A Statute of Basis

An interesting Tax Court decision came down today in the case of Beard v. Commissioner. The taxpayer sells a business and correctly notes the gross income. However, he may have made a major error in calculating his basis (generally, the cost of acquiring the business). The IRS alleges he overstated the basis leading to an understatement of income. However, the IRS doesn’t get around to sending the Notice of Deficiency until after the three-year statute of limitations has expired. Can the IRS use the extended six-year period when, under Section 6501(e)(1)(A)

If 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.

The question the Court had to decide was whether or not the alleged overstatement of basis (the Court, in ruling on this motion, assumed that there was an overstatement of basis) was equivalent to an omission from gross income. Unfortunately for the IRS, the law wasn’t on their side here. Section 6591(e)(1)(A)(i) defines gross income in this case as,

In the case of a trade or business, the term ‘gross income’ means the total of the amounts received or accrued from the sale of goods or services * * * prior to the diminution by the cost of such sales or services.

Section 6501(e)(1)(A)(ii) provides a safe harbor for taxpayers in this regard,

In determining the amount omitted from gross income, there shall not be taken into account any amount which is omitted from gross income stated in the return if such amount is 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.

Two court cases took the wind out of the IRS’ sails. The court noted,

In Colony, Inc. v. Commissioner, 357 U.S. 28, 33, 37 (1958), the Supreme Court, interpreting section 275(c) of the 1934 Revenue Act, the predecessor of section 6501(e), held that the extended period of limitations applies to situations where specific income receipts have been “left out” in the computation of gross income and not when an understatement of gross income resulted from an overstatement of basis…

In Bakersfield Energy Partners, LP v. Commissioner, 128 T.C. 207 (2007), affd. 568 F.3d 767 (9th Cir. 2009), a partnership (Bakersfield) which owned oil and gas property used the Internal Revenue Code’s partnership termination and transfer provisions to increase its basis in that property before selling it to a third party in 1998…Because Bakersfield did not omit any income receipt or accrual in its computation of gross income, we held that the Supreme Court’s decision in Colony applied and Bakersfield’s overstatement of basis did not trigger the extended limitations period…

We believe that it would be inappropriate to “distinguish and diminish the Supreme Court’s holding in Colony”. Bakersfield Energy Partners, LP v. Commissioner, 128 T.C. at 215. The principles of Colony apply where a taxpayer overstates his basis…

We assume that petitioners overstated the bases of their S corporations on their 1999 return. Under Colony and Bakersfield, petitioners did not omit income from their return such as would subject them to the extended period of limitations. Accordingly, petitioners’ motion for summary judgment will be granted.

So whether or not Mr. Beard’s businesses overstated their basis, the IRS is precluded from coming after him because he correctly reported the gross income and the statute of limitations had run out. Sometimes time is on your side.

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