In a recent case of first impression, the U.S. Tax Court held that in “stand alone” innocent spouse cases under I.R.C. section 6015(e)(1) the Court has discretion to allow the petitioner to withdraw the petition without entering a decision because petition does not invoke the Court’s deficiency jurisdiction.[1]  The taxpayer filed a Form 8857, Request for Innocent Spouse Relief, seeking relief from joint and several liability for 2007 and 2008.  The IRS denied relief.  The taxpayer timely petitioned, but later filed a motion to dismiss, seeking to voluntarily withdraw the petition.  The IRS did not object.

Typically cases before the Tax Court involve petitions to redetermine deficiencies under I.R.C. section 6213.  When the Court’s jurisdiction to redetermine a deficiency is invoked I.R.C. section 7459(d) provides:

“If a petition for a redetermination of a deficiency has been filed by the taxpayer, a decision of the Tax Court dismissing the proceeding shall be considered as its decision that the deficiency is the amount determined by the Secretary.  An order specifying such amount shall be entered in the records of the Tax Court unless the Tax Court cannot determine such amount from the record in the proceeding, or unless the dismissal is for lack of jurisdiction.”[2]

Essentially this means that a taxpayer cannot withdraw a petition in cases brought under I.R.C. 6213 in order to avoid a decision.[3]

Congress has expanded Tax Court jurisdiction to cases that do not require a redetermination of a deficiency.  These include collection due process actions and stand alone innocent spouse cases.  Previously the Tax Court held that a taxpayer can withdraw their petition when challenging the validity of a lien because there was no deficiency involved.[4]  In determining that the taxpayer could withdraw the petition, the Court looked to Federal Rule of Civil Procedure rule 41(a), which allows voluntary dismissal under certain circumstances.

In holding that the petitioner could withdraw her petition, the Tax Court distinguished its opinion in Vetrano v. Comm’r.[5]  In that case the petitioner invoked innocent spouse as an affirmative defense in a deficiency case.  In that scenario, under I.R.C. section 7459(d), the Court must enter a decision.

One important effect the Davidson decision has is that by withdrawing the petition, I.R.C. section 6015(g)(2), which makes the Court’s decision on innocent spouse res judicata, does not apply.[6]  The withdrawal has the same result as if the case was never brought.[7]  Despite this, the petitioner could not reinstitute the case before the Tax Court because the time to petition had now expired.

JONATHAN KALINISKI – For more information please contact Jonathan Kalinski at Mr. Kalinski is a former trial attorney with the IRS Office of Chief Counsel litigating Tax Court cases and advising IRS Revenue Agents and Revenue Officers on a variety of complex tax matters. Jonathan received his LL.M. in taxation from New York University and served as an Attorney-Adviser to the United States Tax Court. He is a tax attorney at Hochman, Salkin, Rettig, Toscher & Perez, P.C. and represents clients throughout the United States and elsewhere involving federal and state, civil and criminal tax controversies and tax litigation. Additional information is available at

[1]Davidson v. Comm’r, 144 T.C. No. 13 (2015)

[2]Id. at pg. 3

[3]Estate of Ming v. Comm’r, 62 T.C. 51 (1974)

[4]Wagner v. Comm’r, 118 T.C. 330 (2002)

[5]Vetrano v. Comm’r, 116 T.C. 272, 280 (2001)

[6]Davidson v. Comm’r, 144 T.C. No. 14, 10 (2015)


Does filing a false return start the six year clock or does it start at the time of the taxpayer’s last act of tax evasion? A taxpayer’s last act of tax evasion may occur many years after the tax return was (or should have been) filed. Some courts have concluded that the six year statute doesn’t start to run until the last act of tax evasion. That means you may have to worry for many years beyond six years from the date the return was (or should have been filed) filed.

Section 6531 provides the periods of limitation on criminal prosecutions and states, “No person shall be prosecuted tried, or punished for any of the various offenses arising under the internal revenue laws unless the indictment is found or the information instituted” within 6 years “after the commission of the offense” “for the offense of willfully attempting in any manner to evade or defeat any tax or the payment thereof.”[i]

In United States v. Irby,[ii] the 5th Circuit held the six year statute starts on the last act of evasion. Mr. Irby used nominee trusts to conceal his assets, delaying when his six years commenced. Years later, he could be prosecuted and convicted because his indictment, which occurred ten years after his failure to file, occurred within six years from his last act of tax evasion.

The issue of whether the six-year statute of limitations for section 7201 offenses begins to run from the date the tax return was due or following the last affirmative act of tax evasion was a question of first impression for the Court in Irby. The 5th Circuit previously held in United States v. Williams,[iii] that the limitations period for a prosecution under section 7201 in which no tax return was filed begins to accrue on the day the tax return is due. In Williams, the Court specifically declined to address whether the effect of the last affirmative act of evasion on the statute of limitations: “We express no opinion relative to the effect of affirmative acts occurring subsequent to the [tax return] filing date.”[iv]

The jury found Mr. Irby guilty of violating section 7201—willfully attempting to evade or defeat tax. Mr. Irby last failed to file his taxes in 2001, so his violation of section 7201 was time barred by the six year statute of limitations unless the period began to accrue following his last affirmative act of evasion.  In holding that the six year statute begins to accrue following the last affirmative act of tax evasion, the Court reasoned that the language of Section 6531(2) provides that taxpayers must be indicted within six years of when the crime of “willfully attempting in any manner to evade or defeat any tax or the payment thereof” was completed.[v] The 5th Circuit also noted that other circuits have considered the issue and concluded that the statute of limitations for section 7201 offenses runs from the later date of either when the tax return was due or the defendant’s last affirmative act of tax evasion.[vi] The Court in Irby focused its reasoning on the decisions in United States v. Dandy[vii] and United States v. Ferris:[viii]

In Dandy, the Sixth Circuit addressed facts similar to those at issue here, where the defendant did not file tax returns for 1982 and 1983, but the last act of evasion did not occur until 1985. Dandy, 998 F.2d at 1355-56. The  Dandy court found that the statute of limitation runs from the last evasion act “because it is these evasive acts . . . which form the basis of the cimes alleged in . . . [the] indictment.” Id. at 1356. In Ferris, the First Circuit supported the rule by pointedly stating, “[t]he defendant, however, by deceitful statements continued his tax evasion through [date of last act of evasion].” Ferris, 807 F.2d at 271 (noting that Habig supports this result because, “[t]he [Supreme Court] held that it made no sense to assert that ‘Congress intended the limitations period to begin to run before appellees committed the acts upon which the crimes were based’” (quoting Habig, 390 U.S. at 224-25)).

The 5th Circuit also noted that no circuit has rejected the last affirmative act of tax evasion rule and reasoned that “one element of the section 7201 offense is the commission of an affirmative act seeking to evade tax liability, which can be shown through the individual’s willful failure to file a tax return…or through continued evasive acts intending to avoid the payment of taxes.” The 5th Circuit held that the District Court in Irby did not err in concluding that Mr. Irby’s section 7201 violation was not time barred because Mr. Irby’s last act to evade the payment of his taxes was in 2006 and he was indicted in 2011.

KRISTA HARTWELL – For more information please contact Krista Hartwell at or 310.281.3200. Ms. Hartwell is a tax lawyer at Hochman, Salkin, Rettig, Toscher & Perez, P.C. and represents clients throughout the United States and elsewhere involving federal and state, civil and criminal tax controversies and tax litigation. Additional information is available at


[i] 26 U.S.C. § 6531(2).

