Statute of Limitations question - audit reconsideration

Taxpayer timely filed a 2012 S-Corp & 1040 tax return reporting income and expenses of business. There was net income from the S-Corp that was reported on the 1040. Tax was paid.

IRS audited and issued adjustment in January 2015. The IRS made two determinations:
* Disallowed all expenses
* Reclassified S-Corp to C-Corp

This created C-Corp tax and reduced their 1040 tax. The IRS assessed the tax against the corporation and issued a credit to the individual, which they have not refunded.

We have worked with the Taxpayer Advocate Office for a while now trying to restore the S-Corp status. We think we are almost there.

Let's say the IRS agrees to restore S-Corp status. What happens with those disallowed expenses? Can the IRS now assess tax at the individual level? Hasn't the 3-year statute run? Or has the statute somehow been suspended during this time?

Get a member of the Tax Court Bar, and file a "timely petition" if you are within the Statute.

nova, Thank you for reply. Can you please expand on your suggestion?

Which Statute are you referring to? The petition date on the notice of deficiency? I presume that time has come and gone? The tax was assessed against the corporation in early 2015?

Wiles, I would be surprised if the IRS agreed to restore the S corporation status given that they announced in Rev. Proc. 2013-30 that they wouldn’t do this more than 3 years and 75 days after the due date for filing the return.

I would also be surprised if the IRS assessed additional tax at the individual level since the 3-year statute of limitations on the 1040 has expired. The IRS might argue for a 6-year statute, but I don’t think this would fly because the additional tax would arguably be attributable to disallowed expenses, not omitted income. The IRS will probably just keep the refund and argue that there’s no overpayment of tax.

As for the C corporation tax assessed, if it hasn’t been paid, then the corporation can ask for audit reconsideration or file an Offer in Compromise (Doubt as to Liability) and argue that the 1120S filing was correct. If it has been paid, then the corporation has 2 years from the date paid to file a claim for refund.

Taxpayer timely filed a 2012 S-Corp & 1040 tax return reporting income and expenses of business. There was net income from the S-Corp that was reported on the 1040. Tax was paid.

IRS audited and issued adjustment in January 2015. The IRS made two determinations:
* Disallowed all expenses
* Reclassified S-Corp to C-Corp

This created C-Corp tax and reduced their 1040 tax. The IRS assessed the tax against the corporation and issued a credit to the individual, which they have not refunded.

We have worked with the Taxpayer Advocate Office for a while now trying to restore the S-Corp status. We think we are almost there.

Let's say the IRS agrees to restore S-Corp status. What happens with those disallowed expenses? Can the IRS now assess tax at the individual level? Hasn't the 3-year statute run? Or has the statute somehow been suspended during this time?

If you are assuming (1) that the IRS does agree to restore the S-corp status and (2) that the S-corp expenses will remain as "disallowed," then one question could be: Was the income amount on the 2012 K-1 understated by so much that the understatement amount was more than 25% of the amount of GROSS income actually reported by the individual on Form 1040? If so, then the statutory period of limitations on assessment of a 2012 Form 1040 tax would be six years instead of three. That is, the IRS would have six years from the time the Form 1040 return was filed (except, if the return was filed before its due date, six years from the due date). So, for example, if the return was filed by about April 15, 2013, the period would expire around April 15, 2019.

There are a whole bunch of other ways that the IRS could still assess an additional 2012 Form 1040 tax. For example, false return with intent to evade tax, willful attempt to evade tax, extension of the time period by agreement between the taxpayer and the IRS, taxpayer in bankruptcy, etc. [EDIT: Actually, the "taxpayer in bankruptcy" exception might no longer apply, because of a change in the U.S. Bankruptcy Code back in 2005. The bankruptcy "automatic stay" no longer prevents the IRS from assessing a tax during bankruptcy, generally. The assessment in such a case cannot result in the creation of a Federal tax lien until certain events have occurred.]

Based on my understanding of what you describe, the U.S. Tax Court may currently have no subject matter jurisdiction to decide a dispute about the 2012 Form 1040 tax liability or potential refund.

Novacpa, why do you believe it takes a Tax Court practitioner to file a petition?

Wiles, I would be surprised if the IRS agreed to restore the S corporation status given that they announced in Rev. Proc. 2013-30 that they wouldn’t do this more than 3 years and 75 days after the due date for filing the return.

I think our chances are very high. The business always filed an S-Corp tax return since incorporating. The issue was that the taxpayer incorporated their Sch C business, but did not apply for a new tax ID #. They used their Sch C EIN and name to apply for S status, which the IRS accepted.

We were not involved with the audit. I think the taxpayer just never responded to anything. The auditor disallowed all expenses. But I was really surprised the auditor took the audit that other direction. Why not just assess the tax at the individual level and move on?

If you are assuming (1) that the IRS does agree to restore the S-corp status and (2) that the S-corp expenses will remain as "disallowed," then one question could be: Was the income amount on the 2012 K-1 understated by so much that the understatement amount was more than 25% of the amount of GROSS income actually reported by the individual on Form 1040? If so, then the statutory period of limitations on assessment of a 2012 Form 1040 tax would be six years instead of three.

