Definition of Omission from Gross Income for Partnership Items and the Six-Year Period for Assessing Tax

The IRS has issued temporary (replacing an existing final regulation) and proposed regulations (T.D. 9466, REG-108045-08) defining an omission from gross income for purposes of the six-year minimum period for assessment of tax attributable to partnership items and the six-year period for assessing tax. Most significantly, the temporary regulations resolve the continuing issue of whether an overstatement of basis in a sold asset results in an omission from gross income. The temporary regulations apply to tax years for which the applicable period for assessing tax did not expire before September 24, 2009.

Temporary Regs.

Sec. 6229(c)(2) provides that if a partnership omits from gross income an amount properly includible therein that is in excess of 25% of the amount of gross income stated in its return, the period for assessing tax attributable to its partnership items is extended to six years. Similarly, Sec. 6501(e)(1)(A) provides that if a taxpayer omits from gross income an amount properly includible therein that is in excess of 25% of the amount of gross income stated in the return, the period of time for assessment is extended to six years. Sec. 6501(e)(1)(A) also defines the term “gross income.” The temporary regulations confirm that the Sec. 6501(e)(1) (A) definition of an omission from gross income applies for purposes of Sec. 6229.

The temporary regulations also define gross income, as it relates to a trade or business, as the total of the amounts received or accrued from the sale of goods or services, to the extent required to be shown on the return, without reduction for the cost of those goods or services (Temp. Regs. Secs. 301.6229(C)(2)-1T(a) (1)(ii) and 301.6501(e)-1T(a)(1)(ii)). They further state that gross income, as it relates to any income other than from the sale of goods or services in a trade or business, has the same meaning as provided under Sec. 61(a) and includes the total of the amounts received or accrued, to the extent required to be shown on the return (Temp. Regs. Secs. 301.6229(C)(2)-1T(a) (1)(iii) and 301.6501(e)-1T(a)(1)(iii)). The regulations under Sec. 61(a) explain that gross income includes “gains derived from dealings in property” and that these gains are “the excess of the amount realized over the unrecovered cost or other basis for the property sold or exchanged” (Regs. Sec. 1.61-6(a)). The temporary regulations also provide that, outside the trade or business context, an understated amount of gross income resulting from an overstatement of unrecovered cost or other basis constitutes an omission from gross income for purposes of Secs. 6229(c)(2) and 6501(e)(1)(A) (Temp. Regs. Secs. 301.6229(C)(2)-1T(a) (1)(iii) and 301.6501(e)-1T(a)(1)(iii)).

The position the IRS takes in the amendments to the regulations is contrary to that of the Ninth Circuit and the Federal Circuit, which both held that outside the trade or business context, an omission for purposes of Sec. 6501(e)(1) (A) does not occur by an overstatement of basis. (See Bakersfield Energy Partners, 568 F.3d 767 (9th Cir. 2009), and Salman Ranch Ltd., 573 F.3d 1362 (Fed. Cir. 2009).) The preamble to the temporary regulations states that both the Ninth and the Federal Circuits acknowledged that the definition of gross income outside the trade or business context was ambiguous, and the Ninth Circuit noted that because of this ambiguity, the IRS might have the power to promulgate a reasonable reinterpretation of Sec. 6501(e)(1)(A) despite the Supreme Court’s holding in Colony Inc., 357 U.S. 28 (1958). Thus, the IRS asserts in the preamble that the “reasonable interpretation of the provisions under sections 6501(e)(1)(A) and 6229(c)(2) provided in these temporary regulations . . . is entitled to deference even if the agency’s interpretation may run contrary to the opinions in Bakersfield and Salman Ranch.”

Adequate Disclosure Exception

Sec. 6501(e)(1)(A)(ii) provides that the amount omitted from gross income does not include any amount disclosed on the return, or in a statement attached to the return, in a manner adequate to apprise the IRS of the nature and amount of the item.

The preamble to the temporary regulations confirms that this adequate disclosure exception to the six-year statute of limitation applies to omissions from gross income resulting from basis overstatements in the same manner as it applies to other omissions from gross income. Accordingly, taxpayers who adequately disclose the nature and amount of the omissions from gross income resulting from dealings in property will not be subject to the extended six-year statute of limitation.

Implications

The temporary regulations may affect taxpayers who overstate basis in a sold asset outside the trade or business context, creating an omission from gross income exceeding 25% of the income stated in a return. Importantly, these temporary regulations resolve an ongoing issue as to whether an overstatement of basis in a sold asset outside the trade or business context results in an omission from gross income. Although not specifically addressed by the temporary regulations, a potential basis overstatement by a partnership of a sold asset would presumably include basis adjustments made under Secs. 734(b) and 743(b) by partnerships that have a Sec. 754 election in effect, and mandatory basis adjustments by partnerships with a substantial built-in loss as defined in Secs. 734(d) and 743(d). Although the regulations attempt to clarify the IRS’s position with regard to basis overstatements, they are still somewhat unclear. Specifically, it may be difficult to determine whether the gross income in question relates to a “trade or business,” which is an undefined term that is used in many different provisions of the Code and regulations without a single comprehensive definition. Furthermore, the temporary regulations do not define or provide any examples of what constitutes “goods and services” for purposes of Secs. 6501(e)(1)(A) and 6229(c)(2).

The adequate disclosure exception to the six-year statute of limitation applies to omissions from gross income resulting from basis overstatements as well as other omissions from gross income. Accordingly, taxpayers who adequately disclose the nature and amount of the omissions from gross income resulting from transactions involving property will likely not be subject to the extended six-year statute of limitation. However, the temporary regulations do not provide any meaningful guidance on the form and manner of making an adequate disclosure.

One additional noteworthy item is the effective date of the regulations. The regulations provide that “the rules of this section apply to taxable years with respect to which the applicable period for assessing tax did not expire before September 24, 2009.” Thus, these regulations presumably apply to tax years that are open as of September 24, 2009.

EditorNotes

David Kautter retired from Ernst & Young LLP in Washington, DC, in December 2009.

Unless otherwise noted, contributors are members of or associated with Ernst & Young LLP.

For additional information about these items, contact Mike Dell at (202) 327-8788 or michael.dell@ey.com.