“You Made Your Bed, Now . . .”
It is a basic precept of the tax law that, for purposes of determining the tax consequences of a transaction, a taxpayer will generally be bound by the form of the transaction that the taxpayer has used to achieve a particular business goal.
The taxing authorities, however, are not bound by the taxpayer’s chosen form; rather, they are free to ignore the form of the transaction, and may disregard or collapse transaction steps that have no business purpose, in order to determine the substance of the transaction and the resulting tax consequences thereof.
Similarly, a taxpayer is generally not free to characterize a transaction in one way for a particular tax year, and to re-characterize it for another tax year, in such a way that the taxpayer is unjustly enriched and the taxing authorities are whipsawed.
Although many taxpayers will never admit it, fairness and the prevention of unjust enrichment – either to the taxpayer or the government – are recurring themes in the administration of the tax laws, as was illustrated by a recent Tax Court decision.
Cash Basis Accounting?
Shareholders owned Corp, a cash basis taxpayer that was organized as an S corporation.
During each of the years at issue, Corp determined the gross receipts reported on its tax return using the deposits made into its bank accounts during such year.
Thus, Corp deposited into its bank account, in January 2009, checks that were received in 2008, totaling $1.63 million. Corp deposited in January 2010 checks that were received in 2009, totaling $1.89 million. Corp deposited in January 2011 checks that were received in 2010, totaling $2.27 million. Corp deposited in January 2012 checks that were received in 2011, totaling $1.56 million.
Corp timely filed its tax returns for the 2009, 2010, and 2011 tax years, on which it reported gross receipts of $7.22 million, $7.93 million, and $8.72 million, respectively.
The reported gross receipts for any year at issue did not include those checks that were received in such year but deposited in January of the following year. Rather, each year’s reported gross receipts included the checks that were deposited in January of the year at issue but received in the prior year.
Shareholders filed timely individual income tax returns that reported their proportionate shares of income from Corp.
That’s Not How It Works
In 2013, the IRS timely issued notices of deficiency to Shareholders for their 2009, 2010, and 2011 tax years. (The period of limitations for 2008 was already closed.) In the notices, the IRS determined that Corp had improperly computed its gross receipts by excluding the checks that were received during the last quarter of each tax year at issue. Shareholders petitioned the Tax Court (“TC”).
However, the issue for consideration by the TC was whether Shareholders were bound under the doctrine of the “duty of consistency” to recognize the $1.63 million in gross receipts that Corp received in 2008 as income for tax year 2009, the year in which it was deposited and actually reported.
In calculating the adjustment to Corp’s gross receipts for each tax year at issue, except 2009, the IRS: (i) included the checks that were received in the year at issue but deposited by Corp in January of the following year and (ii) excluded the checks that were deposited in January of the tax year at issue, but received in the prior year.
To illustrate: the IRS adjusted the 2010 gross receipts by excluding the checks that had been received in 2009 but deposited in January 2010 and by including the checks that had been received in 2010 but deposited in January 2011.
For 2009, however, the IRS did not make the second adjustment; in other words, it did not exclude the checks that had been received in the prior year, 2008, but deposited in January 2009.
Shareholders did not dispute that Corp incorrectly computed its gross receipts for 2009 by using bank account deposits.
However, Shareholders contended that gross receipts of $1.63 million should be excluded from their 2009 income – notwithstanding their having reported them in 2009 – because they were actually received in 2008, and that the IRS did not have the authority to make adjustments for Shareholders’ 2008 tax year.
Shareholders further contended, and the IRS did not dispute, that the period of limitations for tax year 2008 was closed, and that the TC did not have jurisdiction to make adjustments for their 2008 tax year.
On the basis of these arguments, Shareholders believed that the $1.63 million of receipts should not be taxed at all.
The IRS contended that under the duty of consistency, Shareholders should be required to include on their 2009 returns the 2008 income, as they originally reported it.
The Code requires that taxable income be computed on the basis of the taxpayer’s taxable year. The Code defines a “taxable year” as a taxpayer’s annual accounting period in the case of a calendar year or a fiscal year. A taxpayer’s “annual accounting period” is the annual period on the basis of which the taxpayer regularly computes his income in maintaining his accounting books.
For purposes of calculating taxable income, the Code provides that all items of income received in a taxable year must be reported as income for that taxable year unless the method of accounting requires that the item be accounted for in a different tax period.
