Understatement of gain does not extend limitation period

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

An understatement of gain due to a sham transaction was not an omission from income under Sec. 6501 that extended the statute of limitation for issuing a final partnership administrative adjustment (FPAA) to six years under Sec. 6229.

Background

From 1987 to 2000, Nelson and Beverly Clark owned a wedding accessories business, the Beverly Clark Collection, which they operated as a sole proprietorship. In March 1999, the couple transferred the business to the newly created Beverly Clark Collection LLC (BCC), with each receiving a 50% interest in the LLC in return.

In 1999, the Clarks contributed Treasury notes they had acquired in a short sale and cash to BCC, which sold the notes, recognizing a small loss. The Clarks then, on Dec. 31, 1999, purportedly sold an 80.01% interest in BCC to Fausset Trust in exchange for a $10,401,300 Treasury note. Upon auditing BCC's and the Clarks' 1999 returns, the IRS characterized the acquisition, contribution, and sale of the Treasury notes as a "son-of-boss" transaction that artificially inflated the Clarks' outside basis in BCC.

On their 1999 returns, the Clarks reported a short-term capital loss of $26,813 and a long-term capital loss of $3,703 on the sale of the BCC interest to Fausset Trust. BCC reported capital contributions of $13,257,425 for the year on its return. BCC reported that Mr. Clark, Mrs. Clark, and Fausset Trust had end-of-year ownership interests of 9.99%, 10%, and 80.01%, respectively.

In March 2000, BCC liquidated and distributed its assets to the members; the assets were then sold to Maplewood LF Investors LLC. The Clarks' 2000 return reported $2,083,976 of gross proceeds and $1,406,395 of gain from the post-liquidation sale of BCC's assets and goodwill. BCC's 2000 Form 1065, U.S. Return of ­Partnership Income, reported a $10,527,061 distribution of property, and the Clarks' 2000 Schedules K-1, Partner's Share of ­Income, Credits, Deductions, etc., reported flowthrough losses of $7,284,835 and $7,284,837, respectively.

The IRS issued an FPAA to BCC in August 2008, challenging the tax consequences reported on BCC's 2000 return. The date the IRS issued the FPAA was more than three but less than six years after the close of the relevant tax years (plus extensions of time for assessment).

BCC filed a motion for summary judgment, claiming that the applicable statute-of-limitation period was three years, not six, and therefore the assessment of any tax stemming from the adjustments set forth in the FPAA was time-barred. The IRS countered that the applicable period was six years because there was a substantial omission of income, as defined in Sec. 6501(e)(1)(A). The IRS first argued that a substantial omission of income arose from the Clarks' overstated bases in their interests in BCC. In the alternative, it argued that the Clarks' 1999 sale of 80.01% of their interest in BCC to Fausset Trust was a sham and should be disregarded. Thus, the Clarks were required to report the entire $12,990,000 in sale proceeds that the Service determined arose from the 2000 post-liquidation sale of BCC's assets. According to the IRS, the omission of 80.01% of the sale proceeds resulted in a substantial omission of income and triggered the six-year limitation period under Sec. 6501(e) with regard to the Clarks' return and, therefore, with regard to BCC's return under Sec. 6229(c)(2), so the FPAA was timely.

The Tax Court initially granted summary judgment to BCC. The court found, based on its opinion in Bakersfield Energy Partners, LP, 128 T.C. 207 (2007), aff'd, 568 F.3d 767 (9th Cir. 2009), that the limitation period for assessment was three years and therefore had expired. It did not address the IRS's sham transaction argument. In Bakersfield, the Tax Court held that an overstatement of basis is not an omission of gross income triggering application of the six-year limitation period.

On appeal of the Tax Court's original decision to the Ninth Circuit, the IRS abandoned its overstatement-of-basis argument. The Ninth Circuit remanded the case to the Tax Court for consideration of the IRS's argument that the limitation period remained open because the 1999 sale was a sham (Beverly Clark Collection, LLC, 571 Fed. Appx. 601 (9th Cir. 2014)).

