A transaction may affect a taxpayer's federal income tax liability for multiple tax periods. If a taxpayer were able to change its treatment of a transaction when the assessment statute of limitation had closed for one of the periods, the government would be prevented from assessing and collecting any additional tax that may be owed. As a result, the taxpayer could possibly benefit by, for example, deducting the same expenses multiple times or excluding certain income so that it is never taxed. The duty of consistency was developed to address these situations.
The duty-of-consistency doctrine is an equitable remedy that has developed over the past 80 years; however, its application has been anything but consistent. Generally speaking, the doctrine precludes a taxpayer from taking one position on one tax return and then, after the assessment statute of limitation closes for that tax return, taking a contrary position on a subsequently filed tax return.
A recent Tax Court case illustrated the IRS's ability to successfully argue that taxpayers should not benefit from their own mistakes if the result is less tax being paid. In Squeri, T.C. Memo. 2016-116, the IRS argued that the duty of consistency required the taxpayers to recognize $1,634,720 as income in 2009, the year in which the gross receipts were reported, rather than in 2008, the year in which the gross receipts were actually received, because the assessment statute of limitation for 2008 had closed.
The taxpayers in Squeri were the owners of an S corporation. For each of the years from 2008 to 2011, the cash-basis S corporation had incorrectly computed its gross receipts by using only the deposits made into its bank account during the year and ignoring checks received during the year but deposited in the following year. For example, the S corporation received checks in 2008 that were not deposited in its bank account until January 2009 and did not include these checks in its 2008 gross receipts.
The IRS issued notices of deficiency to recalculate the gross receipts for each of the years from 2009 to 2011 to treat the amounts received before the end of each of those years as gross receipts for the year of the receipt of the payment. In calculating the adjustment to theS corporation's gross receipts for 2010 and 2011, the IRS first included the checks that were received during the year but deposited in January of the following year and then excluded the checks that were deposited in January of that year but received in the prior year. For 2009, while the IRS included the checks that were received during 2009 but deposited in January 2010, it did not exclude the checks that were deposited in January 2009 but received in 2008, as the assessment period for 2008 was closed and the IRS was therefore unable to assess any additional tax in 2008.
The taxpayers argued that the notice of deficiency for 2009 was incorrect because it did not take into account the $1,634,720 of gross receipts that had been originally reported in 2009 but which actually belonged in 2008. The Tax Court acknowledged that, because the taxpayers used the cash method of accounting, the checks received in 2008 but deposited in 2009 should be included on the 2008 return. However, the Tax Court looked to the duty of consistency as applied by the Ninth Circuit, to which an appeal of this case would lie, which had previously stated:
When all is said and done, we are of the opinion that the duty of consistency not only reflects basic fairness, but also shows a proper regard for the administration of justice and the dignity of the law. The law should not be such a[n] idiot that it cannot prevent a taxpayer from changing the historical facts from year to year in order to escape a fair share of the burdens of maintaining our government. Our tax system depends upon self assessment and honesty, rather than upon hiding of the pea or forgetful tergiversation. [Janis, 461 F.3d 1080, 1085 (9th Cir. 2006)]
The Tax Court found that each of the requirements for applying the duty of consistency was met and held that the gross receipts received in 2008 but reported in 2009 should be recognized as income in 2009.
As noted above, the duty-of-consistency doctrine was designed to address situations in which taxpayers take a position on one tax return and a contrary position on a subsequent return after the assessment statute of limitation in the earlier year has expired. The duty of consistency is a judicially created doctrine that was established by the Supreme Court in R.H. Stearns Co., 291 U.S. 54 (1934), where the Court applied the duty based on the principle that a taxpayer may not base a claim on an inequity of his or her own making.
The duty of consistency has been applied in a variety of situations, such as when taxpayers exclude income from multiple years (see Koppen, T.C. Memo. 1995-316), deduct the same expense in multiple years (see Robinson, 181 F.2d 17, 18 (5th Cir. 1950)), improperly inflate or deflate the basis of an asset in one year only to use a different basis in a later year (see Beltzer, 495 F.2d 211, 211-13 (8th Cir. 1974)), or change the classification of an entity (see Coldiron, T.C. Memo. 1987-569). The duty of consistency does not apply to pure questions of law (see Herrington, 854 F.2d 755, 758 (5th Cir. 1988)), but only to questions of fact or mixed questions of law and fact (see Estate of Letts, 109 T.C. 290 (1997), aff'd 212 F.3d 600 (11th Cir. 2000)).
