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Home Concrete Opinion Doesn't Affect Prior Tax Court "Gross Income" Decisions.
(Parker Tax Publishing September 16, 2014)

Just two years ago, the Supreme Court clamped down on the number of years the IRS could go back and assess tax deficiencies. Its decision in U.S. v. Home Concrete & Supply, LLC, 2012 PTC 94 (S. Ct. 2012), was a big win for taxpayers because the Court limited the IRS to a three-year statute of limitations period, rather than the six-year statute of limitations, in situations where a taxpayer overstates the basis of property sold. In Barkett v. Comm'r, 143 T.C. No. 6 (8/28/14), the taxpayers hoped to capitalize on the Home Concrete decision, by arguing that it invalidated IRS regulations on the calculation of gross income for purposes of determining whether a taxpayer omitted more than 25 percent of gross income from its tax return, thus extending the limitations period to six years. Unfortunately for the taxpayers, the Tax Court held that earlier opinions where it considered this issue continued to apply and were not invalidated by the Home Concrete decision. As a result, proceeds from the taxpayers' sales of investments did not constitute "gross income." for purposes of determining whether the three- or six-year statute of limitations applied. By reducing the total gross income that went into the 25 percent calculation, the court affirmed that the taxpayers omitted more than 25 percent of gross income on their returns and were thus subject to the six-year statute of limitations period.

Background

Douglas Barkett and his wife, Rita, filed their 2006 and 2007 Forms 1040 on September 17, 2007, and October 2, 2008, respectively. The Barketts were 80.04 percent partners in Barkett Family Partners, a limited partnership. They were also 100 percent shareholders of Unicorn Investments, Inc., an S corporation. These entities reported extensive investment activity on their 2006 and 2007 returns, the gains and losses of which the Barketts then included on their returns. The Barketts reported capital gains from the sale of investments of approximately $123,000 for 2006 and $314,000 for 2007. 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 sent the Barketts a notice of deficiency (NOD) on September 26, 2012, determining income tax deficiencies for 2006 to 2009. With respect to the Barketts' 2006 and 2007 returns, the IRS determined that gross income of approximately $630,000 and $432,000, respectively, was omitted. These amount represented additional gain on investments. On the original returns, the Barketts reported gross income totaling almost $272,000 and $341,000.

A dispute arose as to the correct limitation period that applied the three year limitations period or the six year limitations period. If the three-year limitations period applied, then the NOD was outside the limitations period. In determining which limitations period applied, the Barketts argued that the amounts they realized on the sales of the investments, not the gains on the sales, should be included in gross income stated on the return.

Statute of Limitations

Generally, under Code Sec. 6501(a), the IRS has three years after a taxpayer files a return to assess tax or send a notice of deficiency (NOD). The limitations period extends to six years under Code Sec. 6501(e)(1) if the taxpayer omits from gross income an amount properly includible in gross income and such amount is in excess of 25 percent of the amount of gross income stated in the return. The IRS issued the NOD to the Barketts more than three years but less than six years after they filed their 2006 and 2007 returns. In determining the appropriate limitations period, the omitted gross income is divided by the amount of gross income stated on the tax return. If the omitted gross income is more than 25 percent of the included amount, the six-year limitations period applies.

While the Barketts and the IRS agreed that the omitted income amounts were $630,000 and $432,000 for tax years 2006 and 2007, respectively, they disagreed over the amounts of gross income stated on those tax returns. According to the Barketts, the gross income stated in their returns should include the amounts realized from the sales of investment assets (i.e., gross proceeds on the sales). The IRS argued that gross income on the returns should include only the gain reported from those sales (i.e., amounts realized less bases of assets sold).

OBSERVATION: The larger the gross income reported on a tax return, the better chance a taxpayer has of not having omitted 25 percent of gross income and thus escaping the six-year statute of limitations period.

Supreme Court Decisions

In 1958, the Supreme Court was asked to decide what constituted omitted income for statute of limitations purposes. In Colony, Inc. v. Comm'r, 357 U.S. 28 (1958), the taxpayer had overstated the basis in property it had sold and had consequently underreported its gain on the sale. The IRS argued that the underreported gain constituted "omitted gross income" for the purpose of determining whether the extended statute of limitations period applied. The Supreme Court disagreed, citing legislative history. The Court determined that in enacting the statute extending the limitations period, Congress intended to give the IRS additional time to review a taxpayer's return when the taxpayer had reported no information about a given transaction. In such cases, the Court said, the IRS is particularly disadvantaged because the return does not alert the IRS to suspicious activity requiring further investigation. When an understatement results from misreported information, rather than a complete omission, the IRS is at no such disadvantage, and the understatement should not contribute to triggering an extension of the statute of limitations period.

In 2010, the IRS issued Reg. Sec. 301.6501(e)-1, which explained when gross income should be considered omitted for purposes of triggering the extended limitations period. Reg. Sec. 301.6501(e)-1(a)(1)(iii) provided that when taxpayers understate their income from a property sale because they overstated their basis in the property, the amount of the understatement is considered omitted income. The regulation directly conflicted with the Colony decision which held that such an understatement was not omitted gross income. In U.S. v. Home Concrete & Supply, LLC, 2012 PTC 94 (2012), the Supreme Court resolved the conflict by holding that the portion of the regulation concerning omitted gross income was invalid.

In Home Concrete, the taxpayer overstated its basis in a partnership it had sold and had consequently underreported its gain on the sale. The IRS again argued, this time under the regulation, that the underreported gain constituted "omitted gross income". The Court held that the regulation was invalid because it conflicted with the Colony holding. The Court followed its Colony analysis and held that the underreported gain was not omitted gross income and that it did not belong in the numerator of the statute of limitations calculation. The Home Concrete decision addressed only when gross income is considered omitted. It did not address how to calculate gross income.

Tax Court's Decision

The Tax Court sided with the IRS, noting that it has considered this issue before and concluded that capital gains, and not the gross proceeds, are treated as the amount of gross income stated in the return for purposes of Code Sec. 6501(e). The court cited its opinions in Insulglass Corp. v. Comm'r, 84 T.C. 203 (1985), and Schneider v. Comm'r, T.C. Memo. 1985-139. Those cases, the court observed, were decided on the basis of Code Sec. 61(a), which defines gross income as all income from whatever source derived, including gains derived from dealings in property.

With respect to Reg. Sec. 301.6501(e)-1, the Tax Court noted that the Supreme Court's Home Concrete decision only invalidated the portion of the regulation concerning omitted gross income. The Tax Court rejected the Barketts' argument that the Supreme Court also invalidated the regulation's instructions concerning the calculation of gross income and, thus, the prior Tax Court cases. The Tax Court also found support for its conclusion in a comment by the Supreme Court in Home Concrete, where the Court explained how to calculate income under the general statutory definition of "gross income." (Staff Editor Parker Tax Publishing)

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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