Taxing Lessons From Court Decisions

Decisions — The 25% Solution

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Image source: Mart9212 (Own work) [GFDL (http://www.gnu.org/copyleft/fdl.html) or CC-BY-SA-3.0 (http://creativecommons.org/licenses/by-sa/3.0)], via Wikimedia Commons
Image source: Mart9212 (Own work) [GFDL (http://www.gnu.org/copyleft/fdl.html) or CC-BY-SA-3.0 (http://creativecommons.org/licenses/by-sa/3.0)], via Wikimedia Commons

There are several exceptions to the general rule that taxes must be “assessed within three years after a return is filed.” (Internal revenue code section 6501(a))

The decision in 143 T.C. No. 6 (Barkett) turned on one of those exceptions—specifically, whether the taxpayers omitted a substantial amount of income from their returns.

“A substantial amount” is generally an amount in excess of 25% of the gross income stated in the return. The percentage is calculated by dividing the amount of the omission by the gross income reported on the return.

When the exception applies, the IRS has six years (instead of the usual three) to assess tax or issue a notice of deficiency.

In this case, the dispute arose over the bottom part of the fraction–how to calculate the gross income reported on the return.

The taxpayers reported gross income of $394,440 on their 2006 return (including $123,000 of capital gain), and $654,591 on their 2007 return (including $314,000 of capital gain). In relation to the capital gains, they reported amounts realized from the sale of investments of more than $7 million for 2006 and more than $4 million for 2007.

The IRS said the taxpayers omitted gross compensation income of $629,850 from their 2006 return and $431,957 from their 2007 return. The IRS sent a notice about the underpayment more than three years but less than six years after the taxpayers filed their 2006 and 2007 returns.

The taxpayers agreed with the underpayment amounts. However, the taxpayers said the omissions were not 25% or more of their gross income and the exception to the three year statute did not apply.

Their argument: “Gross income” should include the amounts realized from the sale of investment assets. Put another way, the taxpayers wanted to include sales proceeds of $7 million for 2006 and $4 million for 2007 in the “gross income” portion of the calculation instead of only the gains from those sales.

The IRS says only the gains from the investment sales are included in gross income for purposes of the exception to the statute of limitations.

What do you think?

or

THE COURT’S DECISION

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Sorry, wrong answer :(
Right answer!
For the IRS. We hold that “gross income” includes gains from the sale of investment assets, not the entire amounts realized from such sales. Under this rule, the taxpayers’ omitted gross income for 2006 and 2007 exceeds 25% of the gross income they stated in their returns for those years. Therefore, the six-year limitations period applies to those years and the notice of deficiency is timely with respect to them.
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