Six-Year Statute of Limitation for Substantial Omissions of Income

Editor: Michael D. Koppel, CPA/PFS/CITP, MSA, MBA

Procedure & Administration

Recently, the IRS indicated in Chief Counsel Advice (CCA) 201333008 that an estimated amount of flowthrough S corporation K-1 income did not constitute proper disclosure per Sec. 6501(e) and therefore the taxpayer’s return was subject to an extended six-year statute of limitation due to a substantial omission of income.

According to the CCA, a taxpayer filed Form 1040, U.S. Individual Income Tax Return, in year 1 reporting an estimated amount of S corporation income from a named S corporation because the S corporation had not yet filed a tax return. In year 4, after the normal three-year statute of limitation had expired, the S corporation filed Form 1120S, U.S. Income Tax Return for an S Corporation, for year 1 showing that the taxpayer’s actual distributive share of the S corporation’s income was more than 125% greater than the amount originally reported on the taxpayer’s return.

Generally, Sec. 6501(a) permits the IRS three years from the date the tax return was filed to assess any tax. However, Sec. 6501(e)(1) extends the period to six years when there is a substantial omission of income, defined as 25% or more of the taxpayer’s gross income on the return, unless proper disclosure had been made to the IRS on the original return.

In Estate of Fry, 88 T.C. 1020 (1987), the Tax Court said that to constitute proper disclosure, “[t]he statement must be sufficiently detailed to alert the [IRS] to the nature of the transaction so that the decision as to whether to select the return for audit may be a reasonably informed one.” The Eighth Circuit in Benderoff, 398 F.2d 132 (8th Cir. 1968), said that “the corporate information return on Form 1120S must be considered along with the taxpayers’ individual returns in resolving the issue of adequate disclosure.” So if a Form 1120S has not been filed with the IRS, adequate disclosure has not been made, the CCA stated. Further, the Tax Court in Insulglass Corp., 84 T.C. 203 (1985), ruled that if a late Form 1120S is not filed until after the taxpayer files Form 1040, the late Form 1120S is treated as an amended return and is ignored for purposes of disclosure under Sec. 6501(e).

In determining what constitutes a substantial omission from gross income for purposes of Sec. 6501(e)(1), Regs. Sec. 1.1366-1(c)(2) states that a shareholder’s gross income includes the shareholder’s proportionate share of S corporation gross income.

Example: A shareholder’s proportionate share of an S corporation’s gross income is $20,000, and the shareholder’s proportionate share of the S corporation’s taxable income is $2,500. The shareholder reported on a return only $1,000, which is 40% of the shareholder’s proportionate share of the S corporation’s taxable income. This meant that the shareholder was deemed to have reported only $8,000 (40% of $20,000) of his proportionate share of the S corporation’s gross income. Assuming no other income items appeared on the shareholder’s Form 1040, this constituted a substantial omission of gross income under Sec. 6501(e) and triggered the six-year statute of limitation.

To summarize, if a shareholder reports an estimated amount of S corporation income on Form 1040 because a Form 1120S has not yet been filed, only the income disclosed on Form 1040 will be considered disclosed for purposes of Sec. 6501(e). The determination of a substantial omission from gross income is made at the time the taxpayer files the original Form 1040. The S corporation’s gross income attributable to the undisclosed taxable income is considered to be omitted.

EditorNotes

Michael Koppel is with Gray, Gray & Gray LLP, in Westwood, Mass.

For additional information about these items, contact Mr. Koppel at 781-407-0300 or mkoppel@gggcpas.com.

Unless otherwise noted, contributors are members of or associated with CPAmerica International.