Category: Tax Returns, Examinations & IRS Procedure
Subject: Statute of Limitations Issues
Title: Corporate Understatement of Gross Earnings
IRC Sections: 6501(e)
Filename: 1064.html
Date Produced: 9/97 Copyright 1998, The Tax Resource Group. All rights reserved. Telephone
800-578-3498. Internet: www.taxresourcegroup.com Background
Taxpayer is an accrual basis C corporation engaged in the construction business.
Through various errors by a prior accountant, gross income has been understated
for a number of tax years. Specifically, it appears that although the taxpayer
provided adequate information about accounts receivable movement, the prior
accountant booked revenue more-or-less based on cash receipts. The returns
disclose a very low level of accounts receivable, which level grossly understates
the correct balances. In addition, cash receipts were understated because
the taxpayer deposited certain receipts in one or more certificates of deposit
(in the corporate name) which the accountant did not consider at all. The taxpayer wishes to file amended returns
to set all this right as nearly as possible. Some of the tax years are closed
based on the three-year statute of limitations. For many of the tax years
involved, the amount by which gross income is understated exceeds 25% of
reported gross income. Issues
Does the 6-year statute of limitations apply in this case given the amount
of the understatements? Answers
It appears that the 6-year statute does not apply. Discussion
The statute of limitations is expanded to 6 years if a taxpayer omits an
amount of gross income exceeding 25% of reported gross income. IRC Section
6501(e). Normally, this rule is applied only by the Service, not by a taxpayer—although
there is nothing in the literature explicitly dealing with that issue. It
seems to me the IRS clearly has the power to assess tax under Section 6501(e)
if they become aware of a situation to which the rule might apply. Theoretically
at least, it would seem that the necessary IRS awareness could result from
an amended return just as well as from an IRS audit, the more traditional
route to Section 6501(e). In this case, however, I think Section 6501(e)
is inapplicable no matter who asserts it. The pertinent language of the
statute is as follows. If a taxpayer omits from gross income an amount
properly includible therein which is in excess of 25% of the amount of gross
income stated in the return, the tax may be assessed, or a proceeding in
court for the collection of such tax may be begun without assessment, at
any time within 6 years after the return was filed... Notice that the statute uses the phrase omits
from gross income as opposed to something like understates gross income.
In 1958, the Supreme Court ruled that Section 275(c) of the Internal Revenue
Code of 1939 (identical in all pertinent respects to the present-day Section
6501(e) except the 1939 rule extended the statute to only five years) requires
omission of an entire income item as opposed to mere understatement of a
certain item. The court analyzed the legislative history surrounding
the statute and found that Congress felt that if a taxpayer's return does
not give the Service sufficient notice to even know of the existence of
certain type of gross income, the Service should have additional time to
examine the return and assess any resulting tax in order to offset the disadvantage
of having not been notified of the existence of such income in the first
instance. Apparently, if a taxpayer reports some income of the type in question
and merely underreports the correct amount (rather than omitting that type
of income entirely), the enhanced statute of limitations is inapplicable.
See Colony, Inc. v. Cmr., 357 U.S. 28, 58-2 USTC ¶9593. It seems to me the taxpayer in this matter has
more than amply put the Service on notice that income from construction
contracts is part of the taxpayer's business. The taxpayer in this case
has merely, through clear error, understated the correct amount of construction
revenue. In my view, that does not trigger the 6-year statute.Collateral
Issue: IRS Attack
I have significant concerns about what the Service might do if, through
whatever means, they come to understand that significant amounts of revenue
went unreported in closed tax years. I think it might be possible to take
the position that the prior accountant established an incorrect method of
accounting (by essentially booking only cash receipts). Thus, the taxpayer
needs IRS permission to switch to a correct method, and any adjustment related
to past understatements would be pushed through the first open year under
examination. As I understand it, the taxpayer would (if it
were possible) simply file amended returns for all incorrect years. Absent
consideration of penalties, the result of treating the problem as a method
of accounting change would presumably be no worse than filing amended returns
for all years for which an error exists. Collateral Issue: Voluntary Accounting Method
Change
We should not overlook the possibility of using the method of accounting
argument to the taxpayer's advantage. If what has happened could be characterized
as use of an incorrect accounting method (in which expenses were booked
on an accrual basis but revenues were booked on what essentially amounts
to a cash method of accounting), could the taxpayer file a voluntary accounting
method change and be better off in the long run? I am not certain that this
is feasible, and I am not certain how the IRS would view it, but I feel
it should be given due consideration whenever you are in the position to
quantify the amount and timing of past understatements. While such a method
change application would be time consuming and involve payment of an IRS
user fee, it might be possible to push at least some of the adjustment into
the future, avoid some of the interest charges, and audit-proof prior years
with respect to this matter. Note that under this theory, it would be necessary
to file the current tax year based on the existing, incorrect method of
accounting. We should discuss this when you have more extensive
information at your disposal. | 