[ii] United States v. Irby, 703 F.3d 280 (5th Cir. Miss. 2012).

[iii] United States v. Williams, 928 F.2d 145, 149 (5th Cir. 1991).

[iv]  Id.

[v] United States v. Irby, 703 F.3d 280, 283 (5th Cir. Miss. 2012).

[vi] Id. at 283-284 (citing United States v. Anderson, 319 F.3d 1218, 1219-20 (10th Cir. 2003) (“Section 7201criminalizes not just the failure to file a return or the filing of a false return, but the willful attempt to evade taxes in any manner.”); United States v. Carlson, 235 F.3d 466, 470 (9th Cir. 2000)United States v. Wilson, 118 F.3d 228, 236 (4th Cir. 1997)United States v. Dandy, 998 F.2d 1344, 1355-56 (6th Cir. 1993) (“To hold that the statute of limitations for income tax evasion . . . began to run on the date the returns were filed would reward defendant for successfully evading discovery of his tax fraud for a period of six years subsequent to the date the returns were filed.”); United States v. Winfield, 960 F.2d 970, 973-74 (11th Cir. 1992) (per curiam); United States v. DiPetto, 936 F.2d 96, 98 (2d Cir. 1991)United States v. Ferris, 807 F.2d 269, 271 (1st Cir. 1986)United States v. Trownsell, 367 F.2d 815 (7th Cir. 1966) (per curiam)).

[vii] United States v. Dandy, 998 F.2d 1344, 1356 (6th Cir. 1993)

[viii] United States v. Ferris, 807 F.2d 269, 271 (1st Cir. 1986).

In a Tax Court Memorandum Opinion released February 26, 2015, the Tax Court held that a taxpayer had fully reported his tip income for tax years 2009 – 2011, rejecting the Service’s determination that the taxpayer had underreported his tip income based on its reconstruction of the taxpayer’s tip income.[i]  During the tax years at issue, the taxpayer, who was a bartender at MGM Grand Hotel and Casino in Las Vegas, self-reported his tip income based on daily contemporaneous records that the taxpayer kept of the tips that he received.   Although the Tax Court found the Service’s method of reconstructing the taxpayer’s income to be reasonable, the Tax Court held that the taxpayer’s records more accurately reflected the taxpayer’s actual tip income.

Tips that employees receive are taxable as compensation for services under Internal Revenue Code § 61(a).[ii]  The Employment Tax Regulations require tipped employees to maintain a daily record or other similarly reliable evidence of their tips.[iii]  A taxpayer’s daily record should include the taxpayer’s name and address, the employer and the establishment’s name, the amount of cash tips and charge tips received from customers or from other employees for each work day, the amount of any tips paid out to other employees through tip sharing or similar arrangements and the names of such employees, and the date that each entry is made.[iv]

The IRS has initiated programs to enhance compliance among tipped employees, which involve a voluntary agreement between an employer and the IRS in which the IRS and the employer determine the amount of tips that employees generally receive and should report.  Participants in these programs are relieved of their recordkeeping requirements and the IRS will not challenge the tip income reported by participants under the terms of the program.[v]  One such program is the Gaming Industry Tip Compliance Agreement Program (GITCA), which sets an automatic tip rate for participating employees in the gaming industry—the employer’s payroll department multiplies the number of hours worked by participating employees by the applicable tip rate to arrive at taxable tip income that is then reported on the participants’ Forms W-2.[vi]

In Sabolic v. Commissioner, T.C. Memo 2015-32, the taxpayer had opted out of the GITCA for tax years 2009 – 2011 and instead self-reported his tips to his employer and maintained a daily log of the tips he received.[vii]  For tips that he earned from credit cards and room charges, the MGM Grand’s system generated a receipt stating how much the taxpayer had earned.  For cash tips, the taxpayer personally kept track of his cash tips for each shift, except for leftover change that he would tip the cashier.  In addition to keeping a daily personal tip diary, the taxpayer would add up his cash tips and his charged tips at the end of each shift and enter them into MGM Grand’s system when he punched out, which would then be reported to MGM Grand’s payroll department and reported on his W-2.  The Taxpayer would then “tip out” a portion, generally 10% to 20%, of his tips to the barbacks who helped him during his shifts.  The taxpayer’s tip diaries showed that the petitioner received tips of $21,849, $24,212, and $22,950 for tax years 2009 – 2011, respectively, and his Forms W-2 reported tip income of $18,110, $23,941, and $21,926 for tax years 2009 – 2011, respectively.[viii]  When reporting these amounts on his returns, the taxpayer deducted 10% for the amount he tipped out to other employees.[ix]

The IRS issued the taxpayer a notice of deficiency, which asserted that the taxpayer underreported his tips by $19,729, $19,000, and $20,284 for tax years 2009 – 2011, respectively, based on its reconstruction of the taxpayer’s tip income using a well-established indirect method for computing tip income, and imposed an accuracy-related penalty.[x]  The IRS argued that the taxpayer’s records were inadequate because (1) the logs were recorded in whole numbers; (2) the taxpayer did not keep track of how much he actually tipped the barbacks; (3) the logs appeared to be missing days; and (4) the taxpayer’s logs did not precisely match up with the information in his Forms W-2.[xi]

Finding no evidence to support the discrepancy asserted by the IRS, the Tax Court rejected each of the IRS’ arguments against the reliability of the taxpayer’s records.  Although there was a small discrepancy between the taxpayer’s personal log and the W-2 amounts and the taxpayer did not maintain a record of the precise amounts that he tipped out to other employees, the Tax Court found the taxpayer’s explanations to be credible and the taxpayer’s logs to be a “substantially accurate” account of his tip income for the tax years at issue.[xii]

Although the IRS’ asserted deficiency based on its indirect method of computing the taxpayer’s income was presumed to be correct, the Tax Court held that the taxpayer satisfied his burden of proving the IRS wrong through his “habitual careful recordkeeping” and his detailed, credible testimony regarding how he kept track of his tips, the nature of the bar he worked at, and the typical tipping behaviors of his patrons.[xiii]

LACEY STRACHAN – For more information please contact Lacey Strachan at Ms. Strachan is a tax attorney at Hochman, Salkin, Rettig, Toscher & Perez, P.C. and represents clients throughout the United States and elsewhere involving federal and state, civil and criminal tax controversies and in tax litigation. Additional information is available at

[i] Sabolic v. Comm’r, T.C. Memo 2015-32.

[ii] IRC § 61(a); Treas. Reg. § 1.61-2(a)(1).

[iii] Treas. Reg. § 31.6053-4(a)(1).

[iv] Treas. Reg. § 31.6053-4(a)(2).

[v] Ann 2001-1, 2001-1 CB 277.

[vi] Rev. Proc. 2007-32.

[vii] Sabolic v. Comm’r, T.C. Memo 2015-32 at *4.

[viii] Id. at *5-*6.

[ix] Id.

[x] Id. at *8.

[xi] Id. at *12-*13.

[xii] Id. at *14.

[xiii] Id. at *10, *14-*16.

