In February of this year, the Fourth Circuit reversed the District Court for the Eastern District of North Carolina and held that a partnership’s overstatement of its basis did not constitute an “omission” subject to the six-year statute of limitations for assessment. Based on a United States Supreme Court case decided in 1958, (when the country used a different tax code) the Fourth Circuit found that an adjustment made in 2006 for a 1999 tax return was untimely. The Fourth Circuit now joins the Federal and Ninth Circuits in so holding.
The case, Home Concrete & Supply, LLC v. U.S., involves two shareholders of a corporation who sought financial planning advice to reduce any tax liability generated by the sale of the business. The taxpayers formed an LLC and inflated the outside basis in the partnership by contributing short sale proceeds of Treasury Bonds. Assets from the corporation were transferred to the LLC and, after another few transactions, the business ended up reporting a modest $69K gain from the sale of the business.
The components of the transaction were reported to the IRS on its 1999 tax return. The IRS failed to initiate its investigation until June 2003, and a Final Partnership Administrative Adjustment (FPAA) was issued on September 7, 2006, which decreased the taxpayers’ reported outside bases in the LLC to zero, resulting in a substantial increase in taxable income. The IRS argued that the partnership was formed solely for the purpose of tax avoidance by artificially overstating the basis of the partnership interest. The entity made its tax deposit and filed a refund suit in the Eastern District of North Carolina pursuant to the argument that the six-year statute of limitations does not apply to an overstatement of basis.
The IRS argued that the six-year statute of limitations applies because Home Concrete “omitted from gross income an amount properly includable therein” which exceeded 25% of the amount of gross income stated in Home Concrete’s 1999 tax return, which triggers the extended statute of limitations under I.R.C. §6501(e)(1)(A).
The District Court issued partial summary judgment in favor of the IRS, stating that when a taxpayer overstates basis and, as a result, leaves an amount out of gross income, the taxpayer “omits from gross income an amount properly includable therein” as required under I.R.C. §6501(e)(1)(A). The taxpayers appealed.
The Fourth Circuit found that Colony, Inc. v. Commissioner, a Supreme Court case decided in 1958, was controlling. In Colony, the IRS alleged that a taxpayer understated the gross profits on the sales of certain lots of land as a result of having overstated the basis of the lots. It argued that its assessments were timely under I.R.C. §275, the predecessor to Section 6501. In 1954, Congress recodified former Section 275 at Section 6501(e)(1)(A) and added several subjections. Save for the additions, the language of the two remains the same. The Colony Court found that the application of the extended statute of limitations found in Section 275 is limited to situations in which specific receipts or accruals of income items are left out of the computation of gross income. An understatement of gross profits based on the overstatement of basis does not fit within this narrow class and therefore, the six-year statute of limitations does not apply.
The Fourth Circuit followed Colony accordingly. It found that Section 651(e)(1)(A)’s special extended statute of limitations applies solely to situations where a taxpayer omits or fails to report some income receipt or accrual in his computation of gross income. It does not apply to general errors in computation that may arise from other causes. The Fourth Circuit joined the Federal and Ninth Circuits in holding that an overstatement in basis does not result in an omission from reported gross income.
This holding comes in stark contrast to the January 2011 holding of the Seventh Circuit in Beard v. Commissioner. In Beard, the Seventh Circuit held that the six-year statute of limitations does apply to an overstatement of basis, reversing the lower court. The Seventh Circuit joins the Fifth Circuit in so holding. See Phinney v. Chambers, 392 F.2d 680 (5th Cir. 1968), cert. denied, 391 U.S. 935.
The Fourth Circuit’s holding provides some transactional flexibility for individuals and businesses who intend on selling businesses or property. We will continue to follow the circuit court rulings on this issue and keep you updated with new information as it become available.
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