TC Ruling on Six-Year SOL

In Harlan, 116 TC No. 4 (2001), the Tax Court ruled that a partner in a partnership that itself is a partner in another partnership can include in gross income his share of both partnerships' gross income for purposes of the six-year statute of limitations (SOL) for assessing tax deficiencies under Sec. 6501(e). The ruling increases the probability that a taxpayer will not be subject to the six-year rule, and instead the normal three-year SOL will apply.

In general, Sec. 6501(a) bars assessment of an income tax deficiency more than three years after the later of the date the return was filed or due. Sec. 6501(e) provides for a six-year SOL if a taxpayer improperly omits from gross income more than 25% of "the amount of gross income stated in the return." The correct amount of gross income is therefore not part of the fraction in applying this six-year rule. Case law has established that the Service has the burden of proving that the 25% test is satisfied. "Gross income" has a well-established meaning under Sec. 61(a), which contains a partial list of items includible in gross income. Sec. 6501(e)(1)(A) contains two modifications: (1) gross income from a trade or business is not reduced by the cost of sales and (2) items adequately disclosed in the return are not deemed omitted.

A partnership is not a taxable entity; however, it must file an information return. Under Sec. 702(a) and (b), partners take into account their share of partnership items on their individual returns, and these items retain their character. Sec. 702(c) requires that whenever a partner's gross income is to be determined, he must include his distributive share of the partnership's gross income.

Ridge and Marjorie Harlan were partners in several first-tier partnerships. Two of these partnerships, Carlyle and Pacific, were partners in one or more other partnerships, making them second-tier partnerships. In June 1992, the IRS issued a deficiency notice for their 1985 return. The issue in Harlan is how to calculate the taxpayer's "gross income stated in the return" under Sec. 6501(e) when the taxpayer is a partner in tiered partnerships.

The parties stipulated that the Harlans' gross income was $1,410,077, which included the gross income from their first-tier partnerships but included only net income or loss amounts from the second-tier partnerships. (These net amounts flowed from the second-tier to the first-tier partnerships.) The record in Harlan did not contain the gross income amounts from the second-tier partnerships, but did contain gross income, net income and loss amounts from the first-tier Pacific real estate partnership. Pacific reported a total (net) loss of $248,153 for 1985. The Harlans' share flowed to their Schedule E and Form 1040. Yet Pacific's gross income was $1,013,673, which included $949,950 gross gains from property sales on Form 4797, Sales of Business Property. This illustrates the dramatic difference between total (net) income or loss and gross income from a partnership. Included in Pacific's loss of $248,153 was a loss from second-tier partnerships of $7,705. The gross income used to calculate this loss was not reported in Pacific's Form 1065, U.S. Partnership Return of Income, nor was it part of the Harlans' gross income of $1,410,077.

The Harlans argued that, because Sec. 702(c) and the regulations require that a partner's gross income include his distributive share of the partnership's gross income, the same rule applies in determining the partnership's gross income when it is a partner in another partnership. The Service argued that the Code and regulations require only the partner's return, and not the partnership returns, be considered in determining the partner's gross income. The IRS alternatively argued that, if gross income amounts from the partnership returns are allowed in determining the partner's gross income, only the first-tier partnerships should be used and the partnership's gross income should not include Form 4797 property sales.

The Tax Court first ruled that gross income is not stated on Form 1040, and that Form 1040's "total income" does not equal Sec. 6501(e) gross income, because total income includes several net amounts from Schedules C, D, E, F, etc. Therefore, the forms attached to Form 1040 must be used to construct a taxpayer's gross income. Also, citing previous cases, the court pointed out that Form 1065 first-tier partnership returns and various forms attached to them are properly used to determine a partner's gross income from partnerships, because the amounts from Form 1065 that flow to Schedule E are net amounts. "Total income" on Form 1065 is also a net amount. Therefore, the various forms (including Form 4797) attached to first-tier partnership returns must be examined to determine a first-tier partnership's gross income.

The Tax Court ruled that the same analysis must be applied to determine gross income from a second-tier partnership; without second-tier partnership gross income, the gross income of the first-tier partnership and the partners cannot be determined. Also, because a partnership is not a taxable entity, its return is considered part of the partner's return in calculating the partner's gross income. Therefore, the Harlans' stipulated gross income of $1,410,077 is too low for Sec. 6501(e) purposes, as it includes net (not gross) income from the second-tier partnerships. Finally, responding to the Service's concern that its ruling might require an audit of all of the tiered partnerships to determine the partner's gross income, the Tax Court ruled that audits would not be necessary. Instead, the same scrutiny should be applied to the second-tier partnerships as has been applied in the past to the first-tier partnerships (i.e., to examine the information on these returns).

Harlan is a clear victory for partners attempting to avoid tax deficiencies under the Sec. 6501(e) six-year SOL. The Tax Court also implied that its ruling would apply to other passthrough entities, such as S corporations. (Although S corporations cannot own other S corporations, an S corporation can be a partner in a partnership.) However, it is very possible that the Service will appeal Harlan, given its importance.

From Peter C. Barton, MBA, CPA, J.D., Professor of Accounting, and Clayton R. Sager, Ph.D., Associate Professor of Accounting, University of Wisconsin-Whitewater, White-water, WI (Neither associated with BDO Seidman LLP)