Deductions are a matter of legislative grace, and taxpayers bear the burden of proving entitlement to any claimed deduction.[i] A taxpayer must identify each deduction available, show that he or she has met all requirements therefor, and keep books or records that substantiate the expenses underlying the deduction.[ii] The mere fact that a taxpayer claims a deduction on an income tax return is not sufficient to substantiate the underlying expense.[iii] Rather, an income tax return “is merely a statement of the * * * [taxpayer’s] claim * * *; it is not presumed to be correct.”[iv]

Ordinary and Necessary Business Expenses. Internal Revenue Code Section 162(a) allows a taxpayer to deduct all ordinary and necessary business expenses paid or incurred during the taxable year. However, a taxpayer’s personal or living expenses are not deductible.[v] Pursuant to Code Sections 67 and 162(a), an employee taxpayer may deduct as miscellaneous itemized deductions all of the ordinary and necessary unreimbursable business expenses paid or incurred during the taxable year in carrying on the trade or business of the taxpayer’s employment.[vi]  “To qualify as an allowable deduction under [section] 162(a) * * * an item must (1) be ‘paid or incurred during the taxable year,’ (2) be for ‘carrying on any trade or business,’ (3) be an ‘expense,’ (4) be a ‘necessary’ expense, and (5) be an ‘ordinary’ expense.”[vii]  An expense satisfies the second element only if it is “directly connected with or pertaining to the taxpayer’s trade or business.”[viii] An expense qualifies as necessary if it is “appropriate and helpful” to the taxpayer’s business[ix] and as ordinary if the underlying transaction is a “common or frequent occurrence in the type of business involved.”[x] A taxpayer must establish these essential elements with credible evidence.[xi]

Personal Expenses Not Deductible. While business expenses are generally deductible, personal, living, and family expenses are typically nondeductible.[xii] A business expense claimed as a deduction must be incurred primarily for business rather than personal reasons.[xiii] Where an expense exhibits both personal and business characteristics, the “test[] requires a weighing and balancing of all the facts * * * bearing in mind the precedence of section 262, which denies deductions for personal expenses, over Section 162, which allows deductions for business expenses.”[xiv]

Personal / Business Expenses. In the personal/business context, a taxpayer must provide evidence from which the government can reasonably apportion the expenses between business and personal use. A taxpayer must generally have “adequate records” for all his or her claimed deductions, and has to have extra evidence for some deductions (the ones listed in Section 274(d)).[xv]   While it is within the purview of a Court to estimate the amount of allowable deductions where there is evidence that deductible expenses were incurred, there must be some basis on which an estimate may be made.

Approximations of Expenses. Under Cohan v. Commissioner[xvi], if a taxpayer claims a deduction but cannot fully substantiate the expense underlying the deduction, the Court may generally approximate the allowable amount, bearing heavily against the taxpayer whose inexactitude in substantiating the amount of the expense is of his own making. The Court must have some basis upon which to make its estimate, however, else the allowance would amount to “unguided largesse.”[xvii]

If a taxpayer’s records are lost or destroyed because of circumstances beyond his control, the taxpayer may instead substantiate the expenses with other credible evidence.[xviii] Here again, although the Court generally may estimate amounts, any estimate must have a reasonable evidentiary basis.[xix]

As we approach tax filing season, it must be remembered that taxpayers (and return preparers) are required to sign their return under penalties of perjury. Information set forth within the tax return must be as accurate and complete as possible – a tax return does not represent an offer to negotiate with the government.

The mere failure to possess all required substantiation should not preclude the ability to claim otherwise deductible expenses if there is a sufficient basis to estimate the amount of such expenses. Finally, acknowledging amounts estimated within the return as estimates should avoid a later difficult discussion regarding the failure to do so.

Form 8275 – Disclosure Statement. In closing, remember that information set forth on the IRS Form 8275 – Disclosure Statement not otherwise adequately disclosed elsewhere within the tax return can avoid certain penalties. Form 8275 is filed with the income tax return to avoid the portions of the accuracy-related penalty due to disregard of rules or to a substantial understatement of income tax if the return position has a reasonable basis. (See also IRS Rev. Proc. 2015-16 for information that can be disclosed elsewhere in the tax return).

[i] U.S. Tax Court Rule 142(a); INDOPCO, Inc. v. Commissioner, 503 U.S. 79, 84 (1992).

[ii]  Roberts v. Commissioner, 62 T.C. 834, 836 (1974).

[iii] Wilkinson v. Commissioner, 71 T.C. 633, 639 (1979).

[iv] Roberts v. Commissioner, 62 T.C. at 837.

[v] Code Sec. 262.

[vi] Lucas v. Commissioner, 79 T.C. 1, 6 (1982).

[vii] Commissioner v. Lincoln Sav. & Loan Ass’n, 403 U.S. 345, 352 (1971).

[viii] Sec. 1.162-1(a), Income Tax Regs.

[ix] Welch v. Helvering, [*32] 290 U.S. at 113

[x] Deputy v. du Pont, 308 U.S. 488, 495 (1940).

[xi] See sec. 1.6001-1(a), Income Tax Regs.

[xii] Code Section  262(a).

[xiii] See Walliser v. Commissioner, 72 T.C. 433, 437 (1979).

[xiv] Sharon v. Commissioner, 66 T.C. 515, 524 (1976) (citing costs of commuting and ordinary clothing as examples of expenses helpful and necessary to an individual’s employment that are “essentially personal” and hence nondeductible), aff’d per curiam, 591 F.2d 1273 (9th Cir. 1978).

[xv] Section 272(d) generally provides “No deduction or credit shall be allowed– (1) under section 162 or 212 for any traveling expense (including meals and lodging while away from home), (2) for any item with respect to an activity which is of a type generally considered to constitute entertainment, amusement, or recreation, or with respect to a facility used in connection with such an activity, (3) for any expense for gifts, or (4) with respect to any listed property (as defined in section 280F(d)(4)), unless the taxpayer substantiates by adequate records or by sufficient evidence corroborating the taxpayer’s own statement (A) the amount of such expense or other item, (B) the time and place of the travel, entertainment, amusement, recreation, or use of the facility or property, or the date and description of the gift, (C) the business purpose of the expense or other item, and (D) the business relationship to the taxpayer of persons entertained, using the facility or property, or receiving the gift. The Secretary may by regulations provide that some or all of the requirements of the preceding sentence shall not apply in the case of an expense which does not exceed an amount prescribed pursuant to such regulations.

[xvi] Cohan v. Commissioner, 39 F.2d 540, 543-544 (2d Cir. 1930),

[xvii] Williams v. United States, 245 F.2d 559, 560 (5th Cir. 1957); Vanicek v. Commissioner, 85 T.C. 731, 742-743 (1985).

[xviii] See Malinowski v. Commissioner, 71 T.C. 1120, 1124-1125 (1979). But cf. sec. 1.274-5T(c)(5), Temporary Income Tax Regs., 50 Fed. Reg. 46022 (Nov. 6, 1985) (providing that for deductions governed by section 274, taxpayer may substantiate the deductions by a reasonable reconstruction of the expenditures or uses).

[xix] See Villarreal v. Commissioner, T.C. Memo. 1998-420, 76 T.C.M. (CCH) 920, 921-922 (1998).

Cono Namorato is an extraordinary individual with an outstanding character and the highest integrity. He is amazingly well qualified to lead the Tax Division with his deep knowledge and understanding of the Internal Revenue Code, the Treasury Regulations and relevant case authorities involved in a wide range of both civil and criminal tax related issues.

Mr. Namorato knows, understands and respects the history and traditions of the Tax Division and its relationship with the Internal Revenue Service. When it occurs, everyone should be extremely proud of his Nomination to become the next Assistant Attorney General for the Tax Division, Department of Justice.




