Supreme Court Rules Overstated Basis Doesn’t Result in Gross Omission of Income

In a stunning blow to the IRS, the U.S. Supreme Court recently held that an overstatement of basis is not an omission of income in Home Concrete & Supply, LLC (Sup. Ct., April 25, 2012). Under Code Section 6501, a gross omission of income (defined as underreporting of income by at least 25 percent) triggers a six-year, rather than the usual three-year, statute of limitations.

Generally, the IRS has three years from the later of the original due date or the date on which the taxpayer files their return to assert that the taxpayer owes additional tax. After that, except under unusual circumstances, the IRS is precluded from collecting additional tax for that year. One of those unusual circumstances is a gross omission of income. The IRS has maintained for many years that an understatement of basis can result in a gross omission of income.

To illustrate the IRS position, assume that John Smith claims that stock he sold for $100,000 had a basis of $75,000. He therefore reports a gain of $25,000 on its sale in determining his taxable income for the year. However, his actual basis in the stock was only $10,000. Thus, a gain of $90,000 should have been reported on the stock sale. If John’s only other income was his $100,000 salary, then the IRS would take the position that John has a gross understatement of income because he had underreported his income by $65,000 ($90,000 minus $25,000), which is more than 25 percent of John’s gross income. Therefore, according to the IRS, a six-year statute of limitations would apply.

The Supreme Court in Home Concrete, resolving conflicts between different Circuit Courts of Appeal, said that the law on this issue was clear. The law specifically states that there must be a gross omission of income. If all of the taxpayer’s income has been reported, there can be no gross omission of income. There may be an underreporting of taxable income, but the statute only refers to an omission of income. Thus, in the example above, John reported all of his income (i.e., the $100,000 gross sales proceeds plus his $100,000 salary) so there was no gross omission of income. A three-year statute would apply to his return, assuming there is no fraud involved. (The statute of limitations never expires on a fraudulent return.)

While the Supreme Court’s decision in this case is good news for taxpayers, it is bad news for the IRS on another issue, which may be of far greater significance. The IRS takes the position that if Treasury issues regulations on a tax issue, the position stated in the regulations is presumptively correct.

Regulations explain and interpret tax laws. This is important and helpful, particularly when the law is not perfectly clear. Generally, the courts have given such regulations deference, meaning that unless the regulations are clearly wrong, they are presumed to correctly explain the law and its application to particular facts and circumstances. This deference has played a major role in helping the IRS successfully litigate tax issues in the courts.

In this instance, however, the IRS issued regulations in December 2010 on the basis overstatement issue at the same time it was litigating the issue in the courts. The courts were more than a little uncomfortable with this as the IRS could, in effect, rewrite the law while a case is being considered by the courts. Justice Scalia, in his concurring opinion, expressed concern about the mischief that could be created by giving an agency the power to change a trial court decision by regulation.

The Home Concrete case blurs the extent to which the courts will or should give deference to IRS regulations in the future. Taxpayers should find it comforting to know that if the statute is clear, Treasury will not be able issue regulations supporting the IRS position and assume that those regulations will be presumptively correct.

Your CB&H tax advisor would be pleased to discuss this case with you and clarify its implications for taxpayers.

Update on U.S. GAAP and IFRS Convergence

Since 2002, the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) have been working toward “convergence” of U.S. Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS). Although the two boards have made significant progress to complete their major convergence projects by mid-2011, several are still in progress.

Recognizing that convergence will take more time, the European Commission (the European Union’s executive body) recently extended rules that permit European Union–listed U.S. companies to continue to use U.S. GAAP. The rules had expired at the end of 2011, but the European Commission granted a three-year extension, retroactive to January 1, 2012.

FASB and IASB Standards
FASB and IASB have completed several short-term convergence projects, substantially converging their standards for share-based payments, segment reporting, the fair value option for financial assets and liabilities, borrowing costs, and more. In some cases, such as share-based payments, both boards issued revised standards. In others, convergence required one board to revise its standards to align with those of the other board.

The boards currently are working on four high-priority convergence projects:

1. Revenue recognition
2. Leasing
3. Financial instruments
4. Insurance contracts

As of this writing, the boards are close to reaching an agreement on revenue recognition but continue to deliberate over the other three projects. In an April 20th update submitted to the Group of 20 industrial nations, FASB and IASB said they expect to begin redeliberations of their joint project on revenue recognition shortly and to re-expose aspects of their financial instrument project, as well as their projects on leases and insurance, in the second half of 2012. The boards expect to issue final standards on these projects by mid-2013 (about two years behind their original schedule).

