Category: Tax Returns, Examinations & IRS Procedures; Accounting Periods & Methods
Subject: Examinations
Title: Statute of Limitations for Individual Examinations
IRC Sections: 6501(e)
Filename: 1357.html
Date Produced: 11/93

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An individual taxpayer (TP) sold property on the installment basis in 1986. That year is statute barred even under a six-year statute of limitations. The property sold was encumbered by a mortgage in excess of the taxpayer's basis in the property. TP did not recognized such excess in the year of sale as is required. Also, TP used a gross profit percentage of 60+, and it appears that the appropriate percentage should have been 100.

TP's 1989 return is under examination by the IRS and the examining agent has contended that the amount not recognized in 1986 should be recognized in the 1989 tax year.

Issues
1. Is it appropriate to recognize in the 1989 return the income improperly excluded from the 1986 return?

2. Is it possible for the IRS to adjust 1987 and 1988 (which are closed based on the normal three-year statute of limitations) to correct the improper gross profit percentage.

Answers
1. The IRS is barred from adjusting 1989 to correct for TP's having improperly excluded gain on the 1986 return. However, the IRS is not barred from using the correct gross profit percentage with respect to 1989 collections.

2. Assuming the six-year statute of limitations is not applicable, the IRS is barred from adjusting the gross profit percentage for tax years 1987 and 1988.

Discussion
In the case of Arthur F. Brook, 28 TCM 1240, the taxpayer sold property on the installment basis. In 1955, a closed tax year, that taxpayer received a payment which was not taken into account in the tax return for that year. The IRS sought to adjust the gross profit percentage in subsequent years to correct for the error made in 1955. The court held that to make such an adjustment was tantamount to opening a closed tax year and thus found in favor of the taxpayer.

Also, in Letter Ruling 8326002, the IRS ruled that the tax effect of an error made in a closed installment sale year could not be pushed through a subsequent open year. In the ruling, the taxpayer sold property on the installment basis and failed to recognize depreciation recapture in the year of sale. The IRS ruled that a subsequent year allocation of income as between ordinary and capital gain could not be disturbed in order to correct the error in the prior year. The author of the ruling cited A.F. Brook as precedent. NOTE THAT UNDER §6110(j), LETTER RULINGS CANNOT BE CITED AS PRECEDENT. It is merely instructive to view how the IRS has ruled on another taxpayer's case in order to understand how the National Office of the IRS might react to one's own situation.

Nothing prevents the IRS from using the corrected gross profit percentage in open years. In both the case and the letter ruling cited above, the IRS attempted to push through the current tax year the cumulative tax effect of an error in a prior closed year. Neither the pro-taxpayer stance in the case and ruling nor anything else would seem to prohibit the IRS from simply using the correct gross profit percentage for the 1989 return.

It is clear that an error with respect to reporting installment sales can invoke the six-year statute of limitations under §6501(e) if the amount of gross income excluded as a result of the error exceeds 25% of the gross income shown on the return. Estate of E.R. Frane, TC Decision 48,115. Accordingly, if the use of incorrect gross profit percentages for 1987 and 1988 resulted in an understatement of gross income in excess of 25% of the gross income actually reported for those years, the six year statute of limitations could be invoked (for either or both years) and the correct gross profit percentage used. However, since you believe that the understatements for 1987 and 1988 do not rise to the 25% level, it appears that the Service would be statute barred from making such adjustments in 1987 and 1988.