Only Gains From Sale of Property Included in Statute-of-Limitation Determination

By James A. Beavers, J.D., LL.M., CPA, CGMA

Procedure & Administration

The Tax Court held that in determining whether the six-year statute of limitation on assessment due to a 25% omission from gross income applied, only the gains, rather than the full amount realized, on the sale of the taxpayers' investment assets are taken into account.

Background

The taxpayers, G. Douglas and Rita Barkett, timely filed their 2006 and 2007 federal income tax returns. In September 2012, the IRS sent the Barketts a notice of deficiency for 2006 to 2009, in which it alleged that the couple omitted from their 2006 and 2007 returns gross income of $629,850 and $431,957, respectively. During these years, the Barketts were 80.04% partners in Barkett Family Partners, a limited partnership, and 100% shareholders of Unicorn Investments Inc., an S corporation. From these entities, they reported amounts realized from the sale of investments of more than $7 million for 2006 and more than $4 million for 2007 and total capital gains from those sales of approximately $123,000 for 2006 and $314,000 for 2007.

Although the IRS sent the notice more than three years after the Barketts filed their 2006 and 2007 returns, it contended that the six-year limitation period under Sec. 6501(e) applied because the Barketts omitted gross income exceeding 25% of the gross income they stated in their returns. The Barketts countered that the six-year limitation period did not apply and the notice of deficiency was invalid for 2006 and 2007.

The couple asserted that the IRS incorrectly calculated the percentage of gross income they omitted because it used the gain on the sale of the net investments by their passthrough entities in calculating the amount of gross income stated on their returns instead of the full amount realized on those sales. If the amount realized was used in the calculations, the Barketts' gross income omitted would be less than 25% of the income stated on their return, and the six-year statute of limitation would not apply. The Barketts filed suit in Tax Court challenging the IRS's determination and moved for summary judgment.

The Tax Court's Decision

The Tax Court denied the Barketts' motion for summary judgment, holding that only their share of the gain from the sale of the investments by the passthrough entities should be included in calculating the amount of gross income stated in a return for purposes of Sec. 6501(e) and that the six-year statute of limitation applied to the Barketts' 2006 and 2007 returns. The Tax Court found that the Supreme Court's decision in Home Concrete & Supply, LLC,132 S. Ct. 1836 (2012), in which the Court held that underreported gain was not omitted gross income for Sec. 6501 purposes, did not have an effect on the Tax Court's precedent that gross income stated in the return should be calculated in accord with the general statutory definition of gross income.

As the Tax Court explained, in cases it decided before the Supreme Court's decision in Home Concrete, it had consistently held that, based on the general statutory definition of gross income, the amount of capital gains from sales of assets, not the gross proceeds from the sales, should be included in the amount of gross income stated in the return for Sec. 6501(e) purposes. The IRS had adopted this position in Regs. Sec. 301.6501(e)-1, in which it also included instructions on how to determine the amount of gross income omitted from a taxpayer's return for Sec. 6501(e) purposes. The regulations 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 omitted income (Regs. Sec. 301.6501(e)-1(a)(1)(iii)).

This portion of the regulations dealing with omitted income was highly controversial because it was an attempt by the IRS to essentially reverse the Supreme Court's decision in Colony, Inc., 357 U.S. 28 (1958), in which the Supreme Court had held that such an understatement of income was not omitted income under the predecessor statute to Sec. 6501(e). A number of taxpayers challenged the regulation's inclusion of underreported gain due to a basis overstatement in omitted gross income, and in Home Concrete, the Supreme Court took up the issue. The Court found that the regulation was contrary to its holding in Colony and therefore the regulation was invalid.

The Barketts argued that the Supreme Court's decision in Home Concrete also invalidated the portion of the regulation dealing with the calculation of gross income stated in the return. The Tax Court disagreed, finding that the Supreme Court did not address the issue of the computation of gross income stated in a return in Home Concrete. However, in a dictum in the Supreme Court's opinion in the case, the Tax Court found support for its position regarding gross income stated in the return. In addressing one of the IRS's arguments, the Supreme Court provided an example in the Home Concrete opinion that explained how to calculate income under the general statutory definition of gross income. This explanation, the Tax Court stated, was consistent with its position that gross income in the return under Sec. 6501(e) included gain from a sale of investment assets, not the amount realized from the sale.

Finally, the court observed that an exception to the general statutory definition of gross income appears in Sec. 6501(e)(1)(B)(i), which provides that "in the case of a trade or business, the term 'gross income' means the total of the amounts received or accrued from the sale of goods or services . . . prior to diminution by the cost of such sales or services." However, the Barketts had not argued that the income in question was from a sale of goods and services and conceded that they sold investment assets. Accordingly, the exception did not apply.

Reflections

While the Supreme Court clearly did not directly address the meaning of "gross income stated in the return" in Home Concrete, it is hard to believe that, if it had, it would have disagreed with the Tax Court's position on this issue. The Barketts argued that in Sec. 6501(e), Congress intended that a gross-receipts concept of gross income applied in the case of the sale of investment assets, rather than the definition of gross income with respect to dealings in property in Sec. 61, which includes only the gains in gross income. However, as the Tax Court pointed out in two earlier cases (Insulglass Corp., 84 T.C. 203 (1985), and Schneider, T.C. Memo. 1985-139), what evidence there is of Congress's intent supports a finding that, with respect to gains from the sale of investment assets, Congress intended the Sec. 61 definition of gross income to apply.   

Barkett, 143 T.C. No. 6 (2014)

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