Office of the Press Secretary 


February 24, 2015

President Obama Announces More Key Administration Posts

WASHINGTON, DC – Today, President Barack Obama announced his intent to nominate the following individuals to key Administration posts:


Cono R. Namorato – Assistant Attorney General for the Tax Division, Department of Justice


President Obama said, “I am honored that these talented individuals have decided to serve our country. They bring their years of experience and expertise to this Administration, and I look forward to working with them.”

President Obama announced . . .

Cono R. Namorato, Nominee for Assistant Attorney General for the Tax Division, Department of Justice. Cono R. Namorato is currently a Member of the law firm Caplin & Drysdale, a position he has held since 2006 and previously from 1978 to 2004. From 2004 to 2006, Mr. Namorato served as Acting Deputy Commissioner for certain designated matters and as Director of the Office of Professional Responsibility for the Internal Revenue Service (IRS) in the Department of the Treasury. Before beginning his career at Caplin & Drysdale, Mr. Namorato held various positions within the Tax Division of the Department of Justice (DOJ), including Deputy Assistant Attorney General from 1977 to 1978, Assistant Chief and then Chief of the Criminal Section from 1973 to 1977, and Supervisory Trial Attorney and Trial Attorney from 1968 to 1973. Mr. Namorato began his career in 1963 as a Special Agent for the Criminal Investigation Division of the IRS in the Brooklyn District. He is a Fellow of the American Bar Foundation and a fellow of the American College of Tax Counsel. Mr. Namorato has headed various tax-related committees and subcommittees for the American Bar Association, serving as Chair of the Tax Section’s Subcommittee on Criminal Tax Policy, Chair of the Committee on Tax Litigation, and Co-Chair of the Committee on Complex Criminal Litigation of the Litigation Section. Mr. Namorato received a B.B.A. from Iona College and a J.D. from Brooklyn Law School.



Posted by: | February 20, 2015


Posted by: | February 9, 2015

ICIJ Reveals Swiss HSBC Data

Section 1031 like-kind exchanges have been one of the California Franchise Tax Board’s (FTB) top audit issues in recent years. [i]  California’s Form 3840, which is new for the 2014 tax year, is one of the latest developments in the FTB’s focus on scrutinizing like-kind exchanges.

On June 27, 2013, Assembly Bill 92 was enacted, which imposed a new information reporting requirement for taxpayers who engage in certain like-kind exchanges under section 1031 of the Internal Revenue Code (IRC).[ii]  The new law creates an annual information reporting requirement for taxpayers who defer recognition of gain on an exchange of real property in California for property outside California.[iii]  This requirement applies to exchanges that occur during tax years beginning on or after January 1, 2014, making this filing season the first time that taxpayers will be required to file the new California Form 3840, titled California Like-Kind Exchanges, which the FTB recently released in final form.[iv]

Section 1031 allows taxpayers to defer recognition of gain or loss on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like kind which is to be held either for productive use in a trade or business or for investment.[v]   California generally conforms to IRC section 1031 under Revenue and Taxation Code (R&TC) sections 18031 and 24941, allowing taxpayers non-recognition treatment for California tax purposes for like-kind exchanges that meet the requirements of section 1031.  The FTB has identified three general requirements to qualify for non-recognition treatment under section 1031: (1) there must be an exchange, as opposed to a separate sale and reinvestment, by the same taxpayer; (2) the relinquished property and the replacement property must be “like kind”; and (3) both the relinquished property and the replacement property must be held for investment or for productive use in a trade or business, which excludes property that is held primarily for sale or for personal use.[vi]  Real property interests are generally considered to be of a like kind to each other, except real property located in the United States and foreign real property are not considered to be of like kind.[vii]

In a section 1031 exchange, a taxpayer’s basis in the replacement property is generally equal to the taxpayer’s basis in the relinquished property, with adjustments for cash received in the transaction and for gain or loss recognized at the time of the exchange.[viii]  This creates a deferral of any gain until the replacement property is disposed of in a taxable transaction.  When the taxpayer later sells the property in a taxable transaction,  the taxpayer then pays tax on not only the appreciation on the property being sold, but also on the gain that was deferred in any earlier section 1031 exchange.

For state tax purposes, this creates the issue of how to source that gain, when part is attributable to a sale of a property in one state and part is attributable to a sale of property in another state.  In general, capital gains and losses from sales of real property located in California are sourced to California.[ix]  That means that the gain on the sale of any California real property is taxable by California, even if the taxpayer is a nonresident at the time of the sale or subsequently moves out of state.

In like-kind exchanges, the source of gain on the exchange of property is determined at the time the gain or loss is realized, i.e., at the time of the exchange.  Where the relinquished property in a like-kind exchange is located in California, the deferred gain on the exchange is sourced to California, regardless of the residence of the taxpayer or the location of the replacement property.[x]  California takes the position that the source of this gain or loss is preserved until the gain or loss is recognized — that is, when the replacement property is ultimately sold in a taxable transaction, the gain originally deferred on the California property will have its source in and be taxable by California.

In audits by the FTB of like-kind exchanges in recent years, the sourcing of gains to California is one of the audit issues that the FTB has been focused on.[xi]  The FTB was having difficulty tracking a taxpayer’s replacement property to determine whether it was later sold in a taxable transaction, triggering a tax liability to California on the California-sourced portion of the deferred gain.  This issue is made more complicated by the fact that taxpayers can engage in multiple consecutive section 1031 transactions, making it so the FTB would have no record of a subsequent exchange by a non-resident taxpayer that further deferred recognition of the gain.

To ensure that taxpayers do not escape California taxation on capital gains realized from the exchange of California real property, the new Form 3840 requires taxpayers to report to the FTB details about the relinquished properties, the replacement properties, and the amount and allocation of the taxpayer’s California source deferred gain.  The form is designed to help taxpayers and the FTB keep track of California sourced gain deferrals from section 1031 exchanges and is required to be filed by the taxpayer on an annual basis until the deferred gain is recognized, even if the taxpayer does not otherwise have any California filing obligation for that year.[xii]  This new filing requirement currently applies only to exchanges involving real property, not tangible personal property.

If a taxpayer fails to file a Form 3840, as required, the FTB may issue a Notice of Proposed Assessment that will adjust the taxpayer’s income to recognize the previously deferred gains, plus penalties and interest.[xiii]

As a result of the FTB’s heightened scrutiny and strict interpretation of the section 1031 requirements, certain exchanges may come under scrutiny by the FTB that would otherwise be respected for Federal tax purposes.  In its most recent list of Top Audit Issues, published in April 2014, the FTB explained that it is continuing to find noncompliance in section 1031 exchanges in the following areas: (1) errors in computing gain, particularly taxable boot due to debt netting and including non-exchange expenses in the computation; (2) failing to properly comply with the section 1031 rules for identifying the replacement property; (3) including the cost of property improvements made after the exchange closed in the calculation of taxable boot; and (4) withdrawing cash out of the proceeds from the relinquished properties.[xiv]  The FTB’s continued focus on section 1031 exchanges makes it especially important for taxpayers considering doing a like-kind exchange to pay careful attention to complying with all of the section 1031 requirements.

