If you ask most taxpayers about the statute of limitations for examining tax returns, they’ll likely tell you that it’s three years. That’s true for most tax returns.
The IRS has the authority, however, to push the date to six years under some circumstances, including a substantial omission of income. But what constitutes a substantial omission?
That’s precisely the question that the U.S. Tax Court tackled, twice, in a case it ruled on most recently this month.
For over a decade, Nelson and Beverly Clark owned a wedding accessories business called the Beverly Clark Collection. For most of that time, they operated the company as a sole proprietorship.
On March 12, 1999, the Clarks transferred the assets and liabilities of the business to a new California limited liability company, Beverly Clark Collection LLC (BCC). In exchange for the transfer, they received 100% of BCC’s equity, or 50% interest each.
In 1999, the Clarks reported capital losses on the sale of 80.01% of the BCC interest to Fausset Trust on their Form 1040 (the Tax Court didn’t dive into the interests of Fausset Trust as it’s not relevant here). The Schedules K-1 for BCC for 1999 reported year-end interests of 19.99% for the Clarks and 80.01% for Fausset Trust.
In 2000, the Clarks filed tax returns reporting the liquidation of BCC and sale of its assets to Maplewood LF Investors LLC. The Clarks reported their share of the proceeds on their form 1040, together with gross income of $811,512. BCC reported a distribution of property on its partnership return and issued Schedules K-1 to the partners showing losses. The partnership also reported guaranteed payments from BCC to the Clarks totaling $150,000, but the Clarks didn’t report this amount on their Form 1040s.
On Aug. 25, 2008, the IRS issued a notice of final partnership administrative adjustment (FPAA), challenging the tax transactions. The Clarks took the matter to court, arguing that the statute of limitations period was only three years, so the adjustments made in the FPAA shouldn’t be allowed.
The IRS objected, claiming a six-year look back period because the Clarks had substantially omitted income. That fact, the IRS argued, would extend the statute of limitations under Section 6501(e)(1)(A).
The IRS first alleged that the Clarks overstated their basis in BCC. Next, it argued that the 1999 sale was a sham and should be disregarded. If the Clarks should have reported the entire proceeds, the omission of 80.01% of the sale proceeds would be a substantial omission of income, triggering the six-year statute of limitations.
(If you’re scratching your head trying to figure out how that math works out, the parties agreed to a consent of time to extend before the expiration of the six-year period.)
The Tax Court initially granted summary judgment to the Clarks, ruling in 2010 that the three-year statute of limitations applied. The IRS appealed to the U.S. Court of Appeals for the Ninth Circuit. By the time the matter went to court, the U.S. Supreme Court had concluded in United States v. Home Concrete & Supply, LLC that Section 6501(e)(1)(A) didn’t apply to an overstatement of basis. So the IRS abandoned that argument in this case and instead focused on a sham transaction argument. The Court of Appeals agreed that it was relevant and sent the case back to the Tax Court.
At Tax Court for a second time, the sham transaction argument took center stage. The court reiterated that since partnerships aren’t taxable entities, any income tax attributable to partnership items must be assessed at the partner level (Rhone-Poulenc Surfactants & Specialties, LP v. Commissioner). So, the court reasoned, if the limitations period was open as to the Clarks when the IRS issued the FPAA, then the case could proceed. If not, then summary judgment was again proper. Under the court’s rules, summary judgment is appropriate when “there is no genuine dispute as to any material fact and that a decision may be rendered as a matter of law.”
The IRS argued that if the transaction were found to be a sham, then the Clarks should have reported the full amount of gain from the sale. By reporting just part of the gain, the Clarks had omitted over 25% of their gross income, and the six-year period of limitations should apply.
The Tax Court went back to the Supreme Court ruling in Home Concrete for interpretation. In that ruling, which also referenced Colony, Inc. v. Commissioner, the Supreme Court rejected the argument that the phrase “omits * * * an amount” found in Section 6501(e)(1)(A) should be read to include an understatement. They found that interpretation would give too much weight to “amount” and too little to “omits.”
The court also referenced a more recent case, CNT Inv’rs, LLC v. Commissioner, where it had ruled that to “‘omit’ an amount properly includible in gross income is to leave something out entirely.”
The Tax Court admitted that the questions in those cases were a little different, but still led to the same conclusion: Even if the 1999 sale were a sham, the Clarks didn’t omit an item of gain entirely, they just reported an incorrect amount of gain. With that, the court didn’t need to examine whether the sale constituted a sham: since the Clarks reported some of the gain, they didn’t “omit” the gain entirely, and the six-year period of limitations wouldn’t apply.
And what about the failure to report those guaranteed payments? Chasing those is also barred. The amount ($150,000) didn’t constitute 25% of the gross income. Additionally, those payments were reported on the partnership’s Schedules K-1; the Tax Court has previously held that information disclosed on partnership returns may constitute adequate disclosure when the taxpayer’s return refers to them. That was the case here.
And remember those consents to extend? The Tax Court found that even though the Clarks signed them, they were issued after the three- year limitation period expired, which meant they were ineffective.
So what’s the takeaway? As always, deadlines matter. But perhaps more important is that reporting transactions—even those that could draw scrutiny—is better than not reporting at all.
The case is Beverly Clark Collection v. Commissioner, T.C., No. 27538-08, 11/14/19.