Partnership's Reporting of Partial Gain Was Enough to Preclude Extension of Statute

(Parker Tax Publishing December 2019)

The Tax Court held that the statute of limitations period for assessing deficiencies on a partnership's return was not extended from three years to six years even though the partnership did not report the full amount of its gain on a post-sale liquidation on its return. The court concluded that, while the return reported only 19.99 percent of the gain instead of the 100 percent that should have been reported, the return did not "omit" an item of gain entirely but rather reported an incorrect amount. Beverly Clark Collection, LLC v. Comm'r, T.C. Memo. 2019-150.

Background

From 1987 to 2000 Nelson and Beverly Clark owned a wedding accessories business, the Beverly Clark Collection, which they operated as a sole proprietorship. In 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 percent of BCC's equity, with the Clarks each receiving 50 percent 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 percent interest in BCC to Fausset Trust in exchange for a $10.4 million 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. The IRS 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.

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 approximately $13.3 million 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 the sale of its assets to Maplewood LF Investors, LLC. The Clarks' 2000 Form 1040 reported approximately $2.1 million of gross proceeds and $1.4 million of gain from the post-liquidation sale of BCC's assets and goodwill. The Clarks also reported gross income of almost $812,000 for 2000. BCC's 2000 Form 1065 reported a $10.5 million distribution of property and the Clarks' 2000 Schedules K-1 each reported a flowthrough loss of approximately $7.3 million. 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.

The IRS issued an FPAA to Beverly Clark on August 25, 2008, challenging the reported tax consequences described above. The parties agreed that the FPAA was issued more than three but less than six years after the close of the relevant tax years (plus extensions of time for assessment).

Beverly Clark filed a motion for summary judgment on the basis that the applicable limitations period was three years, not six, and therefore the assessment of any tax stemming from the adjustments set forth in the FPAA was time barred. The IRS objected that the applicable period is six years because there was substantial omitted income within the meaning of Code Sec. 6501(e)(1)(A). The IRS offered two theories in support of this argument. First, the IRS argued that substantial omitted income arose from the Clarks' overstated bases in their interests in BCC. Second, the IRS argued that the Clarks' 1999 sale of 80.01 percent of their interest in BCC to Fausset Trust was a sham and should be disregarded, and, therefore, the Clarks were required to report the entire $12,990,000 in sale proceeds that the IRS determined arose from the 2000 post-liquidation sale of BCC's assets. According to the IRS, the omission of 80.01 percent of the sale proceeds resulted in a substantial omission of income and triggered the six-year statute of limitations period under Code Sec. 6501(e) as to the Clarks' return and, therefore, as to BCC's return under Code Sec. 6229(c)(2), making the FPAA timely.

The Tax Court granted summary judgment to Beverly Clark after finding that the statute of limitations period was three years and therefore had expired. The court based its decision on its opinion in Bakersfield Energy Partners, LP v. Comm'r, 128 T.C. 207 (2007), aff'd, 568 F.3d 767 (9th Cir. 2009), and did not address the IRS's sham transaction argument. The Tax Court specifically noted that Bakersfield held that an overstatement of basis is not an omission of gross income triggering application of the six-year period of limitations. The IRS appealed that decision to the Ninth Circuit. The IRS abandoned its overstatement of basis argument after the U.S. Supreme Court decided United States v. Home Concrete & Supply, LLC, 566 U.S. 478 (2012). In an unpublished opinion, the Ninth Circuit vacated the Tax Court's decision so the Tax Court could consider the IRS's remaining argument that the limitations period remained open because the 1999 sale was a sham.

The IRS contended that the omission of the $12,990,000 of proceeds of the post-liquidation sale was an omission in excess of 25 percent of the gross income the Clarks reported on their 2000 Form 1040 and BCC reported as attributable to the Clarks on its 2000 Form 1065. Therefore, the IRS argued, the six-year period of limitations applies, and the FPAA issued to Beverly Clark was timely.

Analysis

Because the question of whether the 1999 sale was a sham was a genuine factual dispute material to the IRS's argument against summary judgment, the Tax Court said it would assume that it was so for purposes of deciding the issue at hand. The Tax Court agreed that, assuming the 1999 sale was a sham, the Clarks should have reported gain on the full amount of the proceeds of the post-liquidation asset sale -- $12,990,000.

The question addressed by the court was whether the Clarks' failure to report the other 80.01 percent of the gain was an omission for purposes of the six-year statute of limitations period. The parties agreed that the Clarks reported gain attributable to the total 19.99 percent interest in BCC that they claimed to retain after the sham transaction. One could argue, the court said, that the Clarks omitted the entire amount of gain allocated to Fausset Trust. But, the court observed, the result of the IRS's sham-sale theory was that the Clarks should have reported 100 percent of the gain on the post-sale liquidation rather than 19.99 percent. And because they reported 19.99 percent of the gain rather than 100 percent, the court held that they did not "omit" an item of gain entirely but rather reported an incorrect amount, and thus the six-year statute of limitations did not apply.

For a discussion of when the six-year statute of limitations applies, see Parker Tax ¶260,130.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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