The Tax Court took a second look at whether the IRS had been too late in attempting to collect tax from the taxpayers in the case of Beverly Clark Collection LLC et al. v. Commissioner, TC Memo 2019-150.[1]  The Ninth Circuit had sent the case back to the Tax Court to determine if the transaction was a sham, as the IRS alleged, and, if so, whether that made any difference in seeing if there had been an omission from gross income.

The limitations period issues are explained by the Tax Court as follows:

Ordinarily, the limitations period on assessment of tax is three years after the return was filed. Sec. 6501(a). The period is extended to six years “[i]f the 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”. Id. [*7] subsec. (e)(1)(A). In determining the amount omitted from gross income, any amounts “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” are not taken into account. Id. cl. (ii).[2]

For the year in question, the partnership was subject to the TEFRA partnership examination rules.  IRC §6229 provides a statute of limitations that allows for assessments against a partner, but it does not eliminate the standard rules.  Generally, if either statute is open, the IRS can assess tax in a TEFRA partnership case.  In particular for this situation the Court notes:

Partnership-level adjustments may result in a substantial omission at the partner level for purposes of section 6501(e). Rhone-Poulenc Surfactants & Specialties, L.P. v. Commissioner, 114 T.C. at 551; see also CNT Inv’rs, LLC v. Commissioner, 144 T.C. 161, 189-191 (2015). And as we explained in Rhone-Poulenc Surfactants & Specialties, partnerships are not taxable entities; any income tax attributable to partnership items must be assessed at the partner level. So if the limitations period was open as to the Clarks when respondent issued the FPAA, the FPAA was not meaningless, and this case may proceed; if it was closed, the FPAA is untimely and we must enter decision for petitioner. See CNT Inv’rs, LLC v. Commissioner, 144 T.C. at 213; see also Rhone-Poulenc Surfactants & Specialties, L.P. v. Commissioner, 114 T.C. at 534-535.[3]

The decision describes the transaction in question as follows:

From 1987 to 2000 Nelson and Beverly Clark owned a wedding accessories business, the Beverly Clark Collection, which they operated as a sole proprietorship. On March 12, 1999, the Clarks transferred all of the assets and liabilities of the business to a newly created California limited liability company, Beverly Clark Collection, LLC (BCC). In exchange they received 100% of BCC’s equity, with the Clarks each receiving 50% interests.

BCC’s 1999 Form 1065, U.S. Return of Partnership Income, and the Clarks’ 1999 Form 1040, U.S. Individual Income Tax Return, reported what they claimed to be a sale on December 31, 1999, of an 80.01% interest in BCC to Fausset Trust in exchange for a $10,401,300 Treasury note. Before that sale the Clarks had contributed Treasury notes and a small amount of cash to BCC. BCC then sold the Treasury notes, recognizing a small loss. Respondent characterized the Clarks’ acquisition of the notes through a short sale, their contribution to BCC, and BCC’s disposition for a small loss as a “Son-of-BOSS” transaction that artificially inflated the Clarks’ outside basis in BCC.[4]

The Clarks then took the following steps in preparing their 1999 Form 1040:

On their 1999 Form 1040 the Clarks reported a short-term capital loss of $26,813 and a long-term capital loss of $3,703 on the sale of the BCC interest to Fausset Trust. BCC’s 1999 Form 1065 reported capital contributions of $13,257,425 for the year. The 1999 Schedules K-1, Partner’s Share of Income, Credits, Deductions, etc., for Mr. Clark, Mrs. Clark, and Fausset Trust showed end-of-year ownership interests of 9.99%, 10%, and 80.01%, respectively. BCC’s Form 1065 and the Clarks’ Form 1040 for 2000 reported what they claimed to be the tax consequences to BCC and its partners, the Clarks and Fausset Trust, of the March 2000 liquidation of BCC and sale of its assets to Maplewood LF Investors, LLC. The Clarks’ 2000 Form 1040 reported $2,083,976 of gross proceeds and $1,406,395 of gain from the post-liquidation sale of BCC’s assets and goodwill. The Clarks also reported gross income of $811,512 for 2000. BCC’s 2000 Form 1065 reported a $10,527,061 distribution of property and the Clarks’ 2000 Schedules K-1 reported flowthrough losses of $7,284,835 and $7,284,837, respectively. The Schedules K-1 also reported guaranteed payments from BCC to the Clarks totaling $150,000; the Clarks did not report this amount on their 2000 Form 1040, however.[5]

The IRS issued a notice of final partnership administrative adjustment (FPAA) in August 2008, taking the position that the transactions were a sham, and that the reported basis for the computations of gain and loss were overstated by the sham.  The FPAA was issued more than three years, but less than six years, after the statute of limitation had begun to run on the 1999 returns.

The IRS had argued both that the understatement of basis triggered the extended six-year statute and that, since the transaction was a sham in the IRS’s view, the taxpayers had also failed to report just over 80% of the ultimate sales proceeds on their return. 

