The U.S. Court of Federal Claims recently held that third-party fraud committed on a partnership's tax return did not extend the three-year statute of limitations period for assessment of income taxes, a decision that conflicts with U.S. Tax Court precedent.
On September 30, 2013, the U.S. Court of Federal Claims held in BASR Partnership v. United States, No. 10-244 (Fed. Cl. 2013), that third-party fraud committed on a partnership's tax return did not extend the three-year statute of limitations period for assessment of income taxes. At odds with U.S. Tax Court precedent, the Court of Federal Claims determined that the notice of final partnership administrative adjustment (FPAA) that the Internal Revenue Service (IRS) sent to the partnership was time-barred because none of the partners intended to fraudulently evade taxes.
Background: Statute of Limitations Period for Assessment of Tax
Generally, the IRS has three years after a taxpayer files a tax return to assess a tax on that return. Section 6501(a). However, certain exceptions to this general rule extend the limitations period, in some cases indefinitely. See section 6501(c). Such an exception applies "in the case of a false or fraudulent return with the intent to evade tax." Section 6501(c)(1). To prevail, the Commissioner must prove by clear and convincing evidence that the return at issue was false or fraudulent. Section 7454(a).
While section 6501 generally applies to all assessments, a special period of limitations applies to assessments of tax on income attributable to partnership items or affected items. See section 6229. For such items, the IRS generally can assess a tax three years after the later of the date on which the partnership return is filed, or the last day for filing the partnership return for a taxable year. Section 6229(a). Similar to section 6501(c)(1), there is an exception to the general period of limitations in the case of fraud. See section 6229(c). Specifically, "[i]f any partner, with the intent to evade tax, signed or participated directly or indirectly in the preparation of a partnership return which includes a false or fraudulent item," then, with respect to such partner, the limitations period is turned off, and with respect to all other partners, the limitations period under section 6229(a) is extended to six years. Section 6229(c)(1).
Although the interplay between sections 6501 and 6229 is not entirely clear, courts have consistently construed them to "operate in tandem to provide a single limitations period." Prati v. United States, 603 F.3d 1301, 1307 (Fed. Cir. 2010); see also Andantech L.L.C. v. Commissioner, 331 F.3d 972, 977 (D.C. Cir. 2003). In determining the time period the IRS has to assess taxes on a partnership return, section 6501 is the starting point. See Prati, 603 F.3d at 1307. When the IRS assesses a tax on a partnership item or affected item, section 6229 can extend the section 6501 time period that the IRS has to make the assessment. See Andantech, 331 F.3d at 977. A taxpayer, however, cannot use the two sections as a sword. They "do not operate independently to allow a taxpayer to assert one in isolation and thereby render an otherwise timely assessment untimely." Prati, 603 F.3d at 1307.
Courts have not been consistent in interpreting who can trigger the fraud exception to the general statute of limitations period. Specifically, courts have grappled with whether the fraudulent intent of someone other than the taxpayer can activate the extended limitations period under section 6501(c)(1). That was the core issue in play in BASR Partnership.
In 1999, a tax lawyer advised William F. Pettinati, Sr., and his accountant, John Malone, on the tax consequences of the sale of a printing business owned by Pettinati, his wife and two gift trusts for the benefit of their sons. Relying on that advice, Malone designed a tax plan that included establishing a family general partnership known as the BASR Partnership (BASR). Each of BASR's four partners (four single-member LLCs—one for each owner of the business) made a series of transfers to the partnership that purportedly increased the partners' outside bases in the partnership by more than $6.6 million. While Pettinati—in his capacity as tax matters partner—filed the partnership's 1999 tax returns (one for year-end June 12, 1999, and another for year-end December 12, 1999) in October 2000, Malone prepared and signed those returns for the partnership and its partners.
