Thought-provokinganalysis and opinion on federal tax issues

ILM 201333008: Reference To S Corporation Return Not In Possession Of IRS At Time Form 1040 Filed Not Adequate Disclosure To Avoid Six-Year Statute Of Limitations

August 17, 2013

by Monte A. Jackel

In ILM 201333008 (released August 16, 2013, and dated June 27, 2013; the text of the legal memorandum is set forth in the Appendix below), the IRS advised that even though a taxpayer’s form 1040 made reference to a form 1120S, the return of an S corporation, this reference was not sufficient to act as a disclosure to avoid the six-year statute of limitations on assessments where more than 25% of the taxpayer’s gross income is omitted from the originally filed tax return. (See section 6501(e)). This was so, the IRS stated, because “Gross income can only be disclosed within the meaning of IRC § 6501(e)(1)(B)(2) if the information necessary to place the IRS on notice of the nature and amount of gross income from the item is in the possession of the IRS when the return is filed.”

Under the facts of this legal memorandum, the taxpayer’s form 1040 referenced a form 1120S as a line item on the form 1040 but the form 1120S was not filed until the 3-year regular statute of limitations on assessment had expired. Thus, as found by the IRS, “For a Form 1120-S to be read as incorporated by reference in the return of the taxpayer, the Form 1120-S must be in existence and within the possession of the IRS. Where a Form 1120-S is not filed until after the return of the taxpayer (Form 1040), the late Form 1120-S should be treated like information found in an amended return and disregarded for purposes of 6501(e) disclosure.” And the IRS also stated, “Any gross income relating to the S-corporation not listed on the face of the Form 1040 (or a referenced document contemporaneously in the possession of the IRS) is an omission.”

The IRS further stated, in regards to whether the disclosure was adequate “to apprise the Secretary of the nature and amount of such item (See section 6501(e)(1)(B)(ii)”:

“The listing of income from an S-corporation on a schedule attached to a Form 1040 is effectively a one line summary of the gross income, exclusions, and deductions of the corporation. ….It speaks to the total gain and loss but does not provide the IRS with the ability to evaluate the accuracy of the determination and does not apprise the IRS of the nature and amount of gross income. Further, in this instance, the information reported was actually misleading….. The taxpayer misstated his net income from the S-corporation and the S-corporation failed to provide the IRS with the Form 1120-S, which includes the information necessary to determine whether that calculation is correct. Taken together these facts constitute a strong indication that the IRS was not on notice of the nature and amount of the item of gross income and therefore, the income was not disclosed for purposes of IRC § 6501(e)(1).”

I smell something not quite right in this analysis. In the legal memorandum, the IRS relied on Houston and Goldring which had held that gross income disclosed in an amended return but not in the original return did not act to shorten the longer statute of limitations, and Insulglass, which had held that information discovered during an audit fell into the same category as income reported on an amended return.

But can it really be right that a document that is referenced in a tax return but is not in the possession of the IRS, such as a contract between the taxpayer and a third party, does not count as adequate disclosure? Under that line of reasoning, a taxpayer would have to attach all sorts of documents to his or her original tax return to allow incorporation by reference to such documents, even though the tax law does not require the filing of those documents with the IRS and an audit of the taxpayer would have then resulted in the IRS asking for the referenced document.

The same should hold true for a referenced form 1120S in a form 1040, I would think. If the IRS had audited the taxpayer’s form 1040, the IRS could have asked for the form 1120S if it was not in its possession. Now, it is true that if the form 1120S had been timely filed the IRS could have audited either or both of the forms 1040 or 1120S but if we are focusing on the form 1040 and whether that return made adequate disclosure of omitted gross income, then it should not matter that the form 1120S had not yet been filed. The IRS could have asked for it.

Even the references to the Houston and Goldring cases do not seem to ring true to me. In the case of determining whether there is an “underpayment” to test for the applicability of the accuracy related penalty under section 6662, Treasury regulation section 1.6664-2(c) treats an amended return that is filed before the IRS starts the process of examining the taxpayer as if the taxpayer had shown the amount of tax on the amended return on the originally filed return. Now, it is indeed true that Houston and Goldring, particularly Goldring, stand for the proposition that when section 6501(e) (or its predecessor, section 275 of the 1939 Code) refers to “the return” it means the original tax return that is filed, section 6664(a), which defines “underpayment” for purposes of the accuracy related penalties, references “his return” and yet the referenced regulation equates a qualified amended return with the originally filed tax return.

