The IRS has a limited period of time to conduct audits. It often fails to finish the audit within this period of time. There are even instances where the IRS does not even start the audit until after this time period has passed.
This raises tough questions for taxpayers. Taxpayers expect some finality with their returns. This is particularly true for those taxpayers who rush to timely file their tax returns only to have the IRS miss the deadline to audit them and raise questions years after the fact.
Taxpayers facing late audits by the IRS should consult with a tax attorney. There may be some tax planning that can be done to avoid or help mitigate the IRS’s dialatory actions. This is particularly true for problem tax returns.
The Pragias v. Commissioner, T.C. Memo. 2021-82, case provides an opportunity to consider this situation.
Facts & Procedural History
This case involves the sale of options by a business the taxpayers owned. The business the taxpayers owned was a flow-through entity. So its items of income and expense flowed through to the taxpayers’ individual income tax return.
The taxpayers reported the capital gain on Schedule D of their personal tax return for 2006. They listed the flow-through business on Part II of their Schedule E with their personal tax return. They did not list a capital gain received by the business on Schedule E. The Schedule E simply listed the name of the business and showed no gain or loss. Instead of reporting the gain received by the business on Schedule E, the capital gain was reported on Schedule D.
The 2006 return was filed in 2007. The IRS started an income tax audit in 2011. The IRS determined that the taxpayers should have reported nearly $5 million in capital gains received by the business.
The IRS issued a statutory notice of deficiency (“SNOD”) and the taxpayers petitioned the U.S. Tax Court to redetermine their tax. The taxpayers filed a motion for summary judgment arguing that the IRS failed to issue the SNOD late. This timing of the IRS’s SNOD was the sole issue addressed in the summary judgment.
The IRS’s Timelimit for Auditing Tax Returns
The IRS cannot audit a taxpayer indefinitely. Congress has set certain time limits for IRS audits.
The IRS generally has three years to audit a timely filed tax return. This time period starts from the date the tax is assessed. This is usually the date the tax return was filed if the tax return was timely filed.
There are exceptions to this three-year audit rule. One exception is if the taxpayer signs a waiver or consent form to extend the audit period, for example. Another exception is if the taxpayer does not file a tax return.
The six-year exception was at issue in this case. This exception allows the IRS to adjust the taxpayer’s balance within six years if the tax return omits from gross income in an amount in excess of 25 percent of the amount of gross income stated in the return.
The Six-Year Statute for Auditing Tax Returns
The courts consider two factors in deciding whether the six-year statute applies. Specifically, the court asks whether there was a 25 percent omission of gross income and, if so, whether the gross income was adequately disclosed on the tax return.
For the 25 percent omission factor, the taxpayers argued that they did not omit the gross income. They argued that they did not leave it out entirely. Rather, the calculation merely understates the gross income. The court did not accept this argument. It cited Fry v. Commissioner, 88 T.C. 1020 (1987) in support of this holding. In Fry, the taxpayers had reported gain from the sale of property. The gain was understated as the valuation used in the sale resulted in the gain being understated. The court in Fry applied the six-year statute of limitations.
This factor is not the subject of this article. Cases involving the six-year statute are often decided based on the adequate disclosure factor. Let’s look at that factor.
What is Adequate Disclsoure?
There are quite a few court cases that help clarify what counts as an adequate disclosure sufficient to avoid the six year statute. These court cases generally say that there is an adequate disclosure if the information on the tax return is enough to apprise the IRS of the omitted income.
The court in the present case concluded that the Schedule E listed the name of the business, but it failed to list the capital gain income received by the business. This income should have been allocated to the taxpayers via a Schedule K-1 issued to the taxpayers by the business. Then the taxpayers would have reported the gain on Schedule D.
In this case, the taxpayers did just that. They reported the gain on Schedule D. This appears to be the correct way to report the capital gain received by the business the taxpayers owned.
The court opinion seems to suggest that the disclosure would have been adequate if the taxpayers had included a Schedule K-1 with their tax return. It is difficult to tell from the court’s opinion, but it appears that the taxpayer may not have filed a copy of the Schedule K-1 with its personal tax return.
A Schedule K-1 is usually not attached to an individual income tax return. This is especially true if the return is eFiled. Schedules K-1 are not usually uploaded as part of the eFiled return. Instead, the Schedule K-1 is remitted to the IRS with the business return. The IRS’s computer system then pulls the Schedule K-1 over to the taxpayer’s individual tax account with the IRS.
Assuming the Schedule K-1 was on file with the IRS and the IRS did in fact use its computer system to record the Schedule K-1 on the taxpayers individual income tax account with the IRS, is that Schedule K-1 and the correctly reported gain on Schedule D sufficient?
The court did not believe it was. The court denied the taxpayers’ summary judgment motion, thereby allowing the IRS to use the six-year statute.
The IRS is grossly inefficient. While it has a monumental task to process the very large volume of information, the IRS fails to employ even basic technological solutions that private businesses have long employed to manage this volume of information.
We as taxpayers accept the IRS’s inefficiency. We just hope that it never directly impacts us. When it does, the taxpayer’s sole remedy is often to file interest abatement claims to at least remove the interest that accrues when the IRS was dialatory in working on its cases.
This case shows that merely following the reporting rules is not always sufficient to avoid a six year statute of limitations. Taxpayers who are concerned about flow-through items and who hope the IRS will not examine these issues after the IRS’s three year period for doing so should consider including more information with their returns. This can help avoid arguments about “adequate disclosure” as in this case.