As with any equitable doctrine, the duty of consistency is not always applied consistently. For example, in Coldiron, above, the court held that the duty of consistency required the taxpayers to treat a company as an S corporation, even though it was not, for purposes of determining their basis. Conversely, in Garavaglia, T.C. Memo. 2011-228, the court held that the determination of a corporation's status as an S corporation was a question of law, not fact, and therefore the duty of consistency did not apply. Additionally, courts have sometimes held that what seems to be a pure question of law is really a mixed question of law and fact in order to apply the doctrine. For example, the Fifth Circuit in Herrington, above, held that the question of whether straddle transactions are a sham, i.e., without economic substance, is at most a mixed question of law and fact, whereas the Eleventh Circuit in Kirchman, 862 F.2d 1486, 1490 (11th Cir. 1989), and the Tenth Circuit in James, 899 F.2d 905, 909 (10th Cir. 1990), held that whether straddle transactions are a sham is solely a question of law.
A simple example of the application of the duty of consistency can be found in Eagan, 80 F.3d 13 (1st Cir. 1996). In Eagan, the taxpayer was a life insurance agent who filed his returns representing that he was an employee of an insurance company. As a result of his purported employment status, the taxpayer claimed that his contributions to the insurance company's employee 401(k) plan were not taxable in the years in which he made them. More than three years from the last return in which he claimed tax-deductible contributions, the taxpayer claimed that he was not an employee of the insurance company, and therefore his withdrawals from the 401(k) plan were not taxable because they should have been taxed at the time he made the contributions. The First Circuit held that the duty of consistency barred the taxpayer from taking one position on his earlier tax returns and then trying to take a contrary position after the assessment statute of limitation had run on those returns. Therefore, the court held that the taxpayer had to pay taxes on his withdrawals from the 401(k) plan.
To establish the duty of consistency, the IRS must show that the following elements have been satisfied: (1) The taxpayer made a representation of fact or reported an item for tax purposes in one year; (2) the IRS acquiesced in or relied on that representation or item reported for that year; and (3) the taxpayer attempted to change the representation or item reported in a subsequent year after the assessment statute of limitation for the first year had closed, and that change was detrimental to the IRS (see Estate of Ashman, 231 F.3d 541, 545 (9th Cir. 2000)). If all three elements are satisfied, the IRS may act as if the previous representation or item reported on which it relied was true, even if it is not.
The Sixth Circuit adds a fourth element, which is that the taxpayer knowingly makes the representation and intends that the IRS will rely on that representation (Crosley Corp., 229 F.2d 376 (6th Cir. 1956)). However, the other courts that apply the duty of consistency hold that it applies equally to a taxpayer who innocently misrepresents a fact and one who misleads intentionally.
As explained above, the first element of the duty of consistency requires that the taxpayer made a representation of fact or reported an item for tax purposes. This element does not require an outright statement of fact on a return; rather, the taxpayer's treatment of an item on a return can be a representation that there are facts that support the reporting of the item on the return (see Estate of Letts, above).
Additionally, the duty of consistency does not require that the same taxpayer have filed both the original and the inconsistent returns, but may also apply to other taxpayers with sufficiently identical economic interests to the taxpayer that originally made the representation or reported the item (see LeFever, 100 F.3d 778, 788 (10th Cir. 1996)). The question of when there is sufficient identity of interests between the taxpayers to apply the duty of consistency to someone other than the taxpayer that filed the first return depends on the facts and circumstances of each case (see Cluck, 105 T.C. 324, 335 (1995)).
For example, the Eighth Circuit held that a brother and sister who were co-executors of and heirs to an estate were individually bound by the duty of consistency to the representations made on the estate tax return (Beltzer, above). In that case, the taxpayers represented the value of stock held by the estate at a reduced value, thereby minimizing the estate tax. After inheriting the stock, the taxpayers sold it at a much higher value than what had been reported on the estate tax return. To reduce the capital gains tax on their individual tax returns, the taxpayers used a higher basis on their individual returns and claimed that the stock was undervalued when the estate tax return was filed. The IRS argued that the taxpayers could not now change the representation they had made on the estate tax return because the assessment statute of limitation for that return had run, thereby preventing the IRS from assessing a deficiency for the earlier, undervalued representation. The Eighth Circuit held that the duty of consistency bound the taxpayers to the value they had represented on the estate tax return.
The second element of the duty of consistency requires that the IRS acquiesced in or relied on the representation or report of an item by the taxpayer. This element does not require the IRS to examine a return before it can be considered to have acquiesced in or relied on a representation or item reported on the return (see Estate of Letts, above); rather, the IRS is treated as acquiescing in or relying on a representation or item reported when the IRS accepts the return as filed. The Fifth Circuit has explained that the requirement that the IRS acquiesced in or relied on a representation or item reported is met when a taxpayer files a return that contains an inadequately disclosed item and the IRS accepts the return and allows the assessment statute of limitation to run without an audit of the return (Herrington, above).