It does not seem to me that this legal memorandum is coming to the correct conclusion and it appears to be overreaching. I hope this is not another saga like the last one that the U.S. Supreme Court put to rest relating to whether an overstatement of tax basis was the same as an omission from gross income. Time will tell.

APPENDIX

ISSUES

What value, if any, should be considered to be disclosed on an individual return (Form 1040) from an S-Corporation return (Form 1120-S) filed more than three years after the filing of the Form 1040 for purposes of determining whether there is a substantial understatement of gross income for purposes of applying the six-year statute under IRC § 6501(e).

CONCLUSIONS

The pro-rata share of S-corporation income attributed to the amount disclosed on the original return of the taxpayer is the only income which is disclosed for purposes of IRC § 6501(e)(1). Where information is provided to the IRS after the filing of the return of the taxpayer, that information is not considered to be disclosed on the return and is omitted gross income for purposes of IRC § 6501(e). The determination of whether the six-year statute applies is made at the time the original return is filed. Information discovered or provided by the taxpayer after that return is filed (for example, during an audit, in amended returns, or in subsequent information returns), regardless of whether such information would ordinarily be considered disclosed, is only includable if it is filed with, or prior to, the return of the taxpayer.

FACTS

A taxpayer filed a Form 1040 in year one showing a certain amount of income from a named S-corporation. More than three years after the filing of the Form 1040, and outside of the ordinary three-year period to assess, the S-corporation filed a Form 1120S revealing that the taxpayer’s distributive share of S-corporation income which was in excess of 125% of the sum reported on the taxpayer’s individual return for the tax year (Form 1040). The question is whether or not the Form 1120-S constitutes a disclosure for purposes of IRC § 6501 since it was referenced in the original Form 1040. It does not.

LAW AND ANALYSIS

IRC § 6501(a) generally requires the IRS to assess any tax within three years after the return was filed. For purposes of IRC § 6501(a), a “return” is the return required to be filed by the taxpayer (and does not include a return of any person from whom the taxpayer has received an item of income, gain, loss, deduction, or credit). IRC § 6501(a). There are several exceptions to the three-year period for assessment. IRC § 6501(e)(1) provides that the period of limitation on assessment is extended to six-years when there is a substantial omission of income equal to twenty-five percent or more of the gross income reported on the return.

The purpose of extending the period of limitations under IRC § 6501(e) is to level the playing field when the taxpayer’s omission of income places the IRS at a disadvantage in discovering errors. Colony, Inc. v. Comm’r, 357 U.S. 28, 36 (1958). Under the statute, items which are adequately disclosed in the return (or attachments and schedules), are not considered omissions for purposes of determining a substantial omission. IRC § 6501(e)(1)(B)(ii). In order to adequately apprise the IRS, “The statement must be sufficiently detailed to alert the Commissioner and his agents as to the nature of the transaction so that the decision as to whether to select the return for audit may be a reasonably informed one.” Estate of Fry v. Comm’r, 88 T.C. 1020, 1023 (1987). While a disclosure must be more substantial than supplying the IRS with “a ‘clue’ which would be sufficient to intrigue a Sherlock Holmes”, the disclosure need not recite every underlying fact. Quick’s Trust v. Comm’r, 54 T.C. 1336, 1347 (1970), affd. 444 F.2d 90 (8th Cir.1971); Benson v. Comm’r, T.C. Memo. 2006-55. Although a misleading statement may provide a “clue” to omitted gross income, it does not adequately apprise the IRS of the nature and amount of an item. Phinney v. Chambers, 392 F.2d 680, 685 (5th Cir.1968); Estate of Fry v. Comm’r, 88 T.C. 1020, 1023 (1987).

