SOL on tax assessments.

Tax professionals are constantly asked about the statute of limitations (SOL) applicable to a taxpayer's situation. Certainly, the answer to this question depends on which SOL is being referred to (there are many). Some of the more important SOLs deal with the time period during which the IRS may assess income tax against a taxpayer.

Like so many other Code matters, the timing and appropriateness of IRS assessments are subject to general rules, but include many exceptions.

The General Rule

Normally, the Service may assess tax against a taxpayer not later than three years from the latter of a return's due date for a given year or three years from the date the taxpayer filed the return.

In clarifying the timing of an assessment, directions are important. Sec. 6501 provides "except as otherwise provided in this section, the amount of any tax imposed by this title shall be assessed within 3 years after the return was filed (whether or not such return was filed on or after the date prescribed)" This is the three-year rule. However, if a taxpayer files a return early (e.g., April 1, for a calendar-year individual), does the three-year period began to run on that date or on the April 15 due date?

Sec. 6501(b)(1) answers this question:

[A] return of tax imposed by this title ... filed before the last day prescribed by law or by regulations promulgated pursuant to law for the filing thereof, shall be considered as filed on such last day.

If a return is filed early, it will be deemed filed on the last day for filing. Therefore, if a return was filed on April 1, the SOL will begin to run on April 15. As with many matters in the Code, exceptions exist. Sec. 6501(c) contains several exceptions to the three-year rule.

Exceptions to the Rule

Filing a false return. Sec. 6501(c)(1) states:

In the case of a false or fraudulent return with the intent to evade tax, the tax may be assessed, or a proceeding in court for collection of such tax may be begun without assessment, at any time.

Accordingly, if a return is "false or fraudulent," there is no stopping the tax from being assessed at any time--be it two or 22 years after the return was filed.

The Fifth Circuit has held that a statement "is materially false if it is shown to be capable of influencing a decision of the institution to which it is made" (Mann, 161 F3d 840 (1998)). When is a matter material? A district court has held that "material matters in income tax returns are those essential to the accurate computation of taxes." So, some guidance exists as to whether an item is false.

Generally a position is false without its being supported by an "evil" intention; according to the Fifth Circuit, it must simply be "capable of influencing a decision." Of course, for a statement to be fraudulent, the standard is much higher. The IRS must show that the taxpayer knew his return was false when he made it. Further, fraud, whether for deficiencies or for additions to tax (i.e., fraud penalties), must be proven by clear and convincing evidence; a mere preponderance of the evidence will not suffice.

"Willful attempt" to evade. Under Sec.6501(c)(2),

In case of a willful attempt in any manner to defeat or evade tax imposed by this title (other than tax imposed by subtitle A or B), the tax may be assessed, or a proceeding in court for the collection of such tax may be begun without assessment, at any time.

Thus, if any part of the additional tax is due to the "willful attempt ... to defeat or evade tax" there is no refuge in an SOL defense. The term "willful attempt" is defined as a taxpayer's knowing attempt to evade the reporting or paying of a tax liability.

Failure to file. Sec. 6501(c)(3) provides that if a taxpayer does not file a return, the IRS can assess tax at any time--be it three or 23 years after the year in which the taxpayer should have reported income.

Section 6501(c)(4) provides:

(A) In general. Where before the expiration of the time prescribed in this section for the assessment of any tax imposed by this title, except the estate tax provided in chapter 11, both the Secretary and the taxpayer have consented in writing to its assessment after such time, the tax may be assessed at any time prior to the expiration of the period agreed upon. The period so agreed upon may be extended by subsequent agreements in writing made before the expiration of the period previously agreed upon.

Thus, it is possible that, in the course of an examination, the Service and a taxpayer will extend the SOL on an assessment of additional tax. The standard power of attorney given by a client to a CPA (Form 2848) will grant the CPA the right to extend the SOL on the client's behalf. An IRS agent will often request that the representative sign Form 872, Consent to Extend the Time to Assess Tax, on the taxpayer's behalf, which will extend the SOL either for an indefinite or specific period of time. Accordingly, the agent may ask the representative to sign Form 872A, Special Consent to Extend the Time to Assess Tax, which extends the SOL an indefinite period of time, so that the Service can proceed with its determination of the correct tax for the year involved. Advisers should agree to execute only Form 872, which extends the SOL to a certain time (e.g., December 31 of a given year).

On doing this, the adviser should also restrict the scope of the extension (e.g., a determination of which items should be capitalized, how much of the travel should be personal, etc.). Agents are not always happy with a restriction, but will often agree to it.

If the agent requests that the SOL be extended, he must inform the representative or the taxpayer that the taxpayer has a right to decline an extension. Sec. 6501(c)(4)(B) states:

The Secretary shall notify the taxpayer of the taxpayer's right to refuse to extend the period of limitations, or to limit such extension to particular issues or to a particular period of time, on each occasion when the taxpayer is requested to provide such consent.