Interesting point & question. Are overstated expenses on a pass-through considered an understatement of gross income?

If you are assuming (1) that the IRS does agree to restore the S-corp status and (2) that the S-corp expenses will remain as "disallowed," then one question could be: Was the income amount on the 2012 K-1 understated by so much that the understatement amount was more than 25% of the amount of GROSS income actually reported by the individual on Form 1040? If so, then the statutory period of limitations on assessment of a 2012 Form 1040 tax would be six years instead of three.

Interesting point & question. Are overstated expenses on a pass-through considered an understatement of gross income?

I haven't researched it, but I'm thinking that it is only the gross income of the individual taxpayer that comes into play. Let's assume that the only figure on the K-1 is the ordinary income on line 1. That figure, obviously, is computed by taking the gross income of the S corp and subtracting the deductible expenses of the S corp, and then allocating a share of the "net" to the shareholder, based on his or her profit ratio, etc. (Of course, the K-1 could have had separately stated items of deduction, but let's keep it simple for now.) And, let's assume that the shareholder had absolutely no other source of income for the year. In this scenario, I think a reasonable argument could be that the only GROSS income reported on the Form 1040 is the amount from line 1 of the Schedule K-1. I think that this amount is the only amount of the INDIVIDUAL'S gross income reported on the Form 1040 return for purposes of section 6501(e)(1).

In this scenario, I think a reasonable argument could be that the only GROSS income reported on the Form 1040 is the amount from line 1 of the Schedule K-1. I think that this amount is the only amount of the INDIVIDUAL'S gross income reported on the Form 1040 return for purposes of section 6501(e)(1).

I don’t think that you can just look at the S corporation income reported on the 1040.

Sec. 6501(e)(1)(B)(iii) states that in determining the amount omitted from gross income, you don’t take into account any amount disclosed in the return or in a statement attached to the return. And in Benderoff v. United States , 398 F.2d 132 (8th Cir. 1968), the Appeals Court said that you may consider information other than shown on a taxpayer's return to establish sufficient disclosure. In Benderoff, the taxpayers' individual return specifically referred to their income from an S corporation, and the court looked beyond the taxpayer's individual return to the 1120S.

As a result, I don’t think that the 6-year statute applies, because like the Benderoff case, you go beyond the 1040 to the 1120S, and if the expenses were listed on that return, then it constitutes sufficient disclosure to negate the 6-year statute.

In this scenario, I think a reasonable argument could be that the only GROSS income reported on the Form 1040 is the amount from line 1 of the Schedule K-1. I think that this amount is the only amount of the INDIVIDUAL'S gross income reported on the Form 1040 return for purposes of section 6501(e)(1).

I don’t think that you can just look at the S corporation income reported on the 1040.

Sec. 6501(e)(1)(B)(iii) states that in determining the amount omitted from gross income, you don’t take into account any amount disclosed in the return or in a statement attached to the return. And in Benderoff v. United States , 398 F.2d 132 (8th Cir. 1968), the Appeals Court said that you may consider information other than shown on a taxpayer's return to establish sufficient disclosure. In Benderoff, the taxpayers' individual return specifically referred to their income from an S corporation, and the court looked beyond the taxpayer's individual return to the 1120S.

As a result, I don’t think that the 6-year statute applies, because like the Benderoff case, you go beyond the 1040 to the 1120S, and if the expenses were listed on that return, then it constitutes sufficient disclosure to negate the 6-year statute.

Thanks! I have never researched this issue. And, based on Benderoff and other cases I've quickly looked at since reading your post, I'm thinking that even the inclusion of a properly completed Form 8082 included in a Form 1040 return (where a K-1 has not been received by the individual shareholder) might be enough to satisfy section 6501 and keep the statutory period at three years.

Thanks for the citation.

As a result, I don’t think that the 6-year statute applies, because like the Benderoff case, you go beyond the 1040 to the 1120S, and if the expenses were listed on that return, then it constitutes sufficient disclosure to negate the 6-year statute.

The only issue there is that the IRS says the 1120S must be in its possession. See this CCA:

https://www.irs.gov/pub/irs-wd/1333008.pdf

That would make this a real technical matter. Here we have an 1120S that was filed, I assume. And, I assume, filed before the related 1040 was filed. But, since there’s an issue with that 1120S, does it constitute the filing of an 1120S when it was filed? Or, would it be treated as an 1120S filing only more recently, when the IRS agrees that the entity is an S-corp (even though retroactive effect may be granted)?

And note that the general rule is that the 1040 filing starts the statute, as per 6501(a).

How do you find this stuff, Jeff?!?

As a result, I don’t think that the 6-year statute applies, because like the Benderoff case, you go beyond the 1040 to the 1120S, and if the expenses were listed on that return, then it constitutes sufficient disclosure to negate the 6-year statute.