When an individual’s return contains a reference to other documents or returns, those references can serve as notice to the IRS. Benson v. Comm’r, T.C. Memo. 2006-55; Reuter v. Comm’r, T.C. Memo.1985-607. Specifically, when a return includes a reference to a partnership return, “partnership returns are considered together with individual returns to determine the amount omitted from gross income.” White v. Comm’r, 991 F.2d 657, 661 (10th Cir.1993), affg. T.C. Memo.1991-552; Benson v. Comm’r, T.C. Memo. 2006-55. Similarly, when a return includes a reference to an S-corporation, “the corporate information return on Form 1120-S must be considered along with taxpayers’ individual returns in resolving the issue of adequate disclosure.” Benderoff v. United States, 398 F.2d 132, 135 (8th Cir.1968); see also Roschuni v. Comm’r, 44 T.C. 80, 85-86 (1965).

For a Form 1120-S to be read as incorporated by reference in the return of the taxpayer, the Form 1120-S must be in existence and within the possession of the IRS. Where a Form 1120-S is not filed until after the return of the taxpayer (Form 1040), the late Form 1120-S should be treated like information found in an amended return and disregarded for purposes of 6501(e) disclosure. See Insulglass Corp. v. Commissioner, 84 T.C. 203, 207 (1985). The Tax Court in Insulglass determined that information discovered by the IRS during an audit should be treated as information filed on an amended return. Id. The Tax Court in Insulglass found support in Houston v. Commissioner, 38 T.C. 486 (1962), and Goldring v. Commissioner, 20 T.C. 79 (1953) which held that a taxpayer’s filing of an amended return that includes in income amounts which had been omitted from the original return does not prevent the IRS from invoking the six-year period provided in section 6501(e)(1)(A), based upon the omission from the original return, even though the amended return disclosed the previously omitted items. Id. This understanding of the necessary timing of the disclosure naturally extends to, and answers the question raised here.

Even if the IRS read the Form 1120-S as an addendum to the Form 1040, the late filed Form 1120-S would be the true equivalent of an amended return since it was filed after the original return and would alter representations made in the original. Gross income can only be disclosed within the meaning of IRC § 6501(e)(1)(B)(2) if the information necessary to place the IRS on notice of the nature and amount of gross income from the item is in the possession of the IRS when the return is filed. The Form 1120-S had not yet been submitted to the IRS and at the time the taxpayer’s return was filed, it provided no information as to the nature or amount of gross income. Therefore, the delinquent Form 1120-S cannot constitute a disclosure. The IRS simply cannot be said to be on notice of information contained in documents, incorporated by reference, when those documents do not yet exist (or at least have not yet been filed).

The Form 1120-S is due to the IRS on the fifteenth day of the third month of the year. That is one month prior to when the individual Form 1040 is typically due. Therefore, the Form 1120-S, if filed timely, should already be within the possession of the IRS at the time the individual return is filed. Where the Form 1120-S is filed after the original individual return, the IRS is not required to consider a theoretical, non-existent Form 1120-S in conjunction with the Form 1040. In this instance, the Form 1120-S cannot be said to be incorporated into the original Form 1040 and therefore the information reported thereon was not disclosed for purposes of IRC § 6501(e)(1). Where the IRS is forced into the disadvantageous position of reviewing an individuals return without the benefit of the Form 1120-S, the taxpayer loses the benefit of any protection the disclosures in that Form 1120-S may have provided.

The listing of income from an S-corporation on a schedule attached to a Form 1040 is effectively a one line summary of the gross income, exclusions, and deductions of the corporation. See Estate of Klein v. Comm’r, 537 F.2d 701, 704 (2nd Cir. 1976). It speaks to the total gain and loss but does not provide the IRS with the ability to evaluate the accuracy of the determination and does not apprise the IRS of the nature and amount of gross income. Further, in this instance, the information reported was actually misleading. While a misleading statement may provide a “clue” to omitted gross income, it does not adequately apprise the IRS of the nature and amount of an item. Phinney v. Chambers, 392 F.2d 680, 685 (5th Cir.1968); Estate of Fry v. Comm’r, 88 T.C. 1020, 1023 (1987). The taxpayer misstated his net income from the S-corporation and the S-corporation failed to provide the IRS with the Form 1120-S, which includes the information necessary to determine whether that calculation is correct. Taken together these facts constitute a strong indication that the IRS was not on notice of the nature and amount of the item of gross income and therefore, the income was not disclosed for purposes of IRC § 6501(e)(1).

In order to determine whether or not there is a substantial understatement of gross income for the purpose of applying the six-year statute under IRC § 6501(e)(1), we must consider the amount of S-corporation income listed on the original return. Any gross income relating to the S-corporation not listed on the face of the Form 1040 (or a referenced document contemporaneously in the possession of the IRS) is an omission.