LACEY STRACHAN – For more information please contact Lacey Strachan at Ms. Strachan is an associate at Hochman, Salkin, Rettig, Toscher & Perez, P.C. and represents clients throughout the United States and elsewhere involving federal and state, civil and criminal tax controversies and tax litigation. Additional information is available at

[i] FTB April 2014 Tax News, (hereinafter April 2014 Tax News); FTB January 2013 Tax News,; FTB January 2012 Tax News, (hereinafter January 2012 Tax News).

[ii] FTB September 29, 2014 Public Service Bulletin, “New FTB Form for Like-Kind Exchanges,” (hereinafter September 29, 2014 Public Service Bulletin).

[iii] Id.

[iv] FTB January 2015 Tax News, The new Form 3840 is available here: Instructions to the Form 3840 are available here:

[v] 1031(a)

[vi][vi] January 2012 Tax News.

[vii] IRC § 1031(h).

[viii] IRC § 1031(d)

[ix] Cal. Rev. & Tax. Code § 25125(a).

[x] 2014 Instructions for Form FTB 3840.

[xi] See, e.g., January 2012 Tax News.

[xii] FTB December 2013 Tax News, “New 1031 Filing Requirements for California,”

[xiii] September 19, 2014 Public Service Bulletin.

[xiv] April 2014 Tax News.

Posted by: | January 23, 2015

Fraudulent Failure to File Tax Returns – 75% of the Tax Due!

Failing to file returns is not a reasonable response to the inability to pay the tax liability associated with the returns. If in doubt, file the returns and work out a payment arrangement with the IRS. Also, know that the civil “failure to file” penalty accrues at 5.0%/month (up to 25% of the tax deficiency). The civil “failure to pay” penalty accrues at the rate of 0.5%/month (up to 25% of the tax deficiency). When you do the math and factor in the numerous other risk factors associated with the failure to file a tax return, the decision to file becomes somewhat obvious in most cases.

Before contacting a non-filer, the IRS will often attempt to identify the non-filer’s occupation, location of bank/savings accounts, sources of income, age, current address, last file returned, adjusted gross income of last file returned, taxes paid on last file returned – amounts and methods of payment (withholding, estimated tax, pre-payments), number of years delinquent, and the non-filer’s standard of living.

Tax Evasion and Fraud? If a non-filer is contacted by the government, the examiner will determine the cause (does the non-filer lack records, ability to pay, lack of education, etc.) and may offer necessary information or assistance (preparation of returns, payment arrangement information, etc.) to secure full cooperation. If the non-filer is not cooperative (won’t respond or refuses to cooperate), third party contacts may be made to determine the non-filer’s income and make an assessment.

IRS Inquiries. On the initial screening of a non-filer case, the IRS will attempt to determine if the facts indicate potential fraud. Indicators of fraud for consideration set forth in the IRS Internal Revenue Manual (IRM) include:

  • History of non-filing or late filing, and an apparent ability to pay;
  • Repeated contacts by the IRS;
  • Knowledge of the filing requirements (i.e., advanced education, business (especially tax) experience, record of previous filing etc.);
  • Experience of the taxpayer in tax matters such as a law professor, CPA or tax attorney;
  • Failure to reveal or attempts to conceal assets;
  • Age, health, and occupation of the taxpayer;
  • Substantial tax liability after withholding credits and estimated tax payments;
  • Large number of cash transactions, i.e., purchases by cash and large cash deposits evidenced by documented cash transactions, payment of personal and business expenses in cash when cash payment is unusual and/or the cashing (as opposed to the deposit) of business receipts;
  • Indications of significant income per Information Return Processing (IRP) documents (i.e., substantial interest and dividends earned, investments in IRA accounts, stock and bond transactions, high mortgage interest paid);
  • Refusal or inability to explain the failure to file; and
  • Prior history of criminal tax prosecutions for Title 26 violations.

If the IRS believes the possibility of fraud exists, the IRM instructs the IRS examiner to not solicit returns. If returns are submitted, they should be accepted but not processed, and clearly documented in the case history. Agents are not to discuss tax liabilities, penalties, fraud, or criminal referral possibilities with the taxpayer.

Non-Filer Examinations. During non-filer examinations, the IRS examiner will determine if related returns (corporate, partnership, employment tax, and excise tax returns) have been filed as required. They will also search for spin-off cases involving relatives, employees, employers, subcontractors, partners, and even return preparers! If a non-filer is involved in a family business, the examiner will determine if all family members have filed returns. If the non-filer is involved in a partnership, the IRS will determine if partnership returns have been filed and determine if all partners have filed returns. For delinquent corporate returns, they will attempt to determine if all shareholders have filed returns. Penalties are not typically be easily waived in non-filer cases without reasonable cause.

During the non-filer examination, the IRM suggests that the examiner:

  1. Interview the taxpayer to determine the reason or the intent of the taxpayer’s noncompliance.
  2. Ask sufficient questions to determine the extent of the delinquency, including the periods and tax due.
  3. Document verbatim, if possible, the questions asked and the taxpayer’s response or lack of response.
  4. Identify any personal reasons that could affect the taxpayer’s ability to comply. If the information is not provided by the taxpayer, attempt to secure the information from third party sources.
  5. Attempt to get a definitive statement from the taxpayer regarding additional expenses not listed in the books and records. These expenses could include, but are not limited to, expenses paid in cash or “under-the-table” payments to employees.
  6. Attempt to establish year-end cash on hand for each year under investigation.

If the IRS receives sufficient information (often utilizing bank deposits plus some specific income items from payments diverted to or for the benefit of the taxpayer) it can prepare substitutes for returns under Internal Revenue Code (26 U.S.C.) § 6020(b). Bank deposits can be prima facie evidence of income.[1] Proof of gross receipts in the amounts shown by a bank deposits analysis is often sufficient to satisfy the Governments burden of showing that a taxpayer had an obligation to file returns.[2]

Fraudulent Failure to File Penalty. Code § 6651(f) provides a penalty of 75% of the amount required to be shown as tax on unfiled returns if the failure to file the returns is fraudulent. The civil fraud penalty is a sanction provided primarily as a safeguard for the protection of the revenue and to reimburse the Government for the heavy expense of investigation and the loss resulting from the taxpayer’s fraud.[3] The Government has the burden of proving fraud by clear and convincing evidence.[4]

Fraud may be proved by circumstantial evidence, and the taxpayer’s entire course of conduct may establish the requisite fraudulent intent.[5] Circumstantial evidence of fraud includes “badges of fraud” such as those present here: a longtime pattern of failure to file returns, failure to report substantial amounts of income, failure to cooperate with taxing authorities in determining the taxpayer’s correct liability, implausible or inconsistent explanations of behavior, and concealment of assets.[6]

In a recent decision by the U.S. Tax Court, the taxpayer contended that compensation for architectural services he performed in Hawaii was not subject to income tax and that therefore he was not required to file returns for the years in issue. Further, he apparently asserted that “his earnings for architectural services rendered in Hawaii are not taxable because he is a U.S. citizen and has no foreign earned income taxable under section 911 and related regulations. His argument is based on inapplicable statutes and circular reasoning. He denies that “worldwide income” includes domestic income, substituting his own reading of statutory and regulatory materials for those of every court that has spoken on the subject in innumerable cases decided over decades. He takes items out of context, treats “includes” as a term of limitation, and contends that references to certain categories within a statute or regulation exclude all others. He has not presented any reason to reject respondent’s recalculated deficiencies and additions to tax or penalties. He has refused to produce evidence of nontaxable bank deposits or deductible expenses.”[7]

