Ability of IRS to Adjust Amount to Recapture for Taxpayer with §108(i) Election in Prior Year Considered by Chief Counsel's Office

The issue of what items IRS can and cannot change that arose in “closed” years is the issue discussed in Chief Counsel Advice 201604017.  In this memorandum the question arose regarding whether the IRS can make adjustments to the amounts included in income under the special temporary provision that allowed for deferral of cancellation of indebtedness income under IRC §108(i).

The memorandum poses the following situation:

B is a sole proprietor. L, an unrelated individual, holds a promissory note that B made in connection with her business, for which $800x remains outstanding. In 2009, L agrees to return the note to B in exchange for $500x in cash. B’s acquisition of the note from L is a “reacquisition” within the meaning of § 108(i)(4).

B attaches a statement to her timely filed 2009 return reporting $100x, not $300x, in total COD income in connection with the note reacquisition. On the statement, B also makes an election under § 108(i) to defer the inclusion of $100x in COD income to the 5-year period beginning with 2014.

In a later year, the Service discovers that B failed to include $200x in COD income in 2009.

The later year when the IRS discovers this problem is after the statute of limitations has run on the 2009 return. 

For those who may have forgotten, under that provision the taxpayer would have pushed the inclusion of income forward and begin picking up 1/5 of the amount each year beginning 2014 until the entire amount was picked up in income.  Thus, given a $100,000 exclusion (assuming that is “x” would represent in the above example) the taxpayer plans to include a $20,000 addition to income on the 2014-2019 returns.

As well a taxpayer had to elect the use of this provision and identify the amount of income to be deferred.  In this case, as noted above, that election stated that $100,000 would be deferred.

IRC §108(i)(5)(B)(i) provided the following details on the election:

(B) Election

(i) In general

An election under this subsection with respect to any applicable debt instrument shall be made by including with the return of tax imposed by chapter 1 for the taxable year in which the reacquisition of the debt instrument occurs a statement which--

(I) clearly identifies such instrument, and

(II) includes the amount of income to which paragraph (1) applies and such other information as the Secretary may prescribe.

Now we can assume the IRS is examining 2014 and is looking at the $20,000 addition to income.  The question becomes can the IRS push that number up to 20% of the actual $300,000 cancellation of income, or is the agency “stuck” with the $20,000 number because the agency failed to examine the 2009 return before the statue ran.

The memo first outlines the general rule that allows the IRS to adjust amounts in “closed” years:

Section 6501 generally limits the period during which tax may be assessed to 3 years after the date the taxpayer files a return. However, § 6501 merely prevents assessment and collection of tax beyond the prescribed period of limitations. Section 6501 does not prevent an adjustment that may affect other taxable years or other tax liabilities, or does not result in the assessment of a tax. There is a well-developed body of law that the Service is generally able to recompute a taxpayer’s income for a closed year in determining the deficiency for an open year (the “adjustment theory”). See Commissioner v. Disston, 325 U.S. 442 (1945) (examination of events in closed years was allowed to correctly determine the gift tax liability in open years); ABKCO Industries Inc. v. Commissioner, 56 T.C. 1083 (1971) (income for a year barred by the statute of limitations recomputed to arrive at correct amount for determining net operating loss carryback or carryover to another year).

However there would appear to be a complicating factor in this case—the law required the taxpayer to identify the amount to be deferred in order to get a deferral.  Initially it would appear that the fact the taxpayer mistakenly only identified $100,000 as deferred mean that the IRS, had it examined 2009, would have been able to assess tax on the additional $200,000 that wasn’t identified.  And, if that is the proper interpretation, then the adjustment in 2014 would remain at $20,000.

The rules for making the election were promulgated by the IRS in Revenue Procedure 2009-37.  One interesting option there, which the memo will look at in evaluating what the IRS can do in this case, regarded protective elections:

Section 4.11 of Rev. Proc. 2009-37 provides that a taxpayer may make a protective election if the taxpayer concludes that a particular transaction does not result in the realization of COD income. If the Service later determines that the transaction did result in COD income, the Service may require the taxpayer making the protective election to report COD income deferred pursuant to the valid and irrevocable protective election even if the statute of limitations has expired for the year in which the COD income was realized and the protective election was made.

In this case a standard, and not protective, election was made.  However the memorandum concludes the IRS may still be able to make an adjustment in 2014.  The memo notes:

Under a given set of facts, the Service may be able to apply the adjustment theory to adjust the amount of COD income that a taxpayer has elected to defer under § 108(i) even if the taxable year of the election is closed under § 6501. In the above example, the Service may be able to treat B as having realized $300x in COD income in 2009 and having elected to defer the entire $300x amount under § 108(i), even if the 2009 taxable year is closed under § 6501.

Note, though, that the memo goes on to recognize that it is far from clear this would pass muster if pushed and goes on to warn that the agency needs to move carefully before asserting this position:

Whether to apply the adjustment theory of Disston and ABKCO Industries, however, requires a thorough development of the facts in each case. For that reason, we strongly recommend that, in handling any case that appears to involve a misstatement or error in a 108(i) deferral, your office develop the facts fully and contact our office for taxpayer specific advice.