If the taxpayer refuses to extend the SOL, the IRS can review the taxpayer's return and propose to determine (somewhat arbitrarily) that some income was not correctly reported or to disallow some deductions. In any event, all issues are usually resolved against the taxpayer, at which point he can appeal. During this period, the Service can proceed with its determination of taxable income. The SOL is only concerned with the period during which the IRS can assess tax--not the period in which the Service can make a determination of the taxable income.

Sins of omissions from gross income. Sec. 6501(e) addresses omissions from income. It provides that, if a taxpayer did not report a given income amount on his return, the IRS has six years from the "due date" (which depends on when the taxpayer filed his return) to assess additional tax. Under Sec. 6501(e):

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 tax may be assessed ... at any time within 6 years after the return was filed.

Accordingly, the taxpayer must have omitted 25% of the gross income stated in the return before this rule comes into play. This begs the question--"What is gross income?"

Sec. 6501(e)(1)(A) states:

For purposes of this subparagraph--

(i) 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 (if such amounts are required to be shown on the return) prior to diminution by the cost of such sales or services; and

(ii) 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.

Thus, for a sale of merchandise, the merchandise's sale price seems to be gross income.

Certainly, for services and rental operations, gross receipts will equal gross proceeds. According to Regs. Sec. 301.6501(e)-1(a)(1)(ii):

(ii) For purposes of this subparagraph, the term "gross income" as it relates to a trade or business, means the total of the amounts received or accrued from the sale of goods or services, to the extent required to be shown on the return, without reduction for the cost of such sales or services.

Again, "gross income" must be based on all income shown on a return; the "gross income" as "stated in the return" must be determined from other figures in the return. Gross income is, as a rule, statutory gross income, covering all sources of taxable income, such as salaries, dividends, interest, etc.; see Green, 7 TC 263 (1946), acq., aff'd on another issue, 168 F2d 994 (6th Cir. 1948), or Hatch, 190 F2d 254 (2d Cir. 1951).

Therefore, a taxpayer must consider all gross income reported. Given this, how does the taxpayer treat passthrough income from a partnership or an S corporation? The taxpayer reports only a Schedule K-1 portion of the entity's income. However, for Sec. 6501(e) purposes, when applying the assessment-period rules to an S shareholder, information disclosed on the S corporation's return must be taken into account in determining whether the shareholder has adequately disclosed the nature and amount of an omitted item on his individual return,

Similarly, if the Code provides for a partner's gross income to be determined:

[H]is gross income shall include the partner's distributive share of the gross income of the partnership, that is, the amount of gross income from the partnership from which was derived the partner's distributive share of partnership taxable income or loss. (Regs. Sec. 1.702-1(c)(1).)

Thus, a mere summing of the items on the first page of Form 1040 will by no means give the taxpayer its gross income for Sec. 6501(e) purposes.

What about the sale of capital items? Is gross income the sales price or the net gain? Also, if a taxpayer sells such an asset at a loss, does it have gross income?

For purposes of the 25% omission-from-gross-income test, in the case of taxpayers who are investors, "gross income stated in the return" is the net gain from the sale of assets, rather than the gross proceeds from the sale. In the case of nonbusiness sales, only the net gains are included in gross income, not the gross receipts; see Insulglass Corp., 84 TC 203 (1985).

Normally, the IRS is entitled to a presumption of correctness. In some areas (e.g., fraud), it has to meet a burden-of-proof test. Can it assert that a taxpayer has a 25% omission (which the taxpayer must prove to the contrary) or must the Service prove the omission? The presumption that the IRS's deficiency notice is correct does not satisfy its burden of proving there has been a more-than-25% omission from gross income. The Service must prove the taxpayer's gross income by a preponderance of the evidence; see, e.g., Reis, 1 TC 9 (1942), aff'd, 142 F2d 900 (6th Cir. 1944); Wood, 245 F2d 888; (5th Cir. 1957), rev'g TC Memo 1955-301;Jones, TC Memo 12/26/51; Hooper, TC Memo 8/31/53; SoRelle, 22 TC 459 (1954); and Page, TC Memo 1956-61.

Therefore, the IRS must carry the burden in showing the perquisite omission of income, to rely on the 25% six-year rule.

Editor's Note: Mr. Holub is a member of the AICPA Tax Division's Tax Practice Responsibility Committee. He is formerly a member of the Member Tax Practice Improvement Committee and Chair of the Tax Practice Management Committee.

Mr. Grooms is a member of the Member Tax Practice Improvement Committee and the Tax Accounting Simplification Task Force.

If you would like additional information about this article, contact Mr. Holub at [phone] or [e-mail] or Mr. Grooms at [e-mail] or [phone].

FROM W.M. GROOMS, PH.D., CPA, COLUMBIA, SC