The Tax Court noted that “Petitioner’s interpretative arguments have been consistently rejected in strong terms, even in judicial opinions sustaining criminal convictions. See, e.g., United States v. Ward, 833 F.2d 1538, 1539 (11th Cir. 1987) (“utterly without merit”); United States v. Latham, 754 F.2d 747, 750 (7th Cir. 1985) (“inane” and “preposterous”); United States v. Rice, 659 F.2d 524, 528 (5th Cir. 1981) (“frivolous non-sequitur”). In Takaba v. Commissioner, 119 T.C. 285, 292 (2002), the taxpayer and his counsel, Paul Sulla (the attorney who assisted petitioner in establishing entities used to conceal income), were sanctioned under section 6673(a)(1) and (2), respectively, for arguing, among other things, that a U.S. citizen residing in Hawaii was not taxable on compensation earned in Hawaii. No further discussion of petitioner’s stale theories is warranted. See Crain v. Commissioner, 737 F.2d 1417 (5th Cir. 1984).”[8]

In concluding that the taxpayer’s failure to file tax returns for the years at issue was due to fraud, the Tax Court rejected “any inference that petitioner’s persistence in his frivolous theories demonstrates sincerity or good faith or is otherwise a defense to the charge of fraud. . . . A person with his education and skills could be expected to abandon unsuccessful arguments if acting in good faith. We conclude that petitioner’s failure to file for each year in issue was due to fraud.”[9]

Additional Penalty for Delay or Where Taxpayer’s Position is “Frivolous.” Finally, the Tax Court apparently warned the taxpayer about the “possibility of a penalty under Code section  6673 if he persisted in his contention that he was not required to file returns and pay tax on his income for architectural services performed in Hawaii.”[10] The Tax Court noted that “section 6673(a)(1) provides for a penalty not in excess of $ 25,000 when proceedings have been instituted or maintained by the taxpayer primarily for delay or the taxpayer’s position is frivolous or groundless. It may seem that an additional $25,000 on top of the amounts petitioner already owes will not change his position. However, serious sanctions also serve to warn other taxpayers to avoid pursuing similar tactics. See Coleman v. Commissioner, 791 F.2d 68, 71-72 (7th Cir. 1986); Takaba v. Commissioner, 119 T.C. at 295. An award of $ 25,000 to the United States will be included in the decision to be entered here.”[11] (emphasis added).

The Path Forward. Generally, people who come forward and file returns prior to being contacted by IRS will not be subjected to a penalty associated with a Code § 6651(f) fraudulent failure to file return penalty nor will they likely be pursued through a criminal investigation.

The “willful” failure to file a tax return, pay a tax that is due or supply information requested can be subject to a criminal prosecution under Code § 7203. The IRS Voluntary Disclosure Practice set forth in Internal Revenue Manual indicates that a timely, truthful voluntary disclosure is a factor to consider in deciding upon a possible criminal prosecution referral by the IRS to the Department of Justice. although this Practice does not technically absolve a taxpayer of civil penalties, it is an important factor in civil penalty determinations as well. Also,Treas. Reg. 1.6664-2(c)(2) generally encourages voluntary disclosures by eliminating accuracy-related (but not civil fraud) penalties on amounts reflected on an amended return that is filed before any IRS contact.

For non-filers, opportunities exist to file returns before any IRS contact that could reduce or eliminate potential civil penalties and any potential criminal prosecution, and may be able to coordinate an effective installment payment arrangement (or Offer in Compromise) for any resulting deficiencies. Regardless, a non-filer should not wait since the “first knock on the door” might not be user friendly . . .

[1] See Tokarski v. Commissioner, 87 T.C. 74, 77 (1986); Estate of Mason v. Commissioner, 64 T.C. 651, 656-657 (1975), aff’d, 566 F.2d 2 (6th Cir. 1977).

[2] See Hamlet C. Bennett v. Commissioner, T.C. Memo. 2014-256 (December 22, 2014)

[3] Helvering v. Mitchell, 303 U.S. 391, 401 (1938).

[4] See Code section 7454(a); Tax Court Rule 142(b).

[5] Rowlee v. Commissioner, 80 T.C. 1111, 1123 (1983).

[6] See, e.g., Bradford v. Commissioner, 796 F.2d 303, 307-308 (9th Cir. 1986), aff’g T.C. Memo. 1984-601; Powell v. Granquist, 252 F.2d 56, 60 (9th Cir. 1958); Grosshandler v. Commissioner, 75 T.C. 1, 19-20 (1980); Gajewski v. Commissioner, 67 T.C. 181, 199-200 (1976), aff’d without published opinion, 578 F.2d 1383 (8th Cir. 1978).

[7]See Hamlet C. Bennett v. Commissioner, T.C. Memo. 2014-256 (December 22, 2014)

[8] Id.

[9] Id.; See also Miller v. Commissioner, 94 T.C. 316, 332-336 (1990); Chase v. Commissioner, T.C. Memo. 2004-142; Tonitis v. Commissioner, T.C. Memo. 2004-60; Madge v. Commissioner, T.C. Memo. 2000-370, aff’d, 23 Fed. Appx. 604 (8th Cir. 2001); Greenwood v. Commissioner, T.C. Memo. 1990-362.

[10] See Hamlet C. Bennett v. Commissioner, T.C. Memo. 2014-256 (December 22, 2014)

[11] Id.

Posted by: | January 20, 2015


I get this question from practitioners and taxpayers several times a year . . .

Question: We are under examination for our corporation in an open loss year, and now the IRS wants to go back and look at a closed year where we took part of the loss as a carryback.  How can they do that?  The carryback year is closed!  Not only that, the IRS already subjected the now closed carryback year to a full-blown examination and issued a “no-change.”  Isn’t this a second unnecessary examination on the carryback year?

Short Answer:  In its attempt to determine the correct taxable situation for your open loss year, the IRS may look at any other year, open or closed, that may relate to the examination.  The IRS can calculate or even recalculate the taxes for the carryover years to see their impact on the open examination of your loss year.  The overriding issue is “What’s the correct tax liability in the open year under examination?”  No facts are off limits.  No, it is not a second unnecessary examination.

Longer Answer:  Section 6501 (h) establishes an exception to the general 3 year limitations period.[1] Section 6501 (h) provides an enlargement of the general limitations period when a taxpayer carries back to the taxable year in question a net operating loss from a subsequent tax year. Section 6501(h) permits the Commissioner to assess a deficiency stemming from a net operating loss carryback deduction before the expiration of the limitations period for the taxable year in which the net operating loss was created.[2]  A similar rule exists under 6501(k) for enlargement of the assessment statute with a tentative carryback that has been applied, credited, or refunded under section 6411.

This rule, however, is often misunderstood.  Taxpayers frequently file refund claims based upon net operating losses, business tax credits, or capital losses on the basis of a claim carrying back a loss to an otherwise closed taxable year.  The easy way to remember the assessment rule is to remember that the year controlling the assessment statute is the year the loss arose.  If a loss arose in 2009 and was carried back to 2007 to obtain a 2007 refund the assessment statute for the 2007 year attributable to a deficiency because of the 2009 carryback is controlled by the 2009 statute of limitations – the year the loss arose. The Code permits assessment of a deficiency in one taxable year (2007) attributable to the carryback of an NOL from a later year (2009) before the expiration of the statute of limitations for the taxable year in which the NOL arose (2009).[3]

Section 6501(h) states:

In the case of a deficiency attributable to the application to the taxpayer of a net operating loss carryback or a capital loss carryback (including deficiencies which may be assessed pursuant to the provisions of Section 6213(b)(3) [dealing with assessments that may arise out of tentative carryback or refund adjustments arising out of excess refunds made under Section 6411]), the deficiency may be assessed at any time before the expiration of the period within which a deficiency for the taxable year of the net operating loss or net capital loss which results in such carryback may be assessed.

