Investors Rejoice: IRS Limited To 3-Year Statute Of Limitations On Basis Misstatements

by Matt Ottemann

Ottemann, Matthew
(402) 341-3070

In tax law, one of the rules with the most impact is the statute of limitations, a rule which limits the time that the IRS may issue an assessment for underpaid taxes (and the time that a taxpayer has to file a claim for overpaid taxes). Under federal tax law, there are three key time periods:

  1. Three-Year Statute For Most Taxpayers.  Generally, the IRS has three years after a return is filed to audit a taxpayer and issue a formal assessment.
  2. Six-Year Statute For Substantial Understatements.  If a taxpayer omits income which is in excess of 25 percent of the amount of gross income stated in the return, then a six-year statute applies.
  3. No Statute Of Limitations For Fraud.  There is no statute of limitations if a taxpayer commits fraud.

While these rules seem clear enough, the federal tax statutes don’t specifically address whether the extended six-year statute of limitations case would apply if the taxpayer overstated its basis in a property sale. An example of such a basis overstatement is this:

Example:  A taxpayer sells a piece of real estate for $5 million, claiming that it paid $3 million for the property. In fact, the taxpayer only paid $1 million. The effect of this basis overstatement is that the taxpayer is taxed on only $2 million of gain ($5 million – $3 million) when the taxpayer should have been taxed on a $4 million gain ($5 million – $1 million).

This point of law was at issue because the statute which established the six-year limit states that the six-year limit applies when a 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.” But in the basis overstatement example above, the taxpayer did not omit the gross proceeds from the sale. The taxpayer correctly reported that it received $5 million in gross proceeds. So the question was whether the term “gross income” in the Code provision refers to the gross proceeds from the sale or the net proceeds – the gross proceeds less basis.

In four circuit court decisions (from the 7th, 10th, Federal and D.C. circuits), the IRS successfully argued that the six-year limit applied to basis overstatements. The IRS also issued a regulation which stated that the six-year limit applied to basis overstatements. But in three other circuit court decisions (4th, 5th, and 9th), taxpayers successfully argued that the three-year limit applied to basis overstatements. In light of this discrepancy (which meant that different rules applied to taxpayers that lived in different states), the Supreme Court chose to consider this issue.

In a recent decision (Home Concrete & Supply v. U.S.), the Supreme Court ruled that only a three-year statute applied to basis overstatements – even in connection with a prohibited tax shelter transaction.

If you or a client is facing a tax audit or federal tax assessment, and the IRS is claiming that a six-year statute of limitations applies, this decision may provide a legal basis to dispute the IRS’ claim. Feel free to contact me or any member of the McGrath North Tax Group to discuss this point further.

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