As I am both preparing materials for co-teaching tax procedure this spring in the Villanova Graduate Tax Program with my colleague Jason Kuratnick and updating parts of Saltzman & Book chapter 5 dealing with statutes of limitation, I came across an interesting Chief Counsel Advice from this past summer. CCA 201333008 considers Section 6501(e). Tax procedure fans know that Section 6501(e)(1)(A) 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. Section 6501(e)(1)(B) essentially provides that omitted income items are disregarded if they are adequately disclosed.
The CCA considers the disclosure issue in the context of an individual and an S Corporation. In particular, the CCA reveals the IRS’s view as to what is considered to be disclosed on an individual’s return when an S Corporation return (1120-S) that is filed late shows that the individual understated her pro-rata share of the S corporation’s income. The short answer is that the CCA found that the information on the late filed S Corporation return was not considered to be disclosed on the individual’s return. The facts and rationale are interesting, and the following post addresses what is disclosure in this general context, and when the Service must receive a document for it to count.
A Little Context: S Corporations
While at some level this post addresses a dry technical issue (and I might add that as a tax proceduralist I think there’s nothing wrong with just that), it relates to bigger issues of tax administration. S corporations are corporations that elect to pass corporate income, losses, deductions and credit through to their shareholders. Shareholders report the items on their individual tax returns, and are subject to tax at their individual tax rates.
S Corporations constitute a significant portion of all business tax returns, and their use has grown substantially over time. To illustrate, a 2012 JCT Report on taxpayer choice of business entities looking at IRS SOI data shows that in 2009 there were over 4 million S Corporation returns, accounting for over 12% of all business entities. Only just 20 years or so before, S Corporations accounted for slightly less than 6% of all business entities.
With the increase in use of S Corporations, there has been concern about S Corporation tax compliance issues. A 2010 GAO Report illustrates how S Corporations contribute to the underreporting tax gap. I will not go deeply into that report, but suffice to say GAO found lots of compliance issues. For example, at around p. 10, looking at IRS National Research Program data from 2003 and 2004, GAO found that approximately 68% of S Corporation returns misreported at least one item affecting net income.
Brief Summary of the SOL Rules
How do the SOL rules in 6501(e)(1) deal with S Corporations? Some technical tax procedure context follows. Section 6501(e)(1)(A) provides in relevant part that “if the taxpayer omits from gross income an amount properly includible therein and such amount is in excess of 25 percent of the amount of gross income stated in the return…the tax may be assessed, or a proceeding in court for collection of such tax may be begun without assessment, at any time within 6 years after the return was filed.” For these purposes, the CCA notes that any gross income allocable to the S Corporation “that is not listed on the face of the Form 1040 (or a referenced document contemporaneously in possession of the IRS) is an omission.”
The CCA rightly points to cases for the proposition that when an individual’s return contains references to other tax returns, those other returns can serve as notice that will constitute disclosure for purposes of considering whether an item is omitted. For example, in White v Commissioner, 991 F.2d 657 (10th Cir. 1993) the Tenth Circuit held that where an individual return referenced a partnership return the partnership return and the individual return together are considered together to determine if the taxpayer has adequately disclosed the item.
In Benderoff v US, 398 F. 2d 132 (8th Cir. 1968) the Eighth Circuit reached a similar result when an individual S Corporation’s shareholder’s return understated income attributable to the S Corporation but also included a reference to an S Corporation. In Benderoff, the court stated that
the corporate information return on Form 1120-S must be considered along with taxpayers’ individual returns in resolving the issue of adequate disclosure. The purpose of the required corporate information return would appear to be to provide the government with information as to the accuracy of the shareholders’ return of Subchapter S corporate income. Without Form 1120-S, there would have been no means of checking the corporate income and the persons chargeable with receiving constructive distribution from the corporation. It would appear that the Form 1120-S return serves the same purpose as a partnership information return.
Bringing it Back: the CCA’s Twist
So, the law is pretty clear that for purposes of determining whether an individual S Corporation shareholder has adequately disclosed an item of income on a 1040, the individual can point to a Form 1120-S (S Corp return) in addition to the 1040 itself if the 1040 at least puts the Service on notice of the existence of a particular S Corporation. In the CCA, the wrinkle that the Service considered was the effect of a late-filed 1120-S. In particular, the 1120-S at issue in the CCA (which showed the shareholder’s distributive share of the S Corp income as in excess of 125% of what was actually reported on the 1040) was filed outside of the ordinary three-year period to assess the individual’s liability attributable to the understatement of the allocable portion of the S Corporation’s income. The filing of that return after the three-year period to asses the individual’s liability from the understated S Corp income thus did little as practical matter toward putting the Service on notice as to the “nature or amount of gross income” that should have been reported from the S Corporation. The CCA stated that the Service should disregard that late filed 1120-S, and that the disclosure on an 1120-S was limited to one that was filed “with, or prior to, the return of the taxpayer.”
As support for its conclusion that to be sufficient for disclosure purposes the 1120-S had to be in possession of the Service at the time of the filing of the 1040, the CCA cited cases that disregarded information submitted to the IRS in an amended return (Goldring v Comm’r, 20 TC 79 (1953)), and documents submitted to the IRS during the course of an audit of the original return (Insulglass v Comm’r, 84 TC 203 (1995)).
It is safe to say that the Service will disregard a really late filed 1120-S as in the case in the CCA where the filing of the delinquent 1120-S was outside the normal three-year assessment period. But should in all circumstances the Service disregard a 1120-S if it is not in possession of the IRS at the time the individual files the 1040? The CCA noted that the 1120-S is due to the IRS on the 15th day of the third month of the year, and that the normal timely-filed 1120-S is due one month prior to the time that the individual’s 1040 is typically due. In light of the normal deadlines, the CCA stated that a timely filed 1120 S “should already be in possession of the IRS at the time the individual return is filed.” What if the 1120-S was filed only a little bit late, but still after the filing of the 1040? The CCA does not directly consider this situation, though its statement that the 1120-S must be in possession of the IRS at the time of the filing of the 1040 suggests that it will disregard any late-filed 1120-S for purposes of considering whether the individual taxpayer has adequately disclosed an omitted item.
The CCA does not also address situations where there may be no delinquencies in the S Corporation return but the return is not in possession of the IRS—such as, for example, if the S Corporation return is on extension, or if the individual files the return before the return’s due date and prior to the filed 1120-S.
Language in the CCA suggests that the key is whether at the actual time of the individual’s filing the 1120-S is in the Service’s possession, but in examples I posit a taxpayer has a stronger chance of a court finding that the 1120-S could still serve as adequate disclosure. After all the purpose of the disclosure exception as the Supreme Court said way back in Colony v Comm’r was to level the playing field when the omission puts the Service at a disadvantage. The disadvantage is less pronounced when the 1120-S is filed close in time to the filed 1040 and when the normal three-year statute of limitations on assessment is still open. In addition, unlike in Goldring, where the Tax Court disregarded information in an amended return in part because the Service’s acceptance of an amended return is without statutory basis, an original filed return has no such limit.
I suspect that the redacted portion of the CCA may have addressed some of these or similar scenarios. In any event, in the future, I would not be surprised to see courts and IRS dealing with situations where the literal language of the CCA would suggest that there was not adequate disclosure.