Surk v. Commissioner: Excess Losses Claimed in Closed Years Reduce Current Tax Basis
Children learn certain social norms through game playing. In hide and seek, when the seekers exclaim, “alley alley oxen free!” the children in hiding are free to return to home base.It would violate a child’s sense of fairness if they could be tagged after the phrase has been called. But the hiders must play fair as well. As adults, taxpayers reasonably expect that when the statute of limitations on the assessment of federal income tax expires that alley alley oxen free has been called and the Internal Revenue Service (IRS) is time-barred from asserting that they owe additional federal income tax for that year. But that doesn’t mean that taxpayers can take advantage of misreporting either. As the October 29, 2024, decision in Surk, LLC v. Commissioner1 shows, the IRS can still reach back into a closed tax year to adjust current year income when doing so prevents a taxpayer from taking advantage of prior misreporting.
I. The Surk Case
The taxpayer in Surk, supra, was a taxable as partnership. The taxpayer owned a majority interest in a lower-tier partnership called Outerknown. In 2014, in violation of Section 704(d) of the Internal Revenue Code of 1986, as amended (the “Code”), the taxpayer deducted losses generated by Outerknown in excess of its basis in the Outerknown partnership interest that it held. The taxpayer made the same mistake in 2015. The total amount of these excess losses was approximately $3.3 million.
In 2016, as a result of making a taxable distribution, the taxpayer was entitled to increase its tax basis in its Outerknown partnership interest by approximately $3 million. The taxpayer, however, failed to take this event into account. Accordingly, when Outerknown allocated a $3 million operating loss to the taxpayer for 2016, it erroneously reported that the loss was suspended by Code § 704(d). In other words, after ignoring Code § 704(d) in 2014 and 2015, the taxpayer applied the rule with respect to Outerknown’s 2016 loss but did so after grossly understating its basis.
In 2017, Outerknown allocated a loss to the taxpayer of approximately $5 million. The taxpayer attempted to correct its 2016 error (but not the 2014 or 2015 mistakes) by increasing its basis in its Outerknown partnership interest by the amount that it neglected to take into account in 2016. The IRS ultimately conceded this issue but further asserted that the excess losses claimed by the taxpayer in 2014 and 2015 must decrease its basis in its Outerknown partnership interest, even though the statute of limitations for assessment had passed for those earlier years.
The taxpayer vigorously fought against the right of the IRS to make this adjustment. It asserted that the issue had not been timely raised, but the court held otherwise. The court then noted that Code § 705(a) provides the general rules for determining a partner’s basis in its partnership interest. This Code section requires a taxpayer to take into account the annual income and loss (but not below zero) from the time that the partner became a partner.2 The court held that the IRS was not improperly reducing the taxpayer’s basis in its Outerknown partnership interest below zero for 2014 or 2015. Instead, the court determined that the IRS was reducing the taxpayer’s basis in its Outerknown partnership interest for 2017.
Importantly for this holding, the court held that Code § 705(a) requires a reduction in the basis of a partnership interest for losses regardless of whether the losses are allowed or disallowed. Code § 704(d), however, only reduces the partner’s basis for allowed losses.3 Even though the losses claimed by the taxpayer for 2014 and 2015 were improper, the court held that they were allowed losses because (1) the taxpayer claimed the losses on its tax returns and (2) the IRS did not challenge those losses. Accordingly, the court’s holding reduced the taxpayer’s basis generally (Code § 705(a)) and for the purpose of claiming losses (Code § 704(d)).
The taxpayer made several arguments to refute the reduction in its Outerknown partnership interest. It asserted that the IRS was required to issue an assessment for 2014 and 2015. It also asserted that the IRS was seeking to disallow losses claimed in 2014 and 2015. The court dismissed both arguments. First, the court was determining the 2017 basis in the Outerknown partnership interest. Second, neither the IRS nor the court was asserting any change to 2014 or 2015 income.
II. Similar Instances
The rules applied to the taxpayer in Surk also come up in other contexts. For example, it is well established that the statute of limitations does not bar recomputing deductions in a closed year to determine the NOL carryforward to an open year.4 This principle is not limited to adjustments to an NOL carryforward being sought by the IRS. The IRS has specifically recognized that taxpayers may adjust taxable income in closed years for the purpose of determining the amount of an NOL carryover. In Revenue Ruling 81-88, 1981-1 CB 585, the IRS held that a taxpayer that inadvertently failed to claim a deduction in 1974 was allowed to reduce the amount of an NOL carryback that was considered to have been absorbed in that year by the amount of the missed deduction, even though 1974 was closed at the time that the carryback was made. In Revenue Ruling 82-49, 1982-1 CB 5, a taxpayer failed to claim an investment tax credit (an “ITC”) in 1976 and paid tax for that year. After the statute of limitations had closed for 1976, the taxpayer sought to carry the unclaimed credit forward and claim it for 1977. The IRS permitted the taxpayer to do so.5
In PLR 9504032 (Jan. 27, 1995), the taxpayer overstated the amount of cancellation of indebtedness (“COD”) income that it incurred in a bankruptcy in “Year-1.” The overstatement of COD income reduced the taxpayer’s NOL carryovers to subsequent years. After the statute of limitations had run on Year-1, the taxpayer sought to increase its NOL carryover based on the lower (correct) amount of COD income. The IRS ruled in favor the taxpayer:
[W]hen an NOL deduction is made up entirely of carryovers from prior loss year, the relevant year for the statute of limitations purposes is the year in which the deduction is eventually taken, not the loss years. Applying this analysis to the present situation, the fact that Year 1 is closed for statute of limitations purposes is irrelevant, since the relevant limitations periods are, or will be, those for the years to which the losses are carried and used as NOL deductions.
Accordingly, the ability to look back at closed years can help taxpayers as well as benefit the IRS.
III. Takeaways
The taxpayer in Surk, supra, sought to have his cake and eat it too: It claimed excess losses in 2014 and 2015 and fought against reducing its basis in its partnership interest when its basis otherwise exceeded such losses in a later year. Apart from any fairness issues, however, Surk, supra, illustrates the principle that the running of the statute of limitations on assessment may not be a “get out of jail free”card. As described above, there are many instances in which current tax consequences can arise from a year that is time-barred for assessment.
Mark (mleeds@mayerbrown.com; (212) 506-2499) is a tax partner with the New York office of Mayer Brown. Mark’s professional practice frequently includes helping clients address Internal Revenue Service audits and disputes.
2 The court cited both Robertson v. Commissioner, T.C. Memo. 2009-91 (taxpayers failed to establish basis in partnership interest and court accepted IRS position that basis was zero) and Chong v. Commissioner, T.C. Memo. 2007-12 (partner failed to establish basis in partnership interest) as illustrations of this rule.
3 Treas. Reg. § 1.704-1(d)(2).
4 See Mecom v. Commissioner, 101 T.C. 374 (1993) (holding that it is well-settled law that the IRS may examine barred years for the purpose of redetermining the NOL deduction for a current year); Barenholtz v. Commissioner, 784 F.2d 375 (Fed. Cir. 1986) (IRS was permitted to recompute taxable income in closed tax years to adjust NOL and charitable contribution carryovers to open years); See also FSA 200112005, where the IRS affirmed its intention to examine closed tax years for NOL redeterminations.
5 See also Phoenix Coal Co., Inc. v. Commissioner, 231 F.2d 420 (2nd Cir. 1956); Rev. Rul. 56-285, 1956-1 CB 134 (NOL carryover must be adjusted by the correct amount of depreciation, even if the amount claimed in an earlier closed taxable year was incorrect).