Additionally, this element requires that the IRS reasonably relied on the representation or item reported by the taxpayer, so if the IRS knew, or should have known, that the representation or item reported was in error, it cannot later argue that the duty of consistency should apply (see Lewis, 18 F.3d 20, 26 (1st Cir. 1994)). Put another way, the IRS cannot rely on a representation or item reported by a taxpayer if the taxpayer provided sufficient facts to the IRS such that the IRS knew or ought to have known of a possible mistake in the representation or reported item (see Estate of Ashman, above).
For example, the Tax Court held that the duty of consistency did not apply when, before the assessment statute of limitation expired, the IRS had knowledge of a taxpayer's involvement in a tax shelter and was therefore on notice that the taxpayer's return for that year claimed deductions related to the tax shelter but nonetheless failed to adjust the return before the assessment statute of limitation expired (Erickson, T.C. Memo. 1991-97). In that case, the taxpayer reported gains and losses from his participation in a tax shelter on each of his returns for 1980 to 1983. In 1983, the IRS notified the taxpayer that his return for 1981 was being examined and requested copies of his 1980 and 1982 returns because the IRS suspected that the taxpayer may have participated in the tax shelter during those years as well. Although the court noted that it could not determine from the record exactly when the IRS first became aware that the taxpayer's participation in the tax shelter commenced in 1980, it was clear that the IRS had met with the taxpayer's representative multiple times before the assessment statute of limitation for the 1980 return expired.
As a result, the court found that at the very least the IRS suspected the taxpayer had participated in the tax shelter during 1980, and noted that the IRS had not argued that the taxpayer's participation in the tax shelter was somehow hidden from the IRS by the taxpayer or his representative at any time. As a result, the Tax Court declined to apply the duty of consistency because the IRS possessed information sufficient to place it on notice that the taxpayer had been involved in the tax shelter during 1980 before the assessment statute of limitation for that year had expired. The IRS was therefore required to disallow the deduction for that year while the assessment statute remained open, rather than attempting to use the duty of consistency to make the correction at a later time.
The third element of the duty of consistency requires that the taxpayer attempted to change the representation or item reported in a subsequent year after the assessment statute of limitation for the first year had closed, and the change was detrimental to the IRS. This element goes to the very heart of the duty of consistency by prohibiting a taxpayer from changing its mind about the representation or reporting of an item when doing so would be harmful to the IRS. Numerous cases explain the detriment requirement as preventing a tax windfall for the taxpayer or, stated differently, preventing an undue revenue harm to the government (see, e.g., Building Syndicate Co., 292 F.2d 623, 626 (9th Cir. 1961)).
Even if the taxpayer's attempt to change the representation or reported item is the result of circumstances outside the taxpayer's control, the duty of consistency can nonetheless apply. In other words, it is the very act of the taxpayer's attempting to change the representation or reported item that is important, not the reason or reasons for that change.
For example, the Fifth Circuit held that the duty of consistency applied to taxpayers who changed their position only after the Tax Court ruled that their previous position was incorrect (Herrington, above). In that case, the taxpayers carried out a series of straddle transactions that resulted in their reporting an ordinary loss in the first year while reporting a capital gain in the second year, which was taxed at a lower rate than the corresponding loss.
On their 1976 return, the taxpayers reported an ordinary loss from the first leg of a straddle. On their 1977 return, the taxpayers reported a capital gain for the second leg of that straddle, as well as an ordinary loss from the first leg of a second straddle transaction. On their 1978 return, the taxpayers reported a capital gain for the second leg of the second straddle. The IRS audited the taxpayers' 1977 and 1978 returns but allowed the assessment statute of limitation to expire on the 1976 return.
The IRS found the straddle was a sham transaction without economic substance and assessed a deficiency for 1977 based on the disallowance of the loss claimed by the taxpayers for the first leg of the second straddle. The taxpayers contested the IRS's determination in the Tax Court, which, in a consolidated case (Glass, 87 T.C. 1087 (1986)), held that the straddle transaction was a sham and had no real economic purpose other than tax avoidance.
The taxpayers then argued that they should not have to report the gain on their 1977 return from the second leg of the first straddle, due to the Tax Court's opinion in Glass that the straddles were a sham. The Tax Court, however, found that even though it was the Tax Court's opinion that led to the change in reporting sought by the taxpayers, the duty of consistency required them to report the 1977 gain because the loss reported on the 1976 return could not be disallowed due to the expiration of the assessment statute of limitation for that year.
The duty of consistency has been around for decades and has been subject to much interpretation, as well as some criticism. The duty of consistency can apply in myriad situations, and taxpayers should be aware of the IRS's ability to affirmatively raise the duty of consistency to bind taxpayers to positions previously taken, even when those positions are not correct.
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Alex Brosseau is a senior manager in the Tax Policy Group of Deloitte Tax LLP’s Washington National Tax office.
For additional information about these items, contact Mr. Brosseau at 202-661-4532 or email@example.com.
Unless otherwise noted, contributors are members of or associated with Deloitte Tax LLP.