January 31, 2011
IRS Issues Final Regulations on Income Understatement
The IRS recently issued final regulations on a long debated tax topic regarding the understatement of income on tax returns, specifically related to the overstatement of unrecovered cost or other basis in relation to gross income. Prior to these regulations, the Tax Court found, in two separate Tax Court Cases, that an overstatement of basis which resulted in an understatement of income was not an omission for purposes the IRS’ extended statute of limitations for examining such an issue. The IRS has released final regulations as of December, 2010 which rebut the Court decisions stating that such an understatement is an omission, and therefore subject to a six, not three year statute of limitations for IRS assessment.
A statute of limitations generally provides the IRS a three year timeframe to assess penalties and interest plus additional tax owed by the taxpayer from the date the return is filed, or the original due date, whichever is later. Once three years have expired, the IRS generally no longer has the ability to assess. One exception to this limitation applies to taxpayers who omit an income amount in excess of 25% of reported gross income. In such an instance, the IRS can assess for an additional three years for potential examination. During this six year period the IRS may assess the tax or begin a proceeding in court without assessment to collect the tax. In this instance, the IRS must prove that the omitted income was includible in the taxpayer’s gross income for the year and that it did, in fact, exceed the 25% threshold. If so, the six year limitation applies to all items affecting the amount of taxes owed, not just income items. Depreciation deductions, which are normally not subject to assessment beyond three years, is just one example of an item other than income that could be reexamined if there is a substantial omission of gross income.
The IRS has responded to prior Tax Court decisions in adoption of provisions of both the temporary and proposed regulations. The final regulations issued this week trigger a new threshold for the six year statute of limitations. Sales of assets used in a business resulting in an omission of gross income because of an overstated basis, thus an understatement of income recognition, is now includible in the six year limitation. The regulations elaborate on the definition of gross income, including gains derived from dealings in property as in the excess amount realized over the unrecovered cost or other basis of the property sold. With this information, the IRS concludes that understatements of gross income resulting from the overstatement of basis in an asset, constitutes an omission of income for Federal income tax purposes for purposes of the six year statute of limitations.
Taxpayers can avoid being subject to the six year statute of limitation by attaching adequate information regarding the nature and amount of an asset’s basis overstatement on the return or as an attachment to the return if they face this situation. Gross Income omission computations by the IRS will not be affected by amendments to the return subsequent to filing, nor will the fact that an omission was unintentional. The six year limitation imposed by these final regulations not only applies to businesses and partnerships, but also to estate and gift tax returns.
Please consult your Marcum LLP Tax Professional today with any questions or concerns regarding how these final regulations might affect your business’ income tax filings today.