Congress enacted this section to provide the Service with an additional amount of time to properly review the claim and determine if any deficiencies are associated with the year in which the loss is carried back.  In our hypothetical situation with a 2009 loss carried back into 2007, the Service would have 3 years from the time the 2009 return was filed to determine any deficiencies for the 2007 year resulting from the carryback.  A carryback extends the assessment period for the carryback year for the loss carryback.[4]

Because the assessment period for both the loss year and the carryback year are the same the assessment period can be extended by agreement, and its running may be suspended for several reasons (e.g., by filing a Tax Court petition). [5] If the normal assessment period for the loss year is extended by agreement, the extension also applies to the carryback years.  If the normal 3 year statute has expired for the carryback year the IRS can only assess a deficiency attributable to items related to the loss carryback, but not any items unrelated to the loss carryback.  The taxpayer is only at risk for a deficiency for the carryback.  The IRS could not assess any amounts above the loss carryback.[6]

IRS Ability To Adjust Attributes In Closed Years For NOL Determinations

Pursuant to IRC § 6501(a) – Limitations on Collection and Assessment a tax year is subject to adjustment for 3 years from filing the federal tax return.  Section 6501(b) states that if a return is filed prior to the due date then the return will be deemed filed on the last day prescribed by law or the regulations.  Therefore, the statute of limitations for each federal tax year will close 3 years from the due date of the federal return, including extensions, or the filing date, whichever is later.

When a company carries forward or back a tax loss or credit, however, the IRS may examine the loss year, and any intervening or prior year, to determine the correct loss or credit available for carryover purposes, even if the statute of limitations on assessment for those years has expired.[7]   The IRS could examine and adjust any “closed” year if the statute for the tax year in which the attribute was utilized remains open.  Note that the IRS could make no additional assessment in the closed year, the IRS’s adjustments would go only to adjusting the carryover amounts.

The IRS may adjust items in any closed year to correctly compute the tax in an open year.[8]  In Lone Manor Farms, the court held that when a taxpayer claimed an NOL for an open year, it was necessary to determine whether the NOLs claimed for that year were still available, or should have been absorbed in closed years, allowing adjustment to the income in such closed years, regardless of whether the taxpayer had claimed the NOL in the closed years.[9]

In Revenue Ruling 85-64,[10] the taxpayer timely filed returns for 1978 through 1981 and reported no tax liability for each of these years.  The IRS examined the returns and found that 1978 had taxable income of $15,000 and 1979 had taxable income of $8,000.   The IRS also found that 1981 had an NOL of greater than $23,000.  At the time of examination, the 1978 year was closed for assessment.  The ruling holds that the 1982 NOL must first be carried back and “absorbed” in 1978, so that only if the NOL exceeded $15,000 would the NOL be available to carry back to 1979.

Taxpayer’s Ability To Make Adjustments To Items In Closed Years For NOL Determinations

The Service has stated frequently that for Section 172 of the Internal Revenue Code, “taxable income” means “correct taxable income.”[11]     Revenue Ruling 56-285,[12] holds that the fact that the statutory period for assessment of income taxes for the year in which a loss was sustained has expired does not preclude the Service from making such adjustments as may be necessary to correct the net operating loss deduction.   The rationale underlying these rulings and the authority to be discussed following is that when a prior year’s taxable income has impact on another taxable year, it is that year’s “correct” taxable income controlling in the related year not the taxable income previously erroneously stated on the return.

In Revenue Ruling 81-87,[13] 1981-1 C.B. 580, the IRS ruled that the correct tax must be considered in determining the amount of an overpayment of tax.  The correct tax is determined by including all adjustments (adjustments that decrease the tax and adjustments that increase the tax), regardless of the expiration of the periods of limitation.  Any excess of tax paid over the correct tax is an overpayment and will be credited or refunded if adjustments decreasing the tax are covered by timely claims for refund.  Revenue Ruling 81-87 was applied by the IRS in rulings involving the computation of foreign tax credit carryovers which have been interpreted to be governed by the same rules applicable to net operating loss carryovers.

The concept of utilizing “correct taxable income” in computing the amount of loss carryovers or carrybacks has long been recognized by the courts.  In Phoenix Coal Company v. Commissioner,[14] the Court of Appeals for the Second Circuit affirmed the Tax Court’s holding that the amount of a net operating loss carryover from a prior and otherwise barred year could be recalculated to determine the amount available for that year.  This rule was repeated by the Tax Court in ABKCO Industries, Inc. v. Commissioner,[15] and in State Farming Co. v. Commissioner.[16]  

With, Hill v. Commissioner,[17] the Tax Court, citing  Mennuto, again allowed the Commissioner to adjust a prior year and reduce unused investment credit available to be carried over to a later year even though the prior year was “barred” to assess additional tax as provided in IRC §6501(a).[18]

While the above cases and rulings concern adjustments to prior years which reduced the loss or credit carryover available to the year in dispute, the taxpayer in Springfield Street Railway Company v. United States[19] could decrease its 1953 taxable income by an available but unclaimed deduction to determine its 1955 net operating loss carryback to be applied against its 1953 and 1954 income.  Similarly, in Situation 2 described in Rev. Rul. 81-88, supra, the Service held that the taxpayer could increase a net operating loss carryover to consider a deduction it had failed to claim in a prior year.  In GCM 38292 (which authorized the issuance of Revenue Ruling 81-88), the Office of the Chief Counsel noted that the cited court decisions concerned adjustments made to the taxpayer’s net operating losses that were favorable to the government but added:

We think that the same logic that allows the Commissioner to correct a NOL with an upward adjustment in a year barred by the statute of limitations also allows the taxpayer to correct a NOL with a downward adjustment in such year.  It would appear inequitable to allow the government to be able to make an upward adjustment in the taxpayer’s NOL, even though the statute of limitations has run, without also permitting the taxpayer to make a downward adjustment in similar circumstances.

Revenue Rulings 81-88 and 56-285 (discussed above) were cited as authority in PLR 9504032 (October 31, 1994) where the Service ruled that the taxpayer was not barred by the statute of limitations from recharacterizing events that occurred in Year 1 to redetermine net operating loss carryovers (either from Year 1 or prior years) that are available for the taxpayer to deduct as net operating loss deductions in subsequent tax years.  While the IRS often states that private letter rulings are not to be cited as precedent, the conclusion reached in this ruling is in accord with previously issued revenue rulings and judicial opinion and appears to be a correct statement of current law.

The ability to adjust items in a closed year to correctly compute tax in an open year is also available to a taxpayer.  In PLR 9504032, Taxpayer determined that as a result of the bankruptcy reorganization it had realized an amount of income from discharge of indebtedness. Pursuant to section 108 of the Internal Revenue Code, Taxpayer excluded this amount from gross income, but reduced its NOL carryovers to Year 1 by the amount of debt discharged.

