Suppose you sell a business for $10,000,000, claiming your basis is $10,000,000 when it’s actually closer to $1,000,000. You’ll have to pay tax on that $9,000,000 difference (plus interest and penalties) if the IRS catches you before the statute of limitations runs out. How long do they have to catch you? The Supreme Court will probably have to step in and resolve this question, which has divided the Courts of Appeals.
The normal statute of limitations is three years from the unextended due date of your tax return, or if later, from the date it was filed. The IRS has twice as long, though, if you made a substantial omission of income. If you show $10,000,000 of income on your tax return and claim $9,000,000 in improper deductions, you owe more tax but you don’t have an omission of income, so the limitations period is three years. If instead you show $1,000,000 of income when the total should be $10,000,000, you’ve made an omission of income that extends the limitations period from three years to six.
The theory is that in the first case the IRS has been placed on notice that you’re claiming $9,000,000 in deductions, and three years should be enough time for them to decide whether to audit your return. In the second case, the income doesn’t appear on your return at all, so it may take longer for the IRS to figure out that you did something improper.
Perhaps this is a good place to note that the statute of limitations is unlimited if your underpayment is due to fraud.
What happens if you claim too much basis when selling an asset? This isn’t a case where you showed the income on your return and separately claimed an improper deduction, so it could be viewed as an omission of income. Yet the tax return shows the full amount of sales proceeds while indicating a large amount of basis claimed against that amount, so it can be argued that this should not be treated as an omission of income.
This argument is playing out in the federal courts with different results in different cases. A recent decision by the Federal Circuit went in favor of the IRS, and may indicate that the tide is tipping in that direction. Grapevine Imports (PDF) involved a scheme to eliminate capital gains through a sequence of transactions that lacked economic substance. The court’s ruling was based on deference to a Treasury regulation, but we can’t help wondering if the decision was influenced by the unsavory nature of the underlying scheme. Be that as it may, with other courts having reached the contrary conclusion and many millions of dollars hinging on the outcome, the Supreme Court may have to step in and settle the question.
