In general, the IRS has a period of three years from the later of the due date of a federal income tax return or the date on which it is actually filed to assess additional taxes with respect to that return. However, this period is extended to six years if the amount of gross income omitted from the return exceeds 25% of the amount of gross income actually reported on the return. IRC § 6501(e)(1)(A). Many of the aggressively marketed tax shelter transactions of the 1990’s resulted in the creation of artificially high basis in assets that could then be sold to create losses in order to offset other income or gains. A question arises whether overstating the basis of an asset is equivalent to omitting gross income from the return. In Bakersfield Energy Partners, L.P. v. Commissioner, decided in June, the Tax Court held that only the three-year statute of limitations applies to situations where the taxpayer has deducted an artificial loss as a result of having overstated his tax basis in an asset.
The taxpayers relied on, and the Tax Court followed, an old Supreme Court case called Colony v. Commissioner where the Supreme Court had said that the reason for the six year statute of limitations was to provide protection to the IRS in circumstances where the return itself does not offer any indication that an item is missing. Where basis is overstated in connection with the sale of an asset, the basis amount, as well as the sales price both appear on the return itself. The Supreme Court in Colony and the Tax Court in Bakersfield Energy Partners both concluded that this was adequate notice to the IRS and that only the three-year statute of limitations should be applicable.
This is a very significant taxpayer victory, although somewhat dampened by the fact that shortly after this case, a United States District Court in Brandon Ridge Partners v. U.S. went the other way and held that a basis overstatement can trigger the application of the six-year statute. Nevertheless, the Tax Court case is probably more significant since most taxpayers choose this forum for the litigation of contested tax matters. In addition to Bakersfield Energy Partners, the Court of Federal Claims in Grapevine Imports Limited v. U.S. also held that only the three-year statute of limitations applies to overstatements of basis.