In January 2010—almost a decade after the returns were filed—the IRS issued an FPAA to the partnership for the 1999 tax years determining that the partnership should be disregarded because, among other reasons, it lacked economic substance. As a result, the IRS determined that the calculations of the partners' adjusted bases in their respective partnership interests were not accurate, resulting in an understatement of tax. After the partnership timely filed a complaint in the Court of Federal Claims, it moved for summary judgment, raising two interrelated issues:
- Whether the FPAA was time-barred because section 6229(c)(1), instead of section 6501(c)(1), governed the period within which the IRS may issue an FPAA
- Even if section 6501(c)(1) governed, whether that provision applied in this case, since the government did not contend that the taxpayer had "the intent to evade tax" nor "signed or participated directly or indirectly in the preparation of a partnership return which includes a false or fraudulent return"
The court quickly resolved the first issue, reiterating the view espoused in Prati that the two sections "operate in tandem to provide a single limitations period." In other words, the court said that "§ 6229(a) establishes a minimum period during which the period for tax assessment for partnerships may not end, although this minimum may expire before or after the maximum period provided in § 6501." Thus, the two sections must be read together.
The court then turned to the second issue—the applicability of the fraud exceptions. Using section 6501 as the starting point, the court noted that for the IRS to assess taxes more than three years after a taxpayer filed the return at issue, the return must be "false or fraudulent . . . with the intent to evade tax." The court found it noteworthy that section 6501(a) defined "return" as "the return to be filed by the taxpayer . . . ." Because that language "is expressly limited to a return filed by the 'taxpayer,'" the court determined that "the fraudulent intent referenced in . . . § 6501(c) is by implication limited to fraud by the taxpayer" (emphasis added). In effect, the court read into section 6501(c) the following bracketed language: "In the case of a false or fraudulent return [filed by the taxpayer] with the intent to evade tax [by the taxpayer] . . . ." The court did acknowledge the "persuasive policy arguments" put forth by the government as to why section 6501(c)(1) "needs to be amended, particularly in light of the practical impediments to the discovery of tax fraud," but ultimately opined that its "function . . . is to interpret, not re-write, the law."
After clearing that hurdle, the partnership had a relatively smooth sail to victory. The court's interpretation of section 6501(c)(1) bound the IRS to the three-year statute of limitations period pursuant to section 6501(a) unless the taxpayer possessed the requisite fraudulent intent (i.e., intent to evade tax) under section 6501(c), or section 6229 extended it. While the court acknowledged there was "no question" that the partnership's returns included "false or fraudulent items," those items did not result from the taxpayer's intent to evade tax; rather, they were the result of the tax advice provided by Mayer. In reaching that conclusion, the court emphasized a concession by the government that the partners themselves did not possess the "intent to evade tax." That concession also disposed of the question as to whether the "special rule in case of fraud" exception under section 6229(c)(1) applied, because that provision requires that a "partner" have "the intent to evade tax" when signing or participating in the preparation of a partnership return. Thus, the court held that the FPAA was time-barred and granted the partnership's motion for summary judgment.
Different Approaches to the Fraud Exception
The BASR Partnership opinion made clear that the U.S. Court of Appeals for the Second Circuit "has taken a different approach" to the application of the fraud exception in section 6501. Citing to City Wide Transit, Inc. v. Commissioner, 709 F.3d 102, 108 (2d Cir. 2013), the court noted that the Second Circuit's approach includes conducting a "factual inquiry into whether a tax attorney's fraud is 'secondary or remote to the fraudulent returns.'" In City Wide Transit, the Second Circuit deemed a tax preparer's fraud—as reflected in a corporate taxpayer's return—to require the application of the section 6501(c) extended limitations period. The court did note the Second Circuit's caveat that it would have ruled differently if the preparer's fraud on the company would have caused the company to file a false return, as opposed to committing fraud related to the preparation and filing of the return. In any event, the court noted that it was not bound by City Wide Transit and explicitly rejected its factual inquiry, stating that it "must interpret . . . § 6501(c)(1) and . . . § 6229(c)(1) as written."
