Procedure & Administration
The Tax Court held that the six-year statute of limitation of Sec. 6501(e)(1)(A) applied to an assessment of tax based on a distribution from an employee stock option plan (ESOP) because the taxpayer had not adequately disclosed the distribution on his tax return.
Thomas Heckman owned an S corporation, KC Investment Management Inc. (KCIMI). On Jan. 1, 2001, KCIMI established an ESOP, and the ESOP acquired 100% of KCIMI's stock, which was its only asset. Heckman participated in the ESOP beginning in 2001, along with one other participant. In December 2002, KCIMI liquidated and transferred all of its assets and liabilities to the ESOP.
In February 2003, Prairie Capital LLC (Prairie Capital) and SMR Holdings LLC (SMR) were formed, and each received a 50% undivided interest in each of the ESOP's assets (other than a note receivable that was contributed solely to Prairie Capital), and the ESOP held 100% of the interests in Prairie Capital and SMR. On April 8, 2003, the ESOP distributed assets in kind to Heckman's and the other participant's traditional individual retirement accounts (IRAs). Heckman's partial interest in Prairie Capital was distributed to his IRA and was worth $137,726, so he received a distribution from the ESOP in that amount in 2003.
Heckman, however, did not include this distribution in gross income on his 2003 return. He also did not explicitly refer to either the ESOP distribution to his IRA or his IRA's membership interest in Prairie Capital on his 2003 return or in any statement attached to it. On July 30, 2010, more than three years but less than six years after the petitioner filed his 2003 return, the IRS mailed Heckman a notice of deficiency for 2003, 2004, 2006, and 2007.
The notice of deficiency determined that Heckman had received a taxable distribution from the ESOP due to the distribution of the interest in Prairie Capital. It stated that the distribution was taxable because the ESOP did not meet the Sec. 401(a) requirements for qualified status and therefore the distribution was not a distribution from a qualified plan that could be rolled over into an IRA. The IRS further claimed that the six-year statute of limitation in Sec. 6501(e)(1)(A) applied to the distribution, so the assessment was timely.
Heckman challenged the IRS's determination in Tax Court. He did not dispute that the distribution was taxable; rather, he asserted that the three-year statute of limitation in Sec. 6501(a) applied to the distribution instead of the six-year statute of limitation, barring the assessment of his 2003 tax liability.
Sec. 6501 and Adequate Disclosure
Pursuant to Sec. 6501(a), the IRS must assess the amount of any tax imposed within three years after the return was filed. Sec. 6501(e)(1)(A) extends the three-year period of limitation to six years where the taxpayer "omits from gross income an amount properly includible therein which is in excess of 25 percent of the amount of gross income stated in the return." In computing the amount of gross income omitted, any amounts "disclosed in the return, or in a statement attached to the return, in a manner adequate to apprise the Secretary of the nature and amount of such item" are not taken into account. In determining whether a taxpayer has adequately disclosed omitted income on a return, the Tax Court has held that it will examine the return in question to see if it offered a "clue" regarding the existence, nature, and amount of omitted income ( Quick Trust , 54 T.C. 1336 (1970), aff'd, 444 F.2d 90 (8th Cir. 1971)).
The Tax Court's Decision
The Tax Court held that the six-year statute of limitation applied to the assessment and, consequently, the assessment was timely. The court found that Heckman had not adequately disclosed the 2003 distribution from the ESOP directly on his return and it could not consider information other than that on his return as evidence of adequate disclosure of the omitted income.
Because his 2003 return was totally devoid of any reference to the ESOP distribution, Heckman argued that the statements made on Prairie Capital's 2003 partnership return and other filings should be considered to be an adjunct to his Form 1040, U.S. Individual Income Tax Return , and thus, the IRS had been provided the necessary clue to the existence of his omission of the distribution from gross income. In particular, Heckman pointed to (1) the Schedule K-1, Partner's Share of Income, Deductions, Credits, etc. , attached to Prairie Capital's 2003 partnership return that identified the partner as "First Trust Company of Onaga FBO Thomas J. Heckman IRA," (2) the Form SS-4, Application for Employer Identification Number , which he filed in 2003 to obtain a taxpayer identification number for Prairie Capital, identifying him as "general managing member of Prairie"; and (3) the Form 5498, IRA Contribution Information , which listed him as the owner of the IRA. However, the Tax Court disagreed with Heckman's claims of the evidentiary value of these documents, stating: "To the contrary, no statement on any of those documents offers any 'clue' as to the existence, nature, or amount of the omitted income. At best, they reveal only that petitioner and/or his IRA are members of Prairie Capital."
In support of the general proposition that the Tax Court could consider information beyond that in his individual return to establish adequate disclosure, Heckman cited Benderoff , 398 F.2d 132 (8th Cir. 1968). The Tax Court found that this case was distinguishable on the facts. Unlike Heckman, the Benderoff taxpayers specifically referred to the amount of their share of undistributed income from an S corporation and the name of the S corporation on their return. Thus, the Eighth Circuit looked beyond the taxpayers' return to the S corporation's return in determining whether the income had been disclosed.
Heckman also claimed that when communicating with the IRS about the audit in 2007, he had adequately disclosed the omitted income. The Tax Court concluded that oral communications three years after the filing of the return did not meet the requirement of being in the return or in a statement attached to the return.
Finally, Heckman cited Rev. Rul. 55-415 to support his argument that disclosure on a partnership return is sufficient to meet the adequate disclosure exception under Sec. 6501(e)(1)(A)(ii). That revenue ruling held, with respect to the predecessor statute to Sec. 6501(e)(1)(A), a proportionate share of gross partnership income is imputed to an individual partner in determining his reportable gross income for purposes of determining whether there was an omission of 25% of gross income. But in Heckman's case, no return filed by the ESOP or any other entity indicated the existence of the distribution other than the 2003 Form 5500, Annual Return/Report of Employee Benefit Plan , for the ESOP that was filed in 2007, which reported that all the assets of the ESOP had been paid out as benefits during the year. Since that return was not filed until 2007, the Tax Court found that it could not be deemed a disclosure on Heckman's 2003 return, which he filed in 2004.
As this case makes clear, a taxpayer will likely get the benefit of information beyond the taxpayer's return only in cases where significant information about the existence of omitted income is actually included on the taxpayer's return. Thus, practitioners should make sure that clients understand the very real potential downside of failing to disclose income.
Heckman, T.C. Memo. 2014-131