With tax season in full swing, now is a good time to review the various civil statutes of limitations (SOL) rules that apply to US tax matters. Perfect timing to review because we also have a Tax Court case from last month showing how harsh the consequences of the SOL can be if a taxpayer cannot outrun it.
In Fairbank v. Commissioner, T.C. Memo. 2023-19, Dkt. No. 13400-18 (February 23, 2023) the Internal Revenue Service (IRS) issued a notice of deficiency in April 2018 for taxable years 2003, 2004, 2005, 2006, 2007, 2008, 2009, and 2011. The taxpayers were surely aghast that the IRS could go back to 2003 and challenged the assessments on SOL grounds. They lost. The Fairbank case will be discussed next week. Today’s post examines the various SOL rules and sets the stage for understanding why the taxpayers lost in Fairbank.
Most of my readers know that the SOL prescribes the length of time the IRS has to enforce the tax rules. If the length of time for a particular tax year has expired, then the IRS is forever barred from claiming that more tax is owed. Depending on the facts, the SOL will be longer than others, or the SOL “clock” will not start to tick at all. The devil is in the details and today’s post provides them.
Keep Running….. IRS has a Longer Time to Catch You
- Understatements of Income / Foreign Financial Assets
Once you file your income tax return, there are several possibilities with regard to the statute of limitations.
General Rule – Three Years: The general rule is that the IRS has three years after the later of the date the tax return was due or the date the return was filed, to assess tax. This rule applies if the tax return is timely filed or if it is filed late.
Substantial Understatement – Six Years: The statute can be extended to six years if there is a “substantial understatement” of income. This means the taxpayer omitted from gross income an amount properly includible in his income and that amount is more than 25% of the amount of gross income stated in the tax return.
FATCA – Six Years: Under a special rule added to the tax law by the notorious “Foreign Account Tax Compliance Act” (FATCA) in 2010, the statute is stretched to six years if the taxpayer omits over $5,000 from gross income that is attributable to certain kinds of foreign financial assets.
2. No Tax Return Filed? Run Forever!
The SOL clock will not even begin to tick unless an income tax return is filed! In other words, not filing the return means a taxpayer will be looking over his shoulder forever, nervously wondering if the IRS is catching up. Even death is no solution, since the tax liabilities will follow the estate and possibly, the heirs.
This is an important point for Americans living and working overseas. Unfortunately, many are under the mistaken assumption that they do not need to file tax returns if they earn less than the so-called “foreign earned income / housing exclusion” amounts. Nothing could be further from the truth. Tax returns must still be filed in order to claim the benefit of these exclusions.
Delinquent filers should take prompt action for many reasons, including to start SOL. For Americans abroad, there is often a fairly painless way to get back on track and in most cases, penalties can be entirely avoided. See my US Tax Primer here, especially noting the sections titled: “Tax Information Reporting Requirements” and “Delinquent Tax Returns and FBARs” and “Options to Remedy Past Tax Noncompliance”.
3. Incomplete Foreign Reporting? Run Forever!
If there is a failure to file certain foreign-related information returns with one’s income tax return, such as Form 8938, 3520 or Form 5471, the statute of limitations does not begin to run because the return is treated as “incomplete”. The statute is suspended until the foreign information is provided to the IRS. This provision was another FATCA addition to the tax rules.
Under these rules, the SOL does not begin to run until the taxpayer has complied with all mandatory foreign reporting. This reporting can include information returns regarding ownership in foreign corporations, foreign partnerships, foreign trusts, information concerning “specified foreign financial assets” and many other transactions in the offshore context. Only when proper reporting is made will the SOL begin. Furthermore, even though the statute starts to run, the entire tax return will remain open for IRS adjustments for a period of three years after the missing information has been provided to the IRS (rather than only for the portions of the return relating to the foreign reporting that had been missing).
The relevant Internal Revenue Code provision is found in IRC Section 6501(c)(8), copied below:
(c)(8) Failure to notify Secretary of certain foreign transfers
(A) In general
In the case of any information which is required to be reported to the Secretary pursuant to an election under section 1295(b) or under section 1298(f), 6038, 6038A, 6038B, 6038D, 6046, 6046A, or 6048, the time for assessment of any tax imposed by this title with respect to any tax return, event, or period to which such information relates shall not expire before the date which is 3 years after the date on which the Secretary is furnished the information required to be reported under such section.
(B) Application to failures due to reasonable cause
If the failure to furnish the information referred to in subparagraph (A) is due to reasonable cause and not willful neglect, subparagraph (A) shall apply only to the item or items related to such failure.
4. Form 8854 and Expatriation
As mentioned, the IRS generally has three years from the date a return is filed to assess additional tax and as discussed above, an extended SOL applies when a taxpayer fails to furnish required information returns relating to various international transactions or assets. In these cases, the SOL does not expire until three years after the information required to be reported is provided. Existing law does not include Form 8854 as one of the information returns that would trigger the extended SOL. Readers may recall that this Form is required of all US citizens who expatriate and long term residents (green card holders) after they relinquish US status. Full details on this topic at my blog posts here and here.
President Biden’s Green Book for 2024 contains various tax proposals. One such proposal addresses the statute of limitations and Form 8854 in order to reduce perceived abuse and noncompliance by high net wealth expatriates (see Green Book page 186 et seq). The proposal would provide that, in the case where a taxpayer is required to provide Form 8854 to the IRS with their tax return, the time for assessment of tax will not expire until three years after the date on which Form 8854 is filed with the IRS. Second, the proposal will grant the Secretary and her delegates authority to provide relief from the rules for covered expatriates for a narrow class of lower-income dual citizens with limited US ties. This relief would apply only to taxpayers that have a tax home outside the United States and satisfy other conditions that ensure that their contacts with the United States are limited, and whose income and assets are below a specified threshold.
5. Civil Fraud? Run Forever!
In the civil context, the statute of limitations also does not start to run if a tax return is false or fraudulent or if there is a “willful” attempt to evade taxation. This means the IRS can look back as far as it wants. When suing for civil fraud in the real world, it is rare that the IRS goes back more than 6 years since it has a significant burden of proof to meet in fraud cases. This burden becomes more difficult to satisfy with the passage of time, and to avoid the added difficulties of proving older charges, IRS usually (but not always) limits the matter to 6 years.
Listen to my podcast on this entire statute of limitations topic with attorney John Richardson.
Posted March 23, 2023
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