With Taxpayer Assistance, IRS Finally Wins a Basis Shifting Partnership Six Year Statute Case

In a case where defeat was effectively snatched out of the jaws of victory, the way a transaction was reported on a return opened up the six year statute of limitations even though the actual transaction in question was not what the IRS planned to assess tax on.

In the case of Highwood Partners v. Commissioner, 133 TC No. 1, the Tax Court again visited the application of §6501(e), an area that had generated a series of IRS losses related to various marketed tax shelter programs. Highwood was another such transaction and, you might expect, the IRS would be facing problems again. Most recenty, the Tax Court in the Beard case (TC Memo 2009-184) had held that an overstatement of basis did not trigger the six year statute, agreeing with recent decisions in the Federal Circuit (Salman Ranch, Ltd.) and the Ninth Circuit (Bakersfield Energy Partners).

But in this case the Tax Court, facing another structure that was using the partnership IRC provisions to attempt to boost basis via a vehicle that would not count a liability to reduce basis on contribution, found that how the taxpayers had reported the underlying transaction on the return triggered the application of the six year statute even though the proper net loss on sale was reported for the specific transaction in question. The opening of the six year statute allowed the IRS to assess tax for what it would argue was the overstatement of basis on the subsequent sale of assets that passed through the partnership and received “extra” basis upon liquidation of the partnership.

In this case, the taxpayers had bought offsetting options. They paid $8,400,000 on the long portion of the option and had effectively offsetting short options for which they received $8,316,000. Following the acquisition of the options, they contributed the options, cash and shares of two corporations to Highwood Partners. The taxpayers treated basis of the option package they contributed as $8,400,000—that is, the basis was not reduced by the contingent liability on the short option.

About a month later, the options expired unexercised by Highwood, creating a short term capital gain of $8,316,000 (the short option) and a short term capital loss of $8,400,000 (the expiration of the long option). The partnership reported the net loss of $84,000 on the partnership return as “Other income (loss)” and did not disclose the details of the underlying two transactions. The partnerships were then liquidated and, under §732(b) took the position that the assets received took the partners remaining basis in the stock—the basis based on counting the basis of the options without considering the contingent liability represented by the short option. Thus, when the shares were sold by the taxpayers, the basis of the shares were “boosted” by the subsidy provided by the short option.

Under §6501(e), the statute for assessing tax on a return is extended to six years from the normal three if a taxpayer omits from gross income an amount in excess of 25% of the amount of gross income stated on the return. In the Bakersfield, Beard and Salman Ranch cases the courts had ruled that even an extreme overstatement of basis did not trigger this provision, as the change did not affect the gross income reported. The courts noted that the IRS had been made aware of the underlying transaction and, based on the Supreme Court’s decision in Colony, the overstatement of basis did not trigger this statute.

However, the Tax Court found the Highwood case to be different. The Tax Court pointed out that under the regulations governing Section 988 foreign currency gains and losses (the governing provisions for these options that were stated in Japanese Yen) that gain or loss must be separately computed for each Section 988 transaction. The taxpayer argued that the two transactions were “integrated” and that therefore it was proper to net the two.

The Tax Court points out, though, that the taxpayer appears to be wanting to have it both ways. The Court notes that for purposes of the partnership basis rules, the partners treated these as two distinct transactions rather than one integrated transaction. The Court found, as well, that these options were two separate financial instruments by their terms.

So even though the proper net loss on the two transactions were reported, the returns are nevertheless open to assessment because of the omission of income, allowing the IRS to challenge other items reported on the return—such as the basis used for the sale of the stock that popped out of the partnership.

The four recent cases (Bakersfield, Salman Ranch, Beard and Highwood Partners) point out the potential complexities of the six year statute rule with partnership based basis inflation shelters (which were most of the popular marketed shelters of the 1990s and early 2000s). The cases can be reconciled if we look at the issue of whether or not the IRS was “put on notice” about the transaction in question. In the Bakersfield, Salman Ranch and Beard cases the underlying facts of the transactions were spelled out on the returns. The fact of the inflation of basis did not trigger the six year statute even though the basis inflation had a tremendous affect on the taxable income reported by the taxpayer.

However transactions that were designed, as some were, to attempt to report in a fashion to disguise the basis inflation through netting of transactions to report the small net loss triggered by the underlying basis inflation option transactions appear to be at risk even though the actual loss reported on that transaction is correct. The “hidden” large gain and large loss transactions end up, in the Tax Court’s view, triggering the IRS’s right to go after the return for six years.

Since, in most cases, these transactions were entered into just before a sale that would trigger a large capital gain, the sale of the asset that eventually receives the “extra” basis will be sitting in that same year. The first three cases make clear that this second, extra basis sale, does not trigger 6501(e) though it may have a grossly overstated basis. However, in this case, the option transactions, for which no change will be made in the overall net loss reported, served to open the door for the IRS go after the year—and now the IRS can look at the basis of the shares sold.

CPAs need to be aware of the rationale of this case when deciding how to report items on returns. It’s easy to convince yourself it’s “OK” to bury potentially problematic issues through reporting means meant to obscure the underlying transaction, and that’s especially true in a case like this when the obscured transaction itself merely indicates a problem in another related transaction. It seems a “practical” solution to avoid IRS scrutiny. But as this case shows, that “practical” solution allowed the a “practical” attack elsewhere on the return.

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