Fact IRS May Have Had Knowledge of Omission from Unrelated Exam Was Not a Bar to Assessment Under Six Year Extended Statute

The Eighth Circuit, in the case of Heckman v. Commissioner, Docket No. 14-3251, affirming TC Memo 2014-131, held that a taxpayer did not escape the six year statute of limitations for assessments when the taxpayer claimed the IRS had been made aware of the underlying issues during an examination of the retirement plan from which the taxable distribution arose.  The IRS, per the taxpayer, became aware of the existence of the distribution during that exam prior to the expiration of the standard three-year statute of limitations.   ut the Eighth Circuit found that the IRS was not required to pursue needles in the haystack of information that might otherwise be vaguely available to the agency.

The plan in question as an employee stock ownership plan which, during the examination in question, had its status as a qualified plan revoked.  The plan in question had not filed a Form 5500 for 2001-2003, a fact the IRS did not notice until April 2007 during an unrelated examination.

When the IRS opened the plan exam in October 2007 the plan filed a Form 1099R that indicated that the plan assets had been distributed and claimed a rollover status for the distribution.  The IRS issued its final revocation letter to the plan in April of 2012.  The IRS also would, in the case of Mr. Heckman, take the position that his receipt of a partnership interest from the plan in 2003 was taxable compensation to him at that time and was not an eligible rollover distribution from a qualified plan.

By the time the case got to the Eighth Circuit Mr. Heckman had conceded that the distribution did not qualify for rollover status.  But he argued that the IRS was “out of luck” because the IRS did not begin the examination of his return or assess tax on that distribution until more than 3 years after he had filed his 2003 return.

The IRS countered that the omitted income was in excess of 25% of the gross income stated on the return and that, pursuant to IRC 6501(e)(1)(A), the agency had six years, and not three, to assess the tax.  The amount was in excess of 25% of the gross income stated on the return (a fact the taxpayer was not contesting) so, the IRS argued, they were clearly assessing in a timely fashion.

However the taxpayer argued that this provision only applies if the IRS was not otherwise aware of the understatement and that, due to the unrelated exam, the IRS had become aware of the transaction prior to the end of three year statute.  He points out that, under §6501(e)(1)(A)(ii), an amount is not considered omitted from gross income for these purposes if it 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.”

The taxpayer cites back to the 1958 Supreme Court case of Colony Inc. v. Commissioner, 357 U.S. 28 (1958) to argue that the provision only applies if the IRS lacks knowledge of the omission.  That case, deciding the application of a similar rule found in §275(c) of the 1939 Internal Revenue Code, has been discussed fairly recently when the Supreme Court looked at this same statute in the Home Concrete case—but not related to this issue.

The Eighth Circuit summarizes the taxpayer’s position as follows:

Colony held that when an understatement of tax arose from an error in reporting an item disclosed on the face of the return, the five-year limitations period did not apply. The Court reasoned that “in enacting § 275(c) Congress manifested no broader purpose than to give the Commissioner an additional two years to investigate tax returns in cases where, because of a taxpayer’s omission to report some taxable item, the Commissioner is at a special disadvantage in detecting errors.” 357 U.S. at 36. Heckman contends that the IRS in this case was not “at a special disadvantage” in detecting his error within the ordinary three-year limitations period, because the government obtained actual knowledge of the distribution before the three-year period expired. On that basis, Heckman contends that Congress did not intend to give the Commissioner six years to investigate his return, and that the longer limitations period does not apply.

The Eighth Circuit initially pointed out that the Colony case was interpreting a statute that differed from the current one in a key way that was very important to the taxpayer’s position—the 1939 statute did not indicate how to “appraise” the IRS of omitted income, but the current statute requires the taxpayer to have disclosed the statement in the return or in a statement attached to the return.

The Court concludes:

There is no provision that says an amount is excluded if the Commissioner is not “at a special disadvantage” in detecting the error, or if the Commissioner learns of the amount within the ordinary three-year limitations period. Colony, moreover, concerned an amount that was disclosed on the face of the taxpayer’s return, id. at 36, so the Court unsurprisingly viewed its decision as “in harmony” with the later enacted § 6501(e)(1) (A). Id. at 37 & n.3.

The Court also notes that the taxpayer’s view (discovery within three years of the date filed) doesn’t actually provide a necessarily practical fix the IRS’s lack of knowledge.  As the Court notes:

Under Heckman’s approach, however, if the Commissioner gains actual knowledge about an amount omitted from a return at some date after the return is filed (say, two years and 364 days later), then the Commissioner would be left with only the remaining time (e.g., one day) to investigate and act on the omission, not the three years contemplated by the statute. It is no answer to say, as Heckman does in the alternative, that the Commissioner could simply be granted another three years after the date when the government acquires actual knowledge of the omission. The Code provides only two statutes of limitations: three years or six years after the return was filed, not three years after the acquisition of actual knowledge.

The taxpayers argued, in that case, the matter was effectively disclosed in the 2003 return of the LLC taxed as a partnership whose interests were the items that Mr. Heckerman failed to include in his income.  Thus he claims, citing the Eighth Circuit’s decision in the case of Benderoff v. United States, 398 F.2d 132 (8th Cir. 1968), his return should be deemed to contain information found in corporate filings.   In that case the taxpayers had disclosed their ownership of the corporation and reported their shares of undistributed corporate income, but failed to report a corporate distribution.   However the corporation had issued an information return containing that information which the Court had concluded the information on that information should be considered along with that actually on the taxpayer’s returns for purposes of this statute, since the whole purpose of the information return was to put the IRS on notice about possible omissions of income.

The Eight Circuit pointed out that Mr. Heckerman’s case wasn’t really comparable, noting:

In contrast to the situation in Benderoff, Heckman’s return contained no reference to Prairie Capital or to the distribution. Neither Heckman’s return nor any attached statement gave the Commissioner a clue that Prairie Capital’s filings were relevant to Heckman’s tax liability. Because Heckman’s individual return made no reference to Prairie Capital’s filings, the latter are not considered in determining whether Heckman’s return disclosed the distribution in a manner “adequate to apprise” the Commissioner of the amount omitted from Heckman’s return. See Taylor v. United States, 417 F.2d 991, 994 (5th Cir. 1969) (“Since the Government in this case examined an individual income tax return giving no suggestion or inference that relevant information may have been contained elsewhere, it cannot be seriously contended that the ‘adequate disclosure’ referred to in section 6501(e)(1)(A)(ii) was made.”); Connell Bus. Co. v. Comm’r, 87 T.C.M. (CCH) 1384, 1387 (T.C. 2004).

The taxpayer countered with his claim in Revenue Ruling 55-415 the IRS had effectively concluded that any items reported in the partnership’s return should be deemed as having been included by the taxpayer.

The Court, however, dismissed this view holding:

The revenue ruling, however, interpreted the 1939 Code. It did not address whether income disclosed in a partnership return is disclosed “in the return” or “in a statement attached to the return” for purposes of the later-enacted § 6501(e)(1)(A) (ii), where “the return” refers to the return filed by the individual taxpayer. In any event, as the tax court observed, no return filed by Prairie Capital for the 2003 tax year disclosed the distribution from the employee stock ownership plan to Heckman’s individual retirement account.

Finally, the Court rejected the taxpayer’s claim that because he reasonably believed the amount was not includable in income when he filed his return that the statute should be limited to three years—that is, he did not intentionally under-report his income.  The Court pointed out that the statute provides no exception for an omission due to a mistaken position of the taxpayer.