Courts Split on Limitations Period for Substantial Omissions of Income by Partnerships

[Editor's Note: This narrative is derived from Tax Planning for Partners, Partnerships, and LLCs, § 15.01[17][b]]

[Editor's Note 2: On September 27, 2011, the Supreme Court granted certiorari in Home Concrete & Supply LLC v. United States, a 4th Circuit Court of Appeals decision that is cited in this narrative.]

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There is a split among the Circuit Courts of Appeals and the Tax Court regarding the applicable statute of limitations for issuing a Final Partnership Administrative Adjustment (FPAA) where an omission of income on a partnership tax return arose from an overstatement of the basis of partnership assets.

Generally, under IRC Sections 6501 (a) and (b), the IRS must assess a tax within three years after the later of the due date for the tax return or the date the tax return was filed.  If the taxpayer makes a substantial omission on the return, which is defined as more than 25% of the gross income reported on the return, the three-year period increases to six years. [IRC Sec. 6501(e)(1)(A).] For a trade or business, gross income means the total amount received or accrued from the sale of goods or services without reduction for the cost of providing the goods or services.  [IRC Sec. 6501(e)(1)(B)(i).] Under the TEFRA audit procedures, a similar six-year limitation period applies to partnership or affected items if the partnership tax return contains a substantial omission. [IRC Sec. 6229(c)(2).]

In COLONY, INC. v. COMMISSIONER OF INTERNAL REVENUE, 357 U.S. 28 (U.S. 1958), the Supreme Court held that the extended limitation period does not apply to an omission of income attributable to an overstatement of basis. The Court maintained that the extended period applies only when the taxpayer does not disclose or leaves out income and not when reported income is reduced because of a basis overstatement.  Following the Supreme Court's holding, the Ninth Circuit affirmed a Tax Court decision that an FPAA issued to a partnership after expiration of the general three-year period was untimely because the reduced income on the return arose from an overstatement of the basis of partnership assets. [Bakersfield Energy Partners, LP v. Comm'r, 568 F.3d 767 (9th Cir. 2009), affg 128 T.C. 207 ((2007).] Similarly, the Court of Appeals for the Federal Circuit concluded that a basis overstatement is not a substantial omission that permits a six-year assessment period. [Salman Ranch Ltd. v. United States, 573 F.3d 1362 (Fed. Cir. 2009).] 

The IRS does not agree with this line of cases, maintaining that the Colony decision is limited to situations involving sales of goods or services in a business context. Accordingly, an overstatement of the basis of an asset sold outside the ordinary course of business may result in a substantial omission of income and a six-year assessment period. [See  CCA 200628021 (I.R.S. 2005).] The Service argues that IRC Section 61(a) specifically provides that gross income includes gain from dealing in property, which inherently takes account of the basis of property a taxpayer sells or exchanges. Accordingly, a basis overstatement that reduces the gain reported from a property transaction can result in a substantial omission from gross income.

In 2009, the Service supported its position by issuing temporary regulations [T.D. 9466 (September 2009)] "clarifying" that for purposes of the substantial omission test under IRC Sec. 6501(e)(1)(A) and IRC Sec. 6229(c)(2), gross income includes income attributable to the basis of assets sold, except for goods or services sold in a trade or business.  A few months later, the Tax Court ruled the temporary regulations invalid because they did not accord with the Supreme Court decision in Colony. [Intermountain Ins. Serv. of Vail, LLC v. Comm'r, 134 T.C. 211 (T.C. 2010).]

Despite the Tax Court's opinion, in December 2010, the IRS issued final regulations restating the provisions of the temporary regulations. [T.D. 9511 (December 15, 2010).  Since the regulations "clarify" existing law, they apply retroactively to all open cases.]  In the preamble to the final regulations, the Service refers to its disagreement with the Tax Court, noting that the Colony decision specifically states that the term gross income is ambiguous and susceptible to more than one reasonable interpretation.

The key issue raised by the Tax Court is the validity of the IRS regulations. In a recent decision, the Supreme Court ruled that the validity of Treasury regulations is determined through a two-part analysis. [Mayo Foundation for Medical Education and Research v. United States, 131 S. Ct. 704 (U.S. 2011).]

Notwithstanding the Supreme Court's test, in very similar cases the Fourth [Home Concrete & Supply, LLC v. United States, 634 F.3d 249 (4th Cir. N.C. 2011).] and Fifth [Burks v. United States, 633 F.3d 347 (5th Cir. Tex. 2011).] Circuit Courts of Appeal and the Tax Court [Carpenter Family Investments, LLC v. Comm'r, 2011 U.S. Tax Ct. LEXIS 17 (T.C. Apr. 25, 2011).] refused to follow the IRS regulations.  These courts continue to assert that a basis overstatement does not create a substantial omission for purposes of the six-year limitation period and that the decision in Colony is controlling regardless of whether the property sale occurs in a trade or business.

Other courts that considered the limitations period question after issuance of the final regulations have reached different conclusions. Recently, the Court of Appeals for the Federal Circuit agreed that the IRS regulations are valid and controlling, holding that an overstatement of basis is an omission of gross income for purposes of the limitations period. [Grapevine Imports, Ltd. v. United States, 636 F.3d 1368 (Fed. Cir. 2011) (revg 77 Fed. Cl. 505 (Fed. Cl. 2007).] These latest holdings create a clear split among the Circuit Courts that have considered the question.   Ultimately, the Supreme Court must resolve the issue.

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