Also note that Treas. Reg. § 1.1366-1(c)(2) defines gross income of an S-corporation shareholder for purposes of IRC § 6501(e)(1).1 The S-corporation’s gross income attributable to the undisclosed taxable income is considered to be omitted.

1 Gross income for substantial omission of items — (i) In general. For purposes of determining the applicability of the 6-year period of limitation on assessment and collection provided in section 6501(e) (relating to omission of more than 25 percent of gross income), a shareholder’s gross income includes the shareholder’s pro rata share of S corporation gross income (as described in section 6501(e)(1)(A)(i)). In this respect, the amount of S corporation gross income used in deriving the shareholder’s pro rata share of any item of S corporation income, loss, deduction, or credit (as included or disclosed in the shareholder’s return) is considered as an amount of gross income stated in the shareholder’s return for purposes of section 6501(e).

(ii) Example. The following example illustrates the provisions of paragraph (c)(2)(i) of this section: Example. Shareholder A, an individual, owns 25 percent of the stock of Corporation N, an S corporation that has $10,000 gross income and $2,000 taxable income. A reports only $300 as A’s pro rata share of N’s taxable income. A should have reported $500 as A’s pro rata share of taxable income, derived from A’s pro rata share, $2,500, of N’s gross income. Because A’s return included only $300 without a disclosure meeting the requirements of section 6501(e)(1)(A)(ii) describing the difference of $200, A is regarded as having reported on the return only $1,500 ($300/$500 of $2,500) as gross income from N.


  • Richard_Jacobus

    ILM 201333008 does not overreach as you suggest. Section 6501(e)(1) hinges exclusively on what the taxpayer discloses on his return when it is filed. The taxpayer is the sole and complete master of what he discloses on his return when he files it. Later events cannot alter the adequacy of the taxpayer’s return disclosures on the date the return was filed. The IRS does not get to choose what the taxpayer discloses on his return when filed. Accordingly, a taxpayer cannot rely later on hypothetical supposition about what the IRS could have learned had it only asked the right questions upon looking at the return, because adequate disclosure “require[s] that the tax return reveal more than obscure, disconnected marks on a treasure map which the IRS was expected to decipher at its peril.” In other words, “the adequate disclosure standard is not met by a retrospective demonstration that the transaction was not so well concealed that a competent IRS agent could not have unraveled the scheme given diligent efforts. Such a standard would turn the statute on its head and turn the inquiry from the adequacy of Debtors’ disclosure to the effectiveness of its efforts at concealment.” In re G-I Holdings Inc., 2006 WL 2595264, reconsideration denied, 2006 WL 3511150 (D.N.J. 2006).

    • http://www.jackeltaxlaw.com/ Monte Jackel

      Richard. I do not think that your reference to the language in G-I Holdings is completely on point with the issue presented in the ILM. G-I Holdings cites two conflicting lines of authority. One is represented by Univ. Country Club, 64 T.C. 460, where the Tax Court determined that disclosure would be adequate if a reasonable follow up from the tax return would lead to the ultimate adjustment. That kind of authority would clearly support what I am saying. The other line of authority was CC&F Western Operations, 273 F. 2d 402, which the district court in G-I Holdings adopted (it was a First Circuit decision) where the test is whether disclosure occurs in substance. The G-I Holdings court had both the partner’s return and the partnership’s return before it and concluded, with the language you quote, that disclosure was not adequate looking at both tax returns. In the ILM, the IRS makes a blanket statement that the 1120S could not be considered at all because it was not filed on or before the date when the form 1040 was filed. We do not know whether, if the form 1120S was timely filed, whether disclosure would have been adequate looking at both the 1040 and the 1120S. The answer could be yes or it could have been no. My principal point with the ILM is my objection to the flat out rejection of a late filed information type tax return that could have been requested by the IRS because it was referenced in the 1040. It could be that the disclosures made in the 1120S would be inadequate and fall within the purview of what you reference from the court’s language in G-I Holdings. But G-I Holdings and the ILM are separate fact patterns and different types of cases and that is my principal point here.

