Where a taxpayer omits from gross income an amount in excess of 25% of the reported gross income, the tax may be assessed under §6501(e)(1)(A) at any time within six years after the return was filed. Two Circuit Courts of Appeals have recently held that this six-year period is not applicable in the case of an understatement of gain on the sale of property due to use of an erroneously high basis. Salman Ranch Ltd. v. U.S., No. 2008-5053 (Fed. Cir. 7/30/09) (a 2 to 1 decision); Bakersfield Energy Partners v. Comr., 568 F.3d 767 (9th Cir. 2009). Both Circuits concluded that this type of understatement of gain was not an omission of an amount properly included in gross income and that Colony, Inc. v. Comr., 357 U.S. 28 (1958), was a controlling precedent.
Colony involved the 1939 Code predecessors of §§6501(a) and (e)(l)(A) and an understatement of gross profits on sales of land attributable to overstating basis. Based on the legislative history, the Supreme Court read the statutory phrase “omits from gross income an amount properly includible therein” as referring to an actual omission of some income receipt or accrual and not to errors in the computation of gross income arising from other causes. It explained that the rationale for giving the Commissioner additional time to assess was that the Commissioner was at a special disadvantage in cases where the taxpayer failed to report some taxable item, as compared to cases of an error in reporting an item disclosed on the face of the return.
Salman Ranch involved the construction of language which is identical in the 1939 and 1954 Codes, and the Federal Circuit found it persuasive that in the 50 years since Colony was decided Congress has not indicated that the Court's interpretation of §275(c) should not apply to §6501(e)(1)(A). In addition, the Federal Circuit believed that the rationale in Colony (more time is appropriate for items left out of a return) applies with equal force to the 1954 Code and that “omits” means to affirmatively “leave out.”
The IRS relied on two subparagraphs added to the extended statute provision for substantial omissions in the 1954 Code. The first (§6501(e)(1)(A)(i)) defines “gross income” in the case of a trade or business as meaning total amounts received before cost of sales or services. The IRS argued that the existence of this special rule for taxpayers engaged in a trade or business indicates that the general rule is that an overstatement of basis constitutes an omission from gross income. Both Circuits concluded that applying Colony to the 1954 Code would not render subparagraph (i) superfluous for the reason that in a case where there is no dispute about the amount of gross income omitted, whether the omission is more than 25% of gross income may depend on whether subparagraph (i) applies and in such cases subparagraph (i) may be dispositive. The Ninth Circuit also explained that “[c]larifying that an overstatement of basis is not an omission from gross income in the case of a trade of business does not establish that Congress also intended to alter the general judicial construction of 'omits' in all other contexts.” The second new subparagraph (§6501(e)(1)(A)(ii)) directs that the amount omitted does not include any amount disclosed in the return or a statement attached thereto. The Federal Circuit concluded that assuming the policy concern mentioned in Colony (additional time is warranted for items not mentioned) and the adequate disclosure provision are related, that is not an adequate reason to conclude that Colonyhas been rendered moot.
In Bakersfield Energy, the Ninth Circuit explained that, having resolved the case on the ground that an overstatement of basis cannot constitute an omission from gross income, it was not necessary to reach the partnership's alternative argument that it adequately disclosed its overstated basis on its return. Perhaps, another reason the court did not consider this adequate disclosure argument is that §6229(c)(2) contains no such escape clause. Accordingly, while adequate disclosure precludes the application of the six-year period of §6501(e)(1)(A), it will not preclude the application of the six-year period in §6229(c)(2).
Having lost in two Courts of Appeals, the IRS has incorporated its position in two temporary regulations, effective on September 24, 2009: Regs. §§ 301.6229(c)(2)-1T and 301.6501(e)-1T. These new regulations will certainly be challenged in court and if the IRS is successful in defending the regulations, there will be a conflict leading to possible resolution by the Supreme Court.
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.
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