On July 31, 2015, Congress enacted H.R. 3236, Surface Transportation and Veterans Health Care Choice Improvement Act of 2015. The bill was introduced in the House and the Senate on July 28, sponsored by Representative Shuster of Pennsylvania, with Representatives Ryan of Wisconsin and Miller of Florida as co-sponsors. It was passed without any amendments. Based on its title, you’d think that the Act had nothing to do with tax. Looks can be deceiving. The Act contains several tax provisions that are of major significance to taxpayers and tax practitioners.
Section 2005 of the Act amends 26 U.S.C. sec. 6501(e)(1), which is the exception to the three-year statute of limitations on assessment for substantial omissions from gross incomes. This amendment overrules the Supreme Court’s decisions in The Colony, Inc. v. Commissioner, 357 US 28 (1958), and United States v. Home Concrete & Supply, LLC, 132 S. Ct. 1836 (2012). The Home Concrete case arose out of the IRS’s efforts to assess deficiencies against Son-of-BOSS tax shelters beyond the three-year period of limitations contained in 26 U.S.C. sec. 6501(a). Aggressively hawked by accounting firms and law firms to wealthy individuals during the 1990s and early 2000s, all Son-of-BOSS shelters had as a common feature “the transfer to a partnership of assets laden with significant liabilities. Id. The liabilities are typically obligations to purchase securities, meaning they are not fixed at the time of the transaction. The transfer therefore permits a partner to inflate his basis in the partnership by the value of the contributed asset, while ignoring the corresponding liability.” American Boat v. United States, 583 F.3d 471 (7th Cir. 2009). A large paper loss would be created by the sale of the asset either by the partnership or, after dissolution of the partnership, by the taxpayer.
Frequently, the IRS did not learn of a taxpayer’s use of a Son of BOSS shelter until after the normal three-year period of limitations had expired. It therefore began to argue that the overstatement of basis resulted in an omission of gross income that triggered the six-year period of limitations for omissions of more than 25% of gross income. The Tax Court and the Ninth Circuit both rejected this argument in Bakersfield Energy Partners, LP v. Commissioner, 128 T.C. 207 (2007), affd. 568 F.3d 767 (9th Cir. 2009). The courts held that under The Colony, Inc., which interpreted the predecessor to sec. 6501(e), an overstatement of basis did not result in an omission of gross income. In response, the IRS promulgated Treas. Reg. §301.6501(e)–1, which stated “an understated amount of gross income resulting from an overstatement of unrecovered cost or other basis constitutes an omission from gross income.” Because of a split in the circuits, the Supreme Court granted certiorari. It held that under The Colony, Inc., an overstatement of basis was not an omission of gross income for purposes of the six-year statute of limitations on assessment contained in 26 U.S.C. sec. 6501(e)(1). This holding stymied the IRS’s efforts to pursue Son of BOSS shelters for which the three-year statute of limitations had expired.
Now, almost three years later, Congress has effectively overruled Home Concrete for returns filed after July 31, 2015, and returns filed before that date if the period of limitations on assessment had not yet expired. As amended, sec. 6501(e)(1)(A) and (B) provides:
(e) Substantial omission of items: Except as otherwise provided in subsection (c)—
(1) Income taxes: In the case of any tax imposed by subtitle A—
(A) General rule: If the taxpayer omits from gross income an amount properly includible therein and—
(i) such amount is in excess of 25 percent of the amount of gross income stated in the return, or
(ii) such amount—
(I) is attributable to one or more assets with respect to which information is required to be reported under section 6038D (or would be so required if such section were applied without regard to the dollar threshold specified in subsection (a) thereof and without regard to any exceptions provided pursuant to subsection (h)(1) thereof), and
(II) is in excess of $5,000,
the tax may be assessed, or a proceeding in court for collection of such tax may be begun without assessment, at any time within 6 years after the return was filed.
(B) Determination of gross income
For purposes of subparagraph (A)—
(i)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; and
(ii) An understatement of gross income by reason of an overstatement of unrecovered cost or other basis is an omission from gross income; and
(iii)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. (Amended language in bold.)