      • Richard_Jacobus

        Monte, you put your finger on the crux of the dispute in G-I Holdings. That is, does section 6501(e)(1)(B)(ii) impose a duty of adequate disclosure on the taxpayer, or a duty of inquiry on the IRS? The taxpayer argued that the corporate return and related partnership return provided a “clue” that should have led a reasonable revenue agent to inquire further about a potential omission of gross income from a disguised sale under section 707(a)(2)(B). Rejecting that contention, the district court followed the First Circuit’s reasoning in CC&F and focused on whether the returns disclosed the material facts of the disguised sale in substance. They did not.

        G-I Holdings and University Country Club, 64 T.C. 460, are consistent in an important sense. In University Country Club, the Tax Court rejected the taxpayer’s contention that the adequacy of a return disclosure is determined from the viewpoint of an ordinary “reasonable man,” not the arguably more perceptive eyes of a reasonable revenue agent. 64 T.C. at 471; see also Mariani Frozen Foods, Inc. v. CIR, 81 T.C. 448, 504-05 (1983) (same). Similarly, in G-I Holdings, the court accepted the government’s argument that the contents of the tax returns should be viewed through the eyes of a hypothetical reasonable man, and rejected the taxpayer’s position that the IRS had a duty to inquire about information extrinsic to the returns.

        The basic problem, as the G-I Holdings court recognized, is that construing section 6501(e)(1)(B)(ii) so as to impose a duty of inquiry upon the IRS invites speculation about whether an examining revenue agent “would” or “should” perceive a large omission of gross income. Conversely, there are sound reasons to construe the statute as imposing a duty of disclosure on the taxpayer. First, by giving taxpayers the opportunity to cut off the statute of limitations at the usual three years, rather than the extended six-year period, by adequately disclosing omitted gross income on the return, Congress plainly meant to encourage more, not less, disclosure by taxpayers. Surely Congress did not intend that taxpayers should play the audit lottery, then, if caught, respond with creative arguments to the effect that a blindfolded IRS should have done a better job of playing pin the tail on the donkey.

        Second, imposing a duty of disclosure on the taxpayer is consistent with the allocation of the burden of proof concerning adequate disclosure. Hoffman, 119 T.C. 140, 146 (2002). Stated differently, in choosing what to disclose on his return, the taxpayer enjoys the advantage of asymmetric information (since the IRS is rarely a party to the private transactions reported on the return). As with the allocation of the burden of proof, imposing a duty of adequate disclosure on the taxpayer somewhat levels the informational playing field.

        Third, as a practical matter the IRS’s later discovery of information cannot change, for better or worse, the contents of a tax return on the date it was originally filed. Therefore, as you note by reference to the Houston and Goldring cases, the taxpayer’s later disclosure of information by filing an amended return does not “relate back” and enhance the adequacy of disclosures on the originally filed return. See also Badaracco, 464 U.S. at 394, 401 (taxpayer’s filing of nonfraudulent amended return does not cure fraudulent original return). Likewise, an IRS agent’s discovery of additional information in the course of examining a return cannot alter the information the taxpayer chose to provide in his return as originally filed. Insulglass, 84 T.C. at 207; see also Bishop v. United States, 338 F. Supp. 1336, 1349-53 (N.D. Miss. 1970) (same), aff’d without opinion, 468 F.2d 950 (5th Cir. 1972); Mel Dar Corp. v. Commissioner, T.C. Memo. 1960-56, 1960 WL 756 (1960) (same), remanded on unrelated ground, 309 F.2d 525 (9th Cir. 1962). Again, if information subsequently discovered by the IRS mattered, that would open all adequate disclosure cases to endless conjecture about how IRS agents ought to examine returns – an inquiry nowhere mentioned by section 6501(e)(1)(B)(ii).

        Even worse, it would make the adequacy of a return’s disclosures a subject of “expert” testimony. To illustrate, G-I Holdings hired a former Assistant Commissioner—Examination (a position predating the IRS reorganization that followed RRA ’98) as an expert witness on the adequate disclosure standard. The gentleman wrote an extensive report that said little about how the corporate and partnership returns disclosed the complicated underlying transaction (undoubtedly because so little was disclosed), but opined at length about how an experienced IRS agent should have spotted the omitted gross income. At the expert’s deposition, a DOJ attorney devised an ingenious hypothetical.