SEC Adoption of IFRS
While FASB and IASB have been striving to converge their standards, the U.S. Securities and Exchange Commission (SEC) has been exploring the possibility of adopting IFRS for use in the United States. In 2007, it eliminated the requirement that foreign registrants that use IFRS reconcile their financial statements to U.S. GAAP. Then, in 2008, the SEC issued its proposed “roadmap” to adoption of IFRS by U.S. companies.

The SEC had planned to vote in 2011 on whether to make IFRS mandatory for U.S. public companies beginning as early as 2015, but the decision was pushed back until 2012. In February 2012, an SEC staff member said that a decision on IFRS was “a few months away.”

Condorsement the Way Forward?
In May 2011, the SEC published a paper suggesting condorsement — a combination of convergence and endorsement — as a possible alternative to requiring U.S. companies to adopt IFRS outright.

Under this approach, FASB and IASB would continue their efforts to converge U.S. GAAP and IFRS. At the same time, FASB would endorse and incorporate other IFRS standards into U.S. GAAP individually over time.

The Financial Accounting Foundation (FAF) – FASB’s parent organization –  proposed that FASB and IASB complete the four high-priority convergence projects discussed above. Then, rather than adopt IFRS, the United States would retain U.S. GAAP but defer to IASB to set new accounting standards (although FASB would actively participate in the process). FASB would retain the authority to develop its own standards in critical areas in the event IASB fails to provide satisfactory guidance or fails to address an issue in a timely fashion.

FASB and IASB leaders emphasized that, for this approach to work, the threshold for deviating from IFRS must be high. If there are too many “nonendorsements” or FASB creates too many “carve-outs” that depart from IASB standards, the benefits of uniform global accounting standards will be lost.

The SEC staff has hinted that its upcoming report on IFRS will recommend an endorsement framework that combines a strong U.S. commitment to international accounting standards while preserving FASB’s role in the standard-setting process.

More Clarity in Coming Months
Just about everyone agrees that a single set of high-quality global accounting standards is a worthy goal. Uniform standards would improve comparability for both domestic and cross-border financial reporting, enhance transparency, facilitate capital raising and reduce accounting complexity and expense. The challenge is finding a way to achieve that goal with minimal disruption to U.S. markets and without diluting the authority of the SEC and FASB over U.S. accounting matters.

2012 Georgia Legislature Changes Several Tax Laws

In the most recent session of the Georgia State Legislature, Governor Deal and lawmakers passed several changes to tax laws that will affect nearly all residents and businesses.

Tax Changes for Individuals

Tax Exemptions Increase for Married Filers
Beginning 2013, married taxpayers filing jointly will receive an exemption of $7,400, a marked increase of the current $5,400 exemption. Those married filing separately will be entitled to an exemption of $3,700. The personal exemption for unmarried individuals remains unchanged at $2,700.

Motor Vehicle Property Tax Phased Out
Vehicles purchased and titled after March 1, 2013 will no longer fall under existing sales and annual property tax regulations. Instead, owners will pay a one-time fee equal to seven percent of fair-market value less trade-in value. The rate is phased in over three years beginning with 6.5% in 2013, 6.75% in 2014 and the full 7% in 2015 and every year thereafter. Individuals purchasing a vehicle between January 1, 2012 and March 1, 2013 may elect either the annual tax or new one-time fee system. Any owner of a vehicle titled before January 1, 2012 will continue to pay annual state taxes as normal.

Retirement Income Exclusion Capped
Beginning 2013, any taxpayer of ages 62-64, or those who are totally disabled, may exclude up to $35,000 of retirement income per year. Taxpayers 65 and older may exclude up to $65,000 of retirement income per year. Qualified retirement income includes interest, dividends, capital gains, pension income, and up to $4,000 of earned income.

Tax Changes for Businesses

Amazon Tax Added
The Legislature added a click-through nexus provision, also known as an “Amazon tax.” Covered dealers now include any person entering into a sales agreement with a Georgia resident, whether online or in-person, if gross receipt sales exceed $50,000 in a 12-month period.

Manufacturing and Agriculture Exceptions Altered
Phased in over a four-year period, manufacturers will now be exempt from sales and use tax on energy used in manufacturing tangible personal property.

The Legislature repealed many sales and use tax exemptions for manufacturing, agriculture, poultry and timber. Some exemptions still remain for businesses such as packaging supplies, energy used in agriculture, and certain agricultural machinery and equipment.

Sales and Use Tax Nexus Altered
An out-of-state business will now be considered to have nexus with Georgia if it makes taxable sales and a related member has substantial nexus with Georgia. This could include a business with a similar line of products and the same or similar name, or a business using trademarks or trade names substantially similar to those used by a business having nexus with Georgia.

If you have any questions about changes to your individual or business taxation under these new rules, contact your local tax professional immediately.