While the impetus for the statutory change appears to be the IRS loss in Home Concrete, and its perceived effect on the IRS’s ability to detect abusive shelters within the normal statutory period, the amendment to sec. 6501(e)(1) will have little if any impact on the IRS’s ability to discover and audit taxpayers who participate in abusive tax shelters that use inflated bases to generate losses. Instead, it will primarily affect honest taxpayers who were not attempting to dodge paying the tax that they otherwise owe.
The purpose of the extended statute of limitations due to omission of gross income is “because of a taxpayer’s omission to report some taxable item, the Commissioner is at a special disadvantage in detecting errors. In such instances, the return, on its face, provides no clue to the existence of the omitted item.” The Colony, Inc., 357 U.S. at 36. Since the enactment of sec. 6501(c)(10), the IRS is not at a “disadvantage” in detecting abusive shelters. Sec. 6501(c)(1) creates an exception to the three-year statute of limitations on assessments for taxpayers who engage in listed transactions. If a taxpayer fails to disclose a listed transaction as required under sec. 6011, the time to assess tax against the taxpayer with respect to that transaction will end no earlier than one year after the earlier of a) the date on which the taxpayer furnishes the information required under section 6011, or b) the date that the material advisor furnishes to the Secretary, upon written request, the information required under section 6112 with respect to the taxpayer related to the listed transaction. Listed transactions are reported on Form 8886. Form 8886 must be attached to the taxpayer’s return for each year in which the taxpayer participated in the transaction and a copy must be sent to the Office of Tax Shelter Analysis. Until the taxpayer files Form 8886, the statute of limitation does not begin to run until the Form is filed. Home Concrete and related cases involved returns for which the normal three-year period of limitation expired before the effective date of sec. 6501(c)(10).
To understand the type of taxpayer who will be impacted by the amendment to sec. 6501(e)(1), you only need to read the opinion in The Colony, Inc. The Colony, Inc., was a real estate company that erroneously included in the basis of land it sold various development expenses. As a result, it over stated basis in the land. This caused it to understate its gross income. After reviewing the legislative history and the purpose of the extended statute of limitations, the Supreme Court concluded that an overstatement of basis was not the type of error that Congress meant to cover.
A taxpayer who includes in basis certain costs that should not have been allocated to a piece of property that was sold may now find himself or herself subject to the six year statute of limitations based on the omission of gross income. An example would be a taxpayer who purchases the assets of a business. The parties, after good faith negotiations, are unable to agree on how the purchase price is to be allocated between various assets. The purchase agreement provides that if the parties cannot agree within 30 days on the allocation, each shall make its own allocation for tax and financial accounting purposes. The purchaser allocates a specified percentage of the purchase price to a manufacturing plant. Several years later it sells the plant. The IRS audits the taxpayer. More than three years after the return was filed, the IRS issues a notice of deficiency. The notice determines that the taxpayer allocated too much of the purchase price to the manufacturing plant. The determination increases gross income by more than 25%. The notice is timely under sec. 6501(e)(1).
Another taxpayer holds securities in a closely held company as an investment. He sells the securities more than 5 years after the date of purchase. He reports the amount he believes in good faith is the basis in the stock on his tax return. Because the IRS deems his records inadequate, it determines that he has no basis in the stock and, thus, omitted more than 25% of gross income. It issues a notice of deficiency more than 3 years after the taxpayer has filed his return. Under sec. 6501(e)(1), the notice is timely, unless the taxpayer can meet his burden of proving his basis.
Under sec. 6501(e)(1)(B)(iii), where the taxpayer includes in the return information sufficient to apprise the IRS of the nature and amount of the omission, the six-year statute does not apply. The amendment makes this provision inapplicable to omissions resulting from an overstatement of basis as determined by the IRS. Thus, even where a taxpayer includes a statement that red flags treatment of an item that results in a potential overstatement of basis, the IRS can still assert a deficiency outside of the normal three-year limitations period.
Robert S. Horwitz – For more information please contact Robert S. Horwitz – firstname.lastname@example.org Mr. Horwitz is a principal at Hochman, Salkin, Rettig, Toscher & Perez, P.C., a former AUSA 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 www.taxlitigator.com