        Q: Assume the taxpayer files a return, omits a large amount of gross income, and discloses nothing about the transaction. Assume, further, that two years later an informant walks into the IRS office and hands over a black book that contains all of the information about the undisclosed transaction. In your opinion, does the informant with a black book make the original return disclosure adequate?

        A: No. It doesn’t change what the return said.

        Game, set and match. Based in part on the expert’s admission, the district court rejected G-I Holdings’s contention that it had met the adequate disclosure test under section 6501(e)(1)(B)(ii) on the theory that a reasonable revenue agent “should” have spotted the disguised sale issue.

        All that said, I agree the reasoning of ILM 201333008 should be limited to its factual context. The extreme tardiness of the Form 1120S, filed more than three years after the S corporation shareholder filed his Form 1040, is a distinctive factor. Had the Form 1120S been filed within a reasonably short time after the shareholder’s Form 1040 was filed, perhaps the IRS would reconsider whether the Form 1120S should play a part in the adequate disclosure analysis.

        • http://www.jackeltaxlaw.com/ Monte Jackel

          Richard. A very thoughtful response. Everything you say makes sense. However, I believe that the ILM is still overreaching because it is attempting to establish a rule of law that all referenced documents, which appears to include more than just other tax returns referred to in the originally filed return but all other referenced documents as well, must be in the possession of the IRS when the original return is filed. And I don’t think that the decision to allow other referenced documents to be incorporated by reference can or should be left to the discretion of the IRS. What is needed here, I think, is a concept similar to the “qualified amended return” rules of sections 6662 and 6664 where, if the other referenced return is filed before first contact by the IRS, then it is taken into account as if all information in both the originally filed tax return and the qualified amended return (which will most likely be an information type return such as form 1120S or form 1065, or even a form 8865 or 5471) were contained in the originally filed return. Perhaps because this was just an internal IRS document that the language used was careless and that more thought would have been given if this had been a revenue ruling, regulation or like. And that is what I think is needed here now-a regulation or at the least a revenue ruling bringing the qualified amended return rules into play for section 6501(e) purposes. The decision to allow a referenced document to be considered just cannot, as a matter of fundamental fairness and good tax policy, be left to the unchallenged discretion of the IRS.

          • Richard_Jacobus

            You probably are correct that the nonprecedential ILM was given insufficient thought. The section 6501(e) adequate disclosure standard has been around for 60 years. A Treasury regulation providing guidance, including illustrative examples, is long overdue (as I told Chief Counsel at the time of the vexatious G-I Holdings dispute to no avail). As an initial reaction, your idea of applying a QAR concept in the section 6501(e) context has merit. It would give taxpayers an incentive to come forward and disclose potentially controversial transactions before the SOL runs, and, in fairness, the IRS would ignore such a filing at its peril.

          • Richard_Jacobus

            Let me add that if, as you say, the ILM “is attempting to establish a rule of law that all referenced documents,” not just other tax returns, “must be in the possession of the IRS when the original return is filed,” it is hard to imagine how the IRS can persuade a court to accept that position. Another G-I Holdings anecdote will illustrate. Twice the government filed a partial summary judgment motion on the adequate disclosure issue under section 6501(e). The issue was argued in mid-2003 before one district court judge, who denied the motion as premature. In late 2005 the government renewed its partial summary judgment motion. After the first judge retired in early 2006, another judge heard oral arguments on the adequate disclosure issue in the summer of 2006.

            Here’s the takeaway. Both judges expressed the concern that the adequate disclosure standard should not be construed to mean the taxpayer must disclose every single fact about the transaction at issue, or attach the relevant contracts to the originally filed return. (In the case of the G-I Holdings transaction, the relevant contracts comprised thousands of pages.) To address this concern, government counsel argued that G-I Holdings needed to disclose only a few major facts on the return (chiefly the interrelationship between the partnership’s formation and the taxpayer’s simultaneous receipt of $450 million from bank financing) in order to attain the adequate disclosure safe harbor; that there was no requirement to attach the underlying contracts to the return; and that it would suffice to attach to the return a short narrative description of the transaction, no more than a couple of paragraphs. This satisfied the judges that the government was not overreaching.

            If the ILM signifies that someone at the IRS thinks section 6501(e)(1)(B)(ii) requires a much greater quantum of disclosure, I would not want the job of arguing that position to a judge.