Case — Statute of Limitations – Substantial Omission from Gross Income

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TL Case Summ

THE QUESTION

Is overstating the basis of assets a “substantial omission from gross income” that is subject to a six year statute of limitations?

THE DISPUTE

Taxpayer Says: The standard three year statute of limitations for assessing tax applies because an overstatement of basis is not a substantial omission from gross income.

Internal Revenue Service Says: The overstatement of basis is a substantial omission from gross income and a six year statute of limitations applies for assessing tax.

THE LAW

From Internal Revenue Code Section 6501(a): The general period of limitations for assessing tax is three years from the filing of a federal income tax return.

From Internal Revenue Code Section 6501(e)(1)(A): That period is extended to six years if the taxpayer omits from gross income an amount properly includible therein which is in excess of 25% of the amount of gross income stated in the return.

From Internal Revenue Code Section 6501(e)(1)(A)(i): For a trade or business, gross income means gross receipts before they are reduced by the cost of goods or services.

From Internal Revenue Code Section 6229(a): For the assessment of tax attributable to a partnership item, the period of limitations remains open for at least three years after the date the partnership return was filed or three years after the last day, disregarding extensions, for filing the partnership return, whichever is later.

From Internal Revenue Code Section 6229(c)(2): The period of limitations for assessing tax attributable to partnership items remains open for at least six years after the later of the two dates described in section 6229(a) if any partnership omits from gross income an amount properly includible therein which is in excess of 25% of the amount of gross income stated in its return.

THE CAUSE OF THE DISPUTE

Generally, the IRS has three years after you file your federal income tax return to assess tax. Two exceptions to the general rule exist in the code. First, if you fail to file a return, or if you file a fraudulent return, there is no statute of limitations. The IRS can assess tax at any time. Second, when you fail to include a substantial amount of gross income in your return, the statute is extended to six years.

Disputes arise because this section of the code does not address the meaning of “gross income” for sales other than goods and services.

In this case, the taxpayer, a partnership, filed a 1999 tax return on September 15, 2000. The timely filed return included a form reporting the sale of assets. On September 14, 2006, after determining the taxpayer overstated the basis of the assets, the IRS issued a notice making adjustments to the 1999 tax return.

The taxpayer says the IRS is too late in making the adjustments because an overstatement of asset basis is not the same as an omission from gross income and the three year statute of limitations applies.

The IRS argues the six year extended statute applies because gross income is omitted when a taxpayer underreports the gain from the sale of property used in a trade or business as the result of overstating the cost or other basis of such property.

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

NOTE: For an update on this case, see this May 23, 2010 post

Download (PDF, 15KB)

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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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Right answer!
Sorry, wrong answer :(
For the Taxpayer. A basis overstatement is not an omission from gross income. The extended period of limitations applies to situations where specific income receipts have been ‘left out’ in the computation of gross income and not when an understatement of gross income resulted from an overstatement of basis.