Most of you know the IRS has a 3 years from the date you file your tax return to commence and complete an audit of your tax return and assess you additional tax owed to the Government. What you might not be aware of is that the Government due to budget cuts now routinely asks you to extend the three year “statute of limitations” to give the IRS more time to complete the audit. If the IRS asks you to sign Form 872, Consent to Extend the Statute, what should you do? If you do sign Form 872 you keep the period to assess the tax longer than required by the 3 year statute of limitations. But if you don’t sign Form 872 the IRS in most cases immediately assesses you a tax and issues you a 90 day Notice of Deficiency propelling the case into US Tax Court and into the hands of a high priced tax attorney. So if you are not sure what you would do, stay with us here on TaxView with Chris Moss CPA Tax Attorney to find out just how to handle a Government request to extend the statue of limitations in a way that best protects your family and saves you taxes.
IRS Code 6501 prohibits the IRS from “assessing a tax” on your income after your tax return has been filed for 3 years. This three year statute of limitations enacted in 1918 has worked well for almost 100 years. But recently agents have told me that due to Federal budget cuts reducing staff the IRS has insufficient time to complete your audit in an expeditious manner within the 3 year period. So taxpayers are now routinely asked to consent to extend the 3 year statute on Form 872. Further complications arise as a result of agents trying to comply with a very complex set of internal rules as per this IRS audit manual yet at the same time trying as best they can to finish up a taxpayer audit prior to the expiration of the 3 year window.
In order to best ascertain whether or not to extend the 3 year statute of limitations best practice is to review with your tax attorney how your audit is going. If you have deductions that cannot be easily and timely documented, but nevertheless know you can at some point provide the necessary documentation the Government has asked for, and you believe the IRS agent is going to need more time to complete your audit examination, you would perhaps want to extend the statute to give the agent time to finish up and give you a no change audit. On the other hand, if you have given the agent sufficient documentation to support your deductions and the audit is taking a long time to complete through no fault of your own, then you would not extend the statute as long as your tax attorney who prepared and filed your tax return could cost effectively litigate the case in US Tax Court.
Furthermore, for those of you being audited who might have underreported income, there should begin a series of confidential attorney-client privileged discussions with your tax attorney on whether or not you should agree to sign a statute extender on Form 872. That is because as Williamson’s Estate found out in Williams v IRS US Tax Court (1996) there are exceptions to the 3 year statute, and of particular relevance to Judge Korner is Code Section 6501 (e) which extends the statute 3 more years to 6 years if there is an undisclosed 25% understatement of gross income on your tax return. Citing Colony v Commissioner 357 US 28 (1958) the Supreme Court said “Congress manifested no broader purpose than to give the Commissioner an additional 2 (now 3) years in cases where because of a taxpayer’s omission to report some taxable income, the IRS is at a special disadvantage.” In Williams, the tax return did in fact disclose the understatement so Williams wins IRS loses.
But for other taxpayers who by accident or intention, there is a 25% understatement of gross income that has not yet been discovered by the ongoing IRS audit, best practice in this case might suggest for you not to sign Form 872 and allow the case go to US Tax Court as quickly as possible in the hope to have the audit end sooner than later. This could have been the case in Connell v IRS US Tax Court (2004).
The facts in the Connell case are very simple. Thomas and Sara Anne Connell had four small trusts which they used to underreport income on their personal return. This scheme was discovered by the IRS Criminal investigation division. While a recommendation to prosecute was made by Criminal division, for reasons not known to the US Tax Court no criminal action was ever undertaken. The IRS then issued Notices of Deficiency which were issued more than 3 but less than 6 years after the returns were filed. Connell appealed to US Tax Court in Connell v IRS US Tax Court (2004) claiming they failed to report additional income, but they adequately disclosed this by filing the bogus trusts.
Judge Gale easily brushes aside the Connell argument and rules for the Government citing Reuter v IRS US Tax Court (1985) requiring that the actual tax returns themselves have to disclose the understatement not some other return or document. In Reuter there was undisclosed S Corporation distributions. In Connell it was the trusts. In both cases the actual 1040 personal tax returns did not disclose the omitted income. As Reuter points out “the legislative history of the 1954 changes made to section 6501(e)(1)(A) does not suggest looking beyond the face of the return to determine disclosure of an omitted item of income. So in Connell as in Reuter, IRS wins, Connell loses.
Further complicating understatement of income issues are the growing popularity of larger partnerships as underscored in a recent 2014 report from the US Government Accountability Office to the Senate Committee on Homeland Security. The report claims the IRS finds it very difficult to audit all these entities within the 3 year statute even if fully staffed with no budget cuts. What happens if you should file your personal tax return with a K1 that as a result of an audit at the partnership level puts you at risk of a substantial understatement? If you get audited personally should you agree to sign Form 872 even though you know you might have substantially overstated your basis on various sales from complex partnerships you have an ownership interest in causing you to have a substantial 25% understatement of income?
In fact, this very question was addressed by a divided US Supreme Court in, US v Home Concrete and Supply LLC, US Supreme Court 566 US_____(2012) affirming 634 F 3d 249. The facts in Concrete were simple, but existing Federal law as applied to these facts was anything but simple. Here are the facts: Partnership tax shelters generated losses to Home Concrete. The losses were a result of an overstated basis which in turn caused a substantial understatement of income. The question presented to the Supreme Court was whether a basis overstatement on sold property can trigger the 6 year statute under 6501(e) and US Treasury regulation 301.6501(e )(1)(A). The majority opinion given by Justice Breyer ruled that based on the facts in this case, Congress did not intend to make basis overstatement the same as substantial understatement of “gross” income subject to the 6 year statute of limitations, thereby in effect overruling the US Treasury regulation. The reason given by Justice Breyer: “taken literally, “omit” limits the statute’s scope to situations in which specific receipts or accruals of income are left out of the computation of gross income; to inflate the basis, however, is not to “omit” a specific item, not even of profit.”
But Justice Kennedy, Ginsburg, Sotomayor and Kagan strongly dissented arguing that “there is a serious difficulty to insisting, as the Court does today, that an ambiguous provision must continue to be read the same way even after it has been reenacted with additional language suggesting Congress would permit a different interpretation. Agencies with the responsibility and expertise necessary to administer ongoing regulatory schemes should have the latitude and discretion to implement their interpretation of provisions reenacted in a new statutory framework.”
So what can you do if the IRS asks you to sign Form 872? Perhaps you could do the same thing Home Concrete and their tax attorney did when they saw a gray area of the law: You just might decide not to sign Form 872 and have your tax attorney take the case to US Tax Court and perhaps as did Home Concrete achieve ultimate victory in the US Supreme Court. So first and foremost if you are asked by the Government to sign Form 872 retain the services of a tax attorney, hopefully the same tax attorney who prepared, filed and handled the audit of your tax return in the first place, before you make a decision whether to sign Form 872 or not. Second, make sure you always contemporaneously prepare the documents and records needed to support your tax return in the unlikely event of an IRS audit, and include summary documents in the tax return you file to create the facts and records you need to win an audit. With a good set of records supporting your tax positions you will hopefully finish up the audit with no adjustments. Finally, if the audit takes too much time, whether due to Government budget cuts, or for lack of records, make sure you have your tax attorney standing by to help you answer the soon to be asked question by your IRS agent: Would you please sign Form 872 to extend the statute of limitations on your audit? If the IRS asks you to sign Form 872, Consent to Extend the Statute, what would you do? Whether you win or lose may depend on how you answer this question.
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Chris Moss CPA Tax Attorney