City Wide Transit, which involved a tax preparer who filed fraudulent payroll tax returns to embezzle hundreds of thousands of dollars from the corporate taxpayer, confronted a "very narrow question" under section 6501(c)(1): whether the Commissioner established by clear and convincing evidence that the tax preparer intended to evade the company's taxes through an embezzlement scheme. That question necessarily assumed that tax preparer fraud can extend the general limitations period under section 6501(a). To make that assumption, the Second Circuit relied on a Tax Court decision that "conclude[d] that the limitations period for assessing [the taxpayer's] taxes is extended if the taxes were understated due to the fraud of the preparer." Browning v. Commissioner, T.C. Memo. 2011-261, 2011 WL 5289636, at *13 n. 14 (quoting Allen v. Commissioner, 128 T.C. 37, 40 (2007)).
The Tax Court's holding in Allen squarely conflicts with the outcome the Court of Federal Claims reached in BASR Partnership. In Allen, the taxpayer's preparer claimed various fraudulent itemized deductions, and was later convicted of 30 violations of willfully aiding and assisting in the preparation of false and fraudulent income tax returns. While both parties agreed that the taxpayer himself did not have the intent to evade tax, they disagreed as to whether the fraudulent intent required to keep the limitations period open indefinitely under section 6501(c)(1) must be that of the taxpayer.
The Tax Court sided with the government, holding that a preparer's fraudulent intent to evade tax is sufficient to keep the limitations period open. It found "[n]othing in the plain meaning of the statute [that] suggests the limitations period is extended only in the case of the taxpayer's fraud." According to the Tax Court, section 6501(c)(1) does not focus on "the identity of the perpetrator of the fraud"; rather, it "keys the extension to the fraudulent nature of the return." And, unlike the Court of Federal Claims, the Tax Court refused to "read the words 'of the taxpayer' into the statute to require the taxpayer to have the intent to evade his or her own tax." It supported that refusal by citing to the general principle that statutes of limitations barring collections otherwise due are strictly construed in favor of the government. To find otherwise, the Tax Court noted, "would allow a taxpayer to receive the benefit of a fraudulent return by hiding behind the preparer."
In reaching conflicting holdings, the analysis of the Court of Federal Claims and the Tax Court diverged in a number of ways. First, the Tax Court cited to a failed legislative proposal to the Revenue Act of 1934 to support the "notabl[e] absen[ce]" of "any express requirement that the fraud be the taxpayer's." (That proposal would have amended the fraud exception to trigger its applicability only if "the taxpayer . . . file[d] a false or fraudulent return with intent to evade tax.") The Court of Federal Claims, however, criticized "reliance on a failed legislative proposal as evidence that Congress considered and rejected" that express requirement, citing to a Supreme Court of the United States case cautioning that "[f]ailed legislative proposals are a particularly dangerous ground on which to rest an . . . interpretation of a statute." Second, while the Court of Federal Claims hinged its section 6501(c)(1) interpretation on the fact that section 6501(a) defines return as "the return required to be filed by the taxpayer," the Tax Court was apparently not persuaded that such definition had any relevance to the inquiry since it did not even mention it. Third, whereas the Tax Court was swayed by "the special disadvantage" the IRS has in investigating fraudulent returns when the tax preparer commits the fraud, the Court of Federal Claims indicated that policy argument should be addressed to Congress, not the courts.
On one hand, the Tax Court has stated that "[n]othing in the plain meaning of the statute suggests the limitations period is extended only in the case of the taxpayer's fraud" and that it would not "read" such words into section 6501(c)(1). On the other hand, the Court of Federal Claims interpreted the "plain and unambiguous meaning of the statute" by holding that the "references in . . . § 6501 to fraudulent intent are solely those of the 'taxpayer.'" Similar to Justice Kagan's recent remarks during oral argument in the United States v. Woods partnership tax case before the Supreme Court, both courts appear to be adding words to the statute: the Court of Federal Claims adds the phrase "by the taxpayer"; the Tax Court adds the phrase "by the taxpayer and/or its agent." Cf. Transcript of Oral Argument at 25, United States v. Woods (Oct. 9, 2013) (No. 12-562) ("And I guess the question is: In some sense you're both adding adjectives to the statute. You add directly, they add indirectly. How do we pick between those?") It remains to be seen whether the government will appeal the BASR Partnership decision to the U.S. Court of Appeals for the Federal Circuit and whether this apparent conflict can be resolved.
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