The Tax Court originally ruled that the six-year statute did not apply since an overstatement of basis did not equate to an understatement of gross income.  The Supreme Court would issue an opinion two years later that came to the same conclusion with regard to overstatements of basis.[6]   The original Tax Court opinion did not address the sham transaction question.

The IRS appealed the Tax Court’s decision to the Ninth Circuit. When the Supreme Court ruled that an overstatement of basis is not an understatement of income for these purposes in the Home Concrete case, the IRS abandoned that argument on appeal.  The Ninth Circuit found that the Tax Court needed to address the sham transaction argument to see if that could lead to an omission of gross income to trigger the six-year statute.

The Tax Court concluded that, even if the transaction is assumed to be a sham, that would not have triggered the six-year statute.  The opinion looks to the Supreme Court’s decisions, noting that the Supreme Court determined the key issue is if the IRS was made aware of the existence of a transaction in determining if the six-year statute rule applies:

In considering the application of a prior version of section 6501(e)(1)(A), the U.S. Supreme Court explained that “the Commissioner is at a special disadvantage” where a taxpayer fails to report an item of tax and “the return on its face provides no clue to the existence of the omitted item.” Colony, Inc. v. Commissioner, 357 U.S. 28, 36 (1958). The Court went on to explain: “On the other hand, when * * * the understatement of a tax arises from an error in reporting an item disclosed on the face of the return the Commissioner is at no such disadvantage. And this would seem to be so whether the error be one affecting ‘gross income’ or one, such as overstated deductions, affecting other parts of the return.” Id.

…

In Home Concrete & Supply, LLC, 566 U.S. at 483, the Supreme Court concluded that its interpretation in Colony, Inc., applied with equal force to the current version. In both cases the Supreme Court considered and rejected respondent’s argument here that the phrase “omits * * * an amount” in section 6501(e)(1)(A) should be read to include an understatement of an amount, concluding that such a reading would give too much weight to “amount” and too little to “omits”. Home Concrete & Supply, LLC, 566 U.S. at 485-486; Colony, Inc. v. Commissioner, 357 U.S. at 32-33. In Colony, Inc., the Court rejected the Commissioner’s argument that the phrase “omits from gross income an amount properly includible therein” should be read to include an understatement of income arising from an overstatement of costs. And in Home Concrete & Supply, LLC, 566 U.S. at 490, the Court expressly rejected the Commissioner’s argument that “omits” could be construed to include an understatement of income arising from an overstatement of basis.[7]

In this case, the Court decided that the taxpayers had reported the transaction, but only reported the wrong amount of gain—and that would not trigger the six-year rule:

… [E]ven if we assume that the basis was not wrong but the sale of BCC to Fausset Trust was a sham, the Clarks did not omit an item of gain entirely; they just reported an incorrect amount of gain. See id. at 208 (concluding that when a taxpayer overstates basis and thereby understates gain, “the taxpayer has reported, not omitted, the item of gain, albeit in an incorrect amount”). We therefore reject respondent’s assertion that the test in section 6501(e)(1)(A) is computational. And we find no support for respondent’s claim that Colony, Inc. should not apply here because that case involved gross proceeds of a business unlike here. See Carpenter Family Invs., LLC v. Commissioner, 136 T.C. 373, 386 (2011).

The parties agree that the Clarks reported gain attributable to the total 19.99% interest in BCC that they claimed to retain after the sham transaction. One could argue that the Clarks omitted the entire amount of gain allocated to Fausset Trust, but the result of respondent’s sham-sale theory is that the Clarks should have reported 100% of the gain on the postsale liquidation rather than 19.99%. And because they reported 19.99% of the gain rather than 100%, they did not “omit” an item of gain entirely but rather reported an incorrect amount, so the six-year period of limitations does not apply.7 While the clues on the returns filed here seem “sufficient to intrigue [only] a Sherlock Holmes”,8 they must suffice under the statutory framework for the reasons explained by the Supreme Court.[8]

[1] Beverly Clark Collection LLC et al. v. Commissioner, TC Memo 2019-150, November 14, 2019, https://www.ustaxcourt.gov/USTCInOP/OpinionViewer.aspx?ID=12105, retrieved November 15, 2019

[2] Beverly Clark Collection LLC et al. v. Commissioner, p. 7

[3] Beverly Clark Collection LLC et al. v. Commissioner, p. 8

[4] Beverly Clark Collection LLC et al. v. Commissioner, pp. 2-3

[5] Beverly Clark Collection LLC et al. v. Commissioner, pp. 3-4

[6] United States v. Home Concrete & Supply, LLC, 566 U.S. 478 (2012)

[7] Beverly Clark Collection LLC et al. v. Commissioner, pp. 10-11

[8] Beverly Clark Collection LLC et al. v. Commissioner, pp. 12-13