The only issue there is that the IRS says the 1120S must be in its possession. See this CCA:

https://www.irs.gov/pub/irs-wd/1333008.pdf

That would make this a real technical matter. Here we have an 1120S that was filed, I assume. And, I assume, filed before the related 1040 was filed. But, since there’s an issue with that 1120S, does it constitute the filing of an 1120S when it was filed? Or, would it be treated as an 1120S filing only more recently, when the IRS agrees that the entity is an S-corp (even though retroactive effect may be granted)?

And note that the general rule is that the 1040 filing starts the statute, as per 6501(a).

OP says that the 1120S and 1040 were timely filed.

OP says that the 1120S and 1040 were timely filed.

I’m just throwing it out there and I doubt Wiles has an issue here. Yet, “timely filed” isn’t the end of the story if you really believe the IRS’ position is valid across the board. Even with timely filed returns, if the 1040 goes in before the 1120S does, for whatever reason apparently, including valid extensions, the IRS might say that you don’t get to incorporate the 1120S figures into the 1040. And this is because the IRS didn’t have the 1120S in its possession when the 1040 was filed.

How do you find this stuff, Jeff?!?

Bookmark “Procedurally Taxing,” which is a really good site. They had a piece on this issue when the CCA came out, which is worth further reading:

http://procedurallytaxing.com/disclosur ... rp-issues/

…and read the comments, including the one by Leslie Book @ 7:39pm on 11/13/13.

In your case, just take it one step at a time. And deal with the disallowed expenses if and when the issue is raised. Your case, though, when they disallow all expenses…that just seems like the taxpayer never responded, so all expenses were disallowed.

I’m just throwing it out there and I doubt Wiles has an issue here. Yet, “timely filed” isn’t the end of the story if you really believe the IRS’ position is valid across the board. Even with timely filed returns, if the 1040 goes in before the 1120S does, for whatever reason apparently, including valid extensions, the IRS might say that you don’t get to incorporate the 1120S figures into the 1040. And this is because the IRS didn’t have the 1120S in its possession when the 1040 was filed.

Well, why don't we ask Wiles whether the 1120S was filed first, instead of throwing out an issue that may not exist?

Jeff does raise an important issue here, and I can only hope it is not a big deal. The taxpayer paper filed both tax returns at the same time, but they have no proof of that. I checked the account transcripts online. I can see when the 1040 was received by the service. But there are no transcripts for the Form 1120S because the IRS has them as a C-Corp. The tax return for the C-Corp is shown as processed at the same time the audit adjustments were posted. That is because the taxpayer did not file the 1120, the IRS did.

Also, I did notice on the 1120 account transcripts, it shows a Code 560 "IRS can assess tax until 04-01-2021". The taxpayer does not recall signing an SOL extension waiver. There is no such Code 560 on their 1040 transcripts.

Well, why don't we ask Wiles whether the 1120S was filed first

My point was a very, very, highly technical one, not really addressed in the IRS guidance. IRS just says if the 1120S is already on file, then those numbers get incorporated into the related 1040 filing. Well, here we apparently have an 1120S filing…but it is not identified as such by the IRS since the S-election was never accepted. If the IRS did get that 1120S, but initially refuses to treat it as such, does that 1120S filing constitute an 1120S filing for 1040 incorporation purposes if the IRS later agrees to grant retroactive S-status?

As practitioners, I think we’d say, “Yes, the 1120S that was filed without proper advance notification that the S-election was accepted works just fine since the IRS’ later acceptance of the S-election is retroactive for all purposes.” I think the key is that the IRS was put on notice…the IRS got the 1120S and, hopefully, the 1040 referenced the S-corp on Schedule E, Page 2.

…but, it does seem like there’s some question if the 1120S was even filed in the first place.

As to this comment:

They used their Sch C EIN and name to apply for S status, which the IRS accepted.

This is fuzzy to me. Is the IRS saying that it accepted a 2553 filing for what amounts to the guy’s sole-proprietorship? Is there even a separate state law corporation that was formed? If so, is the name of the state law corporation fundamentally different from the sole-proprietorship? And did said state law corporation, if there is one, even have an EIN?

In other words, is the IRS saying, “Sure, we’ll grant your S-election for your sole-proprietorship. But this new corporation you set up, well, you never even made an S-election for that new and completely separate entity.” Also, as to this part:

“Sure, we’ll grant your S-election for your sole-proprietorship.

…I’d think that would only work if the sole-proprietorship was a single-member LLC (wherein a check-the-box election isn’t necessary).

But this part of the discussion might be moot if the IRS grants S-status to the thing we want to be an S-corp, so maybe this is why Wiles hasn’t given us all of the facts.

Yes. A real CA Corp was created in 2008. Let's call it "The Krusty Krab". The prior Sch C was under the owners name and dba, let's call it "Eugene Krabs dba Gene's Krab Shack". The IRS accepted the S election under that name & the Sch C EIN. All S-Corporation tax returns were filed using the same EIN but with the corporation name "The Krusty Krab".

Well, you and I both know that the S-election the guy filed was completely bogus. It was for his Schedule C business…which, quite obviously, isn’t the same entity that was established with the state of CA. It is basically a situation of no S-election ever having been filed. Nonetheless, if you can get the IRS to accept the S-election as if it was made for the state law entity, more power to you.