Subsequently, in May of Year 5, Taxpayer’s liquidating trustee filed an amended federal income tax return for Year 1, asserting that Taxpayer’s net operating loss carryover from Year 1 should be increased, on the ground that all but a small amount of the indebtedness in question was not in fact discharged in Year 1. The Service Center responded that Taxpayer’s claim was being disallowed because the statute of limitations for Year 1 had expired.

The IRS, following Phoenix Coal v. Commissioner and Rev. Rul. 56-285, ruled:

The real question is whether, in determining the NOL deduction for an open year, taxpayers (and the service) may redetermine correct taxable income in a closed year in order to ascertain either the amount of an NOL, or the amount of an NOL that is absorbed, in the closed year.

Rev. Rul. 56-285, 1956-1 C.B. 134, holds that the fact that the statutory period for assessment of income taxes for the year in which a loss was sustained has expired does not preclude the Service from making such adjustments  [*7]  as may be necessary to correct the net operating loss deduction.

Rev. Rul. 81-88, 1981-1 C.B. 85, applies the same principle to the refund limitations period. It holds, in part, that in determining the amount of a net operating loss that may be carried from a closed year forward to an open year, all adjustments to taxable income, whether or not barred by the statute of limitations, will be taken into account.

Accordingly, we conclude that Taxpayer is not barred by the statute of limitations from recharacterizing events that occurred in Year 1 for purposes of redetermining net operating loss carryovers–either from Year 1 or from prior years–that are available for Taxpayer to deduct as net operating loss deductions in subsequent tax years.

The cases and rulings cited above support a general rule that when the tax liability for a prior year is necessary to a determination of the correct tax liability for a year placed in issue that is otherwise an open year, either the Taxpayer or the Commissioner can recompute the “correct tax liability” for a prior year to correct for errors or omissions in such prior year.  Taxpayers can correct and increase its NOL carryover schedule to reduce its taxable income.  Taxpayers are not required to file amended returns to increase its NOL for a subsequent return rather it can reflect the changes on its NOL schedule.

There Is No Second Unnecessary Examination Here, Even If the Carryover Year Was Previously Examined

The IRS published policy on reopening closed examinations section 7605(b) is found in Revenue Procedure 2005-32, 2005-1 C.B. 1206 which states that the examination may be reopened if one of the following three conditions is met:

(1) there is evidence of fraud, malfeasance, collusion, concealment, or misrepresentation of material fact;

(2) the closed case involved a clearly-defined, substantial error based on an established Service position existing at the time of the examination; or

(3) other circumstances exist indicating that a failure to reopen the case would be a serious administrative omission.

The decision whether to reopen an examination pursuant to this administrative policy must be reviewed and approved by the Chief, Examination Division or Chief, Compliance Division, for cases under his/her jurisdiction and based upon historical experience reopening is a rare occurrence.  Under the Revenue Procedure examining an amended return or verifying a net operating loss carryover year is not considered a reopening as it is a separate tax matter, even if the particular loss year or refund year was previously subjected to an examination.

EDWARD M. ROBBINS, Jr. – For more information please contact Edward M. Robbins, Jr. – Mr. Robbins is a principal at Hochman, Salkin, Rettig, Toscher & Perez, P.C., the former Chief of the Tax Division of the Office of the U.S. Attorney (C.D. Cal) and represents clients throughout the United States and elsewhere involving federal and state, civil and criminal tax controversies and tax litigation. Additional information is available at

[1] For Amended Corporate Returns, Form 1120X, see Rev. Rul. 81-88, 1981-1 C.B. 585.  Application of otherwise barred deduction in NOL carryback year.  The taxpayer is permitted to carryback an NOL to the full extent possible, without first applying the barred deduction to reduce taxable income in the carryback year.  If the barred deduction were taken into account first, the taxpayer would be denied that portion of the refund attributable to the barred deduction (as the claim would not be timely).  For a further analysis of this rule, see GCM 38292.

[2] IRC § 6501(h); see also Colestock v. Commissioner, 102 T.C. 380 (1994); and Schneer v. Commissioner, T.C. Memo 1993-372.

[3] IRC § 6501(h).  See also, Bryce E. Nemitz et ux. v. Commissioner, 130 T.C. 9 (2008).

[4]  See Mennuto v. Commissioner, 56 tc 910 (1971); see also Rev. Rul. 69-543, 1969-2 c.B. 1.)  Similarly a taxpayer with a NOL carryover generated in years for which the statute of limitations on assessment is closed may increase the amount of the NOL as long as the statute of limitations is open for the year the NOL is utilized.  PLR 9504032.

[5] Note that the IRS may offset tax, interest, and penalties, the assessment of which is otherwise time-barred, against a claim for refund so long as the items fall within the same tax year.  Fisher v. United States, 96-1 USTC ¶50,204 (Fed. Cir. 1996).  This is consistent with the long-standing doctrine of Lewis v. Reynolds, 284 U.S. 281 (1932), 52 S. Ct. 10 that permits the IRS to offset a tax refund by any additional time-barred amounts the taxpayer owes for the year.  See also Dysart v. United States, 340 F.2d 624 (Ct. C1. 1965). For an exception see Pacific Gas & Electric Co. v. U.S. 417 F. 3d 1375 (Fed. Cir. 2005).

[6]  See Rev. Rul. 56-285, 1956-1 C.B. 134—NOL carried over to a subsequent open year and claimed as a deduction could be adjusted to reflect proper depreciation even though the statute of limitations on assessment for the year of the NOL had expired.

[7]   ABKO Industries v Commissioner, 56 T.C 1083, 1088-89 (1971; State Farming Co. v. Commissioner, 40 T.C 774, 781 (1963).

[8]  See Lewis v. Reynolds, 284 U.S. 281 (1932); Lone Manor Farms, Inc., v. Commissioner, 61 T.C. 436 (1974).

[9]  See also, Rev. Rul. 81-87, 1981-1 C.B. 580 and Rev. Rul. 81-88, 1981-1 C.B. 585.

[10]  Rev. Rul. 85-64, 1985-1 C.B. 365.

[11]  See, e.g., G.C.M. 39358; G.C.M. 38292; Rev. Rul. 81-88, 1981 C.B. 585; Rev. Rul. 85-64, 1985-1 C.B. 7.

[12]  Rev. Rul. 56-285, 1956-1 C.B. 134.

[13]  Rev. Rul. 81-87, 1981-1 C.B. 58.

[14]  Phoenix Coal Company v. Commissioner, 231 F. 2d 420 (2d Cir. 1956).

[15]  ABKCO Industries, Inc. v. Commissioner, 56 T.C. 1083 (1971) aff’d on other grounds 482 F. 2d 150 (3d Cir. 1973).

[16]  State Farming Co. v. Commissioner, 40 T.C. 774 (1963).  See also Mennuto v. Commissioner, 56 T.C. 910 (1971)(affirming the Commissioner’s right to adjust a prior year’s taxable income in order to determine the amount of unused investment credit available to be carried over to the year in dispute).

[17]  Hill v. Commissioner, 95 T.C. 437 (1990).

[18]  See also Calumet Industries, Inc. v. Commissioner, 95 T.C. 257 (1990); Lone Manor Farms v. Commissioner, 61 T.C. 436 (1974) aff’d without opinion 510 F. 2d 970 (3d Cir. 1975); Rev. Rul. 77-225, 1977-2 C.B. 73.

[19]  Springfield Street Railway Company v. United States, 160 Ct. Cl. 111, 312 F.2d 754 (Cl. Ct. 1963).

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