Basis Reporting Mistakes Lead to Extended IRS Scrutiny

3/3/2011

By Mark Corey, CPA

The Internal Revenue Service (IRS) generally has three years to scrutinize your taxes and determine if there has been an error. An error can be an overstatement of expenses or underreporting of income that requires an audit adjustment and the imposition of interest and penalties. That general time limit for IRS scrutiny is doubled if the IRS can show an omission of gross income that is greater than 25 percent of the gross income that was reported by the taxpayer.

This rule historically has only snared those who have not reported gross income from a trade or business, before reduction for cost of goods. This rule does not apply to taxpayers who intentionally (or willfully as used in the code) underreport income or overstate expenses in an effort to evade taxes. If the IRS can prove an attempt to evade taxes there is no statute of limitations to audit the taxpayer.

In a recent case in the Court of Appeals for the Seventh Circuit, the court overturned a tax court decision and found that over reporting cost basis in an investment could trigger the six-year statute of limitations for auditing a tax return.

There has been general consensus among the various courts that hear tax cases that this extended statute of limitation provision was only triggered if there was an omission of gross income, usually from business receipts. However, in this particular case, Bakersfield Energy Partners v. Comm. 103 AFTR 2d 2009-2712, the IRS, relying on recently finalized regulations, successful argued in front of the Seventh Circuit Court of Appeals that the taxpayer did overstate the basis in their investment by the required greater than 25 percent and thus triggered the six-year statute of limitations. The court rejected the findings of other courts faced with similar facts by concluding that the underlying statute had been changed since the Supreme Court last heard a case on that statute.

The implication is that if a taxpayer unintentionally overstates basis in an investment which results in income being under reported by greater than 25 percent, they can expect an audit if the IRS discovers evidence that shows that the taxpayer over stated their basis. This decision, coupled with the recent change to 1099 rules for brokers requiring them to report the basis of investments sold, could allow the IRS to audit more returns if they suspect that the reported basis from brokers exceeds the amount reported by the taxpayer.

Since there is now a split in the courts as to the treatment of this statute of limitations rule, and the IRS is apparently pushing its position in favor of extending the circumstances where the extended statute applies, expect this case to end up in front of the Supreme Court. In the meantime, be careful to review the basis of investments reported on your tax return.