Case — Exceptions to the Statute of Limitations

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TL Case Summ

THE QUESTION

Can the IRS ask for additional tax after the statute of limitations expires?

THE DISPUTE

Taxpayer Says: The three year statute of limitations expired before the IRS issued a notice of deficiency.

Internal Revenue Service Says: The additional tax can be assessed despite the expiration of the statute of limitations because special mitigation procedures apply.

THE LAW

From Internal Revenue Code Section 1311: Correction of error. (a) General rule — If a determination (as defined in section 1313) is described in one or more of the paragraphs of section 1312 and, on the date of the determination, correction of the effect of the error referred to in the applicable paragraph of section 1312 is prevented by the operation of any law or rule of law, other than this part and other than section 7122 (relating to compromises), then the effect of the error shall be corrected by an adjustment made in the amount and in the manner specified in section 1314.

From Internal Revenue Code Section 6501: Provides the period of limitations for assessing all taxes assessed under the code. Generally, the period for assessment under section 6501 is the later of three years from the date the return is due or filed, unless extended by consent.

From Fong v. Commissioner, T.C. Memo. 1998-181: The limited conditions under which the mitigation provisions will be applied may be described generally as follows: (1) There has been a determination (as defined in section 1313(a)); (2) the determination must fall within one of the specified “circumstances of adjustment” or “doubling-up” situations described in section 1312; (3) with respect to the treatment of the item in question for the determination year, the party against whom the mitigation provisions are invoked must have maintained a position inconsistent with the treatment of the item in another year of the same (or related) taxpayer, which year is barred by the generally applicable period of limitations or by some other rule of law, see sec. 1311(b); and (4) the party who seeks to employ the mitigation provisions must act timely thereunder and in the proper manner to make a corrective adjustment, see sec. 1314.

From Estate of SoRelle v. Commissioner, 31 T.C. 272, 274 n.2 (1958): For mitigation purposes, changes to inventory may be treated as a change in an item of gross income and may result in a double exclusion or inclusion of gross income.

THE CAUSE OF THE DISPUTE

Under Internal Revenue code section 6501, the “normal” time period, or statute of limitations, during which the IRS can assess back tax is three years after a return is filed or due, whichever is later, unless the IRS and the taxpayer consent to a longer period.

Exceptions to this general rule apply in some situations, such as when certain errors are made. In those circumstances, the IRS (or the taxpayer) can change a tax return for a year that is “closed” under the normal statute of limitations. These “mitigation” provisions are spelled out in Internal Revenue code sections 1311-1314, and have four general requirements:

1)      A decision, agreement or act regarding the matter that is final;

2)      A specific “circumstance of adjustment” as listed in code section 1312;

3)      Inconsistent treatment of the item in question for another year that is closed;

4)      A timely request for invoking the mitigation provisions.

In this case, the taxpayer, who owned a beauty consulting business, agreed in a prior tax court case (settled in December 2009) to a $20,549 change to the ending inventory for her 2004 tax year.

After settlement of the prior case, the IRS adjusted the beginning inventory for her 2005 tax year to reflect the agreed-upon ending amount for the 2004 year. The adjustment increased the income on the 2005 tax return, resulting in an increase in tax, which the IRS assessed in January 2010.

The taxpayer says the general three year statute of limitations for the 2005 tax return expired April 15, 2009 (three years after the April 15, 2006 due date), and that the IRS can no longer assess additional tax for 2005.

The IRS says the inventory change is the correction of an error that the taxpayer admitted to in a final agreement, and one that is inconsistent between years (the ending 2004 inventory differs from the opening 2005 inventory). In addition, the error could result in income being omitted twice (in 2004 and 2005). Therefore, the assessment of additional tax is allowed under the mitigation provisions.

WHAT WOULD YOU DECIDE?

Make your selection, then see “The Court’s Decision” below for a full explanation

For the or for the

THE COURT’S DECISION

Download (PDF, 19KB)

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HL Carpenter, an experienced investor and a CPA, specializes in reader friendly articles on taxes and investing for individuals and small businesses, and publishes two newsletters: Taxing Lessons and Top Drawer Ink. Visit TaxingLessons.com and HLCarpenter.com.

This information should not be considered legal, investment or tax advice. Taxing Lessons and Top Drawer Ink Corp. do not provide legal, investment or tax advice. Always consult your legal, investment and/or tax advisor regarding your personal situation.

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Sorry, wrong answer :(
Right answer!
For the IRS. The change meets all four requirements of the mitigation provisions: 1) The prior court case constituted a specific, final agreement; 2) The changes to inventory are a specific “circumstance of adjustment” (specifically, the changes may result in a double exclusion or inclusion of gross income); 3) The taxpayer has treated the ending 2004 inventory and the beginning 2005 inventory inconsistently (because when closing inventory for a taxable year is reduced, the opening inventory for the following taxable year is automatically reduced in the same amount); and 4) The IRS made the mitigation request timely (within one year of the final agreement). On the basis of the foregoing, the IRS properly issued the notice of deficiency for 2005.
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