Thus, income properly includible for one tax year is not deemed income for some other tax year, even if it was not reported for the proper year.
Because Corp was a cash method taxpayer, all of the checks received in 2008 should have been included in Corp’s gross receipts for tax year 2008.
Duty of Consistency
The duty of consistency, or quasi-estoppel, is an equitable doctrine which prevents a taxpayer from benefiting in a later year from an error or omission in an earlier year which cannot be corrected because the limitations period for the earlier year has expired.
According to the TC, the duty of consistency not only reflects basic fairness, but also shows “a proper regard for the administration of justice and the dignity of the law.”
The TC stated that “[t]he law should not be such a[n] idiot that it cannot prevent a taxpayer from changing the historical facts from year to year in order to escape a fair share of the burdens of maintaining our government. Our tax system depends upon self-assessment and honesty, rather than upon hiding of the pea or forgetful tergiversation.”
The TC explained that for the duty of consistency to apply, the following requirements must be satisfied: (i) a representation or report by the taxpayer, (ii) reliance by the IRS, and (iii) an attempt by the taxpayer, after the statute of limitations has run, to change the previous representation or to re-characterize the situation in such a way as to harm the IRS.
If all those elements are present, the IRS may act as if the previous representation, on which it relied, continues to be true, even if it is not. The taxpayer is estopped to assert the contrary.
The duty of consistency is an affirmative defense. Therefore, the party asserting the duty of consistency bears the burden of proving that it applies. In the present case, that burden rested on the IRS.
Does it Apply?
In applying the first element of the duty of consistency, it had to be shown that Shareholders made a representation or report.
Shareholders consistently reported income on the basis of Corp’s bank deposits. The IRS asked that the TC hold them to this consistent reporting as to 2009.
The TC found that Shareholders made a clear representation on the 2009 tax return for Corp when they represented that Corp had received the $1.63 million of gross receipts in 2009 (rather than in 2008, when it was actually received). Thus, this element of the duty of consistency was met.
The second element of the duty of consistency requires a showing of reliance by the IRS on the taxpayer’s representation. According to the TC, “[c]ase law establishes that the necessary acquiescence exists where a taxpayer’s return is accepted as filed; examination of the return is not required.” The TC further stated that “[t]he [IRS] may rely on a presumption of correctness of a return or report that is given to the [IRS] under penalties of perjury.”
Shareholders claimed that the IRS did not reasonably rely on their representation because the IRS knew that the notices of deficiency did not accurately reflect Shareholders’ income from 2009.
The TC disagreed, stating that the IRS had already relied upon Shareholders’ representations by accepting the 2008 tax returns and allowing the period of limitations to expire. This element of the duty of consistency was met.
The third element of the duty of consistency requires an attempt by the taxpayer, after the statutory period of limitations has expired, to change the previous representation or to re-characterize the situation in such a way as to harm the
Shareholders admitted that reporting the 2008 payments for 2008, rather than for 2009, would be inconsistent with their previous reporting. The period of limitations had expired on the 2008 tax year, and allowing Shareholders to re-characterize their income as belonging in 2008 would harm the IRS; it would allow Shareholders to avoid tax on $1.63 million.
Thus, the IRS established that all of the elements for the duty of consistency had been met.
The TC concluded that the duty of consistency required that the $1.63 million in gross receipts that Corp received in 2008, but reported for 2009, be recognized by Shareholders as income for tax year 2009.
It doesn’t take a degree in tax to figure out that the Shareholders’ position in the case discussed above was untenable. Even on just a visceral level, their gambit feels wrong.
They knew that they were not reporting their income in accordance with Corp’s chosen method of accounting. Rather than reporting items of income in the year in which they were received, Corp effectively “stuck the checks in a drawer” until the following tax year.
When it was found out, Corp tried to turn the IRS’s own argument against it in order to avoid the taxation of income altogether.
A taxpayer and its advisers should always assume that the taxpayer’s tax return, and any transactions reported therein, are going to be examined. That mindset should force them to consider the bona fide nature of such a transaction, and to assess the strength of the return positions to be relied upon. This exercise should be conducted before the transaction is even undertaken, and well before the return is filed.
Once an examination has begun, the taxpayer stands to lose credibility in the eyes of the IRS if the taxpayer has taken indefensible or irrational positions on its return. This may adversely affect the taxpayer’s ability to sustain other, reasonable positions, and it will certainly invite the imposition of penalties that cannot be abated.