The Tax Court's decision

The Tax Court granted BCC summary judgment. Based on the Supreme Court's decisions in Colony, Inc., 357 U.S. 28 (1958), and Home Concrete & Supply, LLC, 566 U.S. 478 (2012), the court found that an understatement of gain from a sham sale was not an omission of income for purposes of Secs. 6501(e)(1)(A) and 6229(c)(2). Thus, the limitation period for BCC's 2000 return was not extended to six years, and the FPAA issued to it for that year was untimely.

Sec. 6229, which was repealed in 2018, provided rules for the statute of limitation for assessing a tax attributable to partnership items or affected items on a partnership return subject to the audit rules under the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA), P.L. 97-248. Under Sec. 6229(a), the IRS had a minimum of three years (from the later of the date the return was filed or the last day for filing the return (excluding extensions)) to challenge these items. Sec. 6229(c)(2) provided that the limitation period is extended to six years if a partnership "omits from gross income an amount properly includible therein" and, referring to Sec. 6501(e)(1)(A), the amount is "in excess of 25 percent of the amount of gross income stated in the return."

Under Tax Court precedent, partnership-level adjustments may cause a substantial omission of income at the partner level for purposes of Sec. 6501. The Tax Court stated that because income tax attributable to partnership items must be assessed at the partner level, if the limitation period was open as to the Clarks when the IRS issued the FPAA, the FPAA was not meaningless and was timely issued.

The IRS argued that the Clarks' understatement of income on their 2000 return was a result of their 1999 sale of an interest in BCC to the Fausset Trust. Because the sale was held to be a sham, the Clarks received greater proceeds from the sale than were reported as allocable to them on BCC's and their 2000 income tax returns.

For purposes of making its decision, the court assumed that the 1999 sale was a sham. Thus, the Clarks should have reported the full amount of the proceeds from the sale, $12,990,000, rather than the $2,083,976 that was reported. The IRS claimed that for purposes of Sec. 6501, this was an omission of income in excess of 25% of the gross income reported on both the Clarks' return and BCC's return, triggering the six-year statute of limitation.

The Supreme Court, in Colony, in considering a prior version of Sec. 6501(e)(1)(A), held that an omission of income for purposes of the statute did not include an understatement of income arising from an overstatement of costs. The Court explained that while the IRS was at a disadvantage if it had no clue about the existence of an item because it was not reported on the face of a return, an error in the amount of an item reported on the face of the return did not put the IRS at a disadvantage. The Court later held in Home Concrete & Supply that its interpretation of Sec. 6501 in Colony applied to the current version of the statute and that an omission from income did not include an understatement of income arising from an overstatement of basis.

The Tax Court, in CNT Investors, LLC, 144 T.C. 161 (2015), applied this precedent in determining whether basis overstatements give rise to an omission from income under Sec. 6501. The court determined that under both Colony and Home Concrete & Supply, "[t]o 'omit' an amount properly includible in gross income is to leave something out entirely" for purposes of Sec. 6501.

The Tax Court noted that the question before it was "a little different" than in CNT Investors because the IRS argued that the omission from income resulted from a sham sale, not from an overstatement of basis. However, it concluded that this distinction made no difference and that it was bound by the Supreme Court's analysis in Colony and Home Concrete & Supply.

The court found that if the sale of BCC to Fausset Trust was a sham, the Clarks did not omit an item of gain entirely; instead they reported an incorrect amount of gain. It acknowledged that it could be argued that the Clarks omitted the entire amount of gain allocated to Fausset Trust but that the result of the IRS's sham-sale theory was that the Clarks should have reported 100% of the gain on the sale rather than the 19.99% amount they did report. Because they reported some but not all the gain, "they did not 'omit' an item of gain entirely but rather reported an incorrect amount." Therefore, the six-year statute of limitation did not apply.

Reflections

Congress overrode the Supreme Court's decision in Home Concrete & Supply in the Surface Transportation and Veterans Health Care Choice Improvement Act of 2015, P.L. 114-41. Under current Sec. 6501(e)(1)(B)(ii), which applies to returns filed after July 31, 2015, and returns for which the statute-of-limitation period for assessments had not yet expired as of July 31, 2015, an understatement of income due to an overstatement of basis is an omission of income for purposes of determining whether the six-year limitation period applies.

Beverly Clark Collection, LLC, T.C. Memo. 2019-150

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