by Ann Holley, Jon Sedon, and Carlo Osi, KPMG LLP
Ann Holley is a partner and Jon Sedon is a manager
with the State and Local Tax group of KPMG LLP’s
Washington National Tax (WNT) office. Carlo Osi is a
former intern with WNT’s State and Local Tax group.
Disclaimer: The information contained herein is of a
general nature and based on authorities that are subject to
change. Applicability of the information to specific situations should be determined through consultation with your
tax adviser. This article represents the views of the authors
only, and does not necessarily represent the views or
professional advice of KPMG LLP.
This article will first discuss the basic operation
of the federal and state income tax returns. It will
then discuss the various omission bases used by
states to determine whether a taxpayer falls under
the extended statute of limitations, as well as exceptions to the extended statutes. Finally, the article
will discuss the effect of extended statutes of limitations on income tax provision and will provide a
series of questions for taxpayers to consider in
analyzing the applicability of a state’s extended
statute of limitations.
Background
Most states increase the statute of limitations on
income tax assessments when the taxpayer makes a
substantial understatement or omission. Those
state statutes are similar — and in some cases
identical — to IRC section 6501(e)(1), which extends
the general three-year statute of limitations for tax
assessments to six years when the taxpayer understates its gross income by more than 25 percent.1
For federal purposes, the extended statute of limitations is an exception from the general three-year
statute of limitations.2
Although state extended statutes of limitations
are often modeled after the federal statute, in many
cases there are significant differences. For example,
some states provide a different limitation period,
while some provide a different omission percentage
threshold that triggers the extended statute.3 However, the most significant difference among the
states is arguably the base on which the omission is
measured (for example, gross income, taxable income, tax liability, and so on).
1
IRC section 6501(e)(1).
IRC section 6501(a).
3
See, e.g., Ore. Rev. Stat. section 314.410(2) (prescribing a
five-year extended statute of limitations); S.C. Code Ann.
section 12-54-85(C)(3) (providing an extended statute of limitations when there is a 20 percent understatement).
2
State Tax Notes, October 3, 2011
To illustrate the differences among the bases on
which substantial omissions are determined, it is
important to understand the basic operation of the
federal and state income tax returns as well as some
terms.
The most significant difference
among the states is arguably the
base on which the omitted income
is measured.
The federal return starts with gross income (that
is, gross receipts or sales) from which the cost of
goods sold is subtracted. Additions (dividends, interest received, and so forth) and deductions (wages,
interest paid, and so forth) are made to reach
taxable income before net operating loss deduction
and special deductions (Line 28 taxable income).
From Line 28 income, NOLs and some special deductions are taken into account, resulting in federal
taxable income (Line 30 taxable income).
States generally start with either Line 28 or Line
30 taxable income and then make some additions
and subtractions, resulting in the state tax base.
The base is then apportioned and allocated to the
state. The state tax rate is applied to the apportioned and allocated income, resulting in a tentative
tax liability. State income tax credits, if applicable,
could reduce the tentative tax liability.
23
(C) Tax Analysts 2011. All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content.
States’ Extended Statutes of
Limitations for Substantial Omissions
Special Report
I. State Variations
Although the substantial omission bases subject
to extended statutes of limitations vary among
states, the bases can be grouped into a handful of
categories.
A. Gross Income
The most common base on which substantial
omissions are determined is gross income. Recall
that the Internal Revenue Code measures the
amount of understatement relative to gross income.4
IRC section 6501(e) provides that ‘‘in the case of a
trade or business, the term ‘gross income’ means the
total of the amounts received or accrued from the
sale of goods or services (if such amounts are required to be shown on the return) prior to diminution by the cost of such sales or services.’’5 Interestingly, IRC section 6501(e) does not provide
definitions for gross income in contexts outside of a
trade or business. However, a Treasury regulation
clarifies that ‘‘gross income,’’ as the term relates to
income other than from the sale of goods or services
in a trade or business, has the same meaning as
provided under IRC section 61(a).6
4
IRC section 6501(e).
IRC section 6501(e)(1)(B)(i).
6
IRC section 301.6501(e)-1(a)(1)(iii). Note that IRC section
61(a) provides that:
gross income means all income from whatever source
derived, including (but not limited to) the following
5
The substantial omission base in many states
mirrors the federal provision. For example, District
of Columbia law provides that:
if the taxpayer omits an amount properly includible in gross income which is in excess of
25% of the amount of gross income stated in
the return, the tax may be assessed, or a
proceeding in court for the collection of the tax
may be begun without assessment, at any time
within 6 years after the return was filed.7
Some states explicitly adopt the code definition or
adopt a definition of gross income similar to the
definition provided under IRC section 6501(e). The
District of Columbia, for example, defines gross
income in words almost identical to the federal
definition.8
Although many states measure a substantial
omission relative to gross income, the state’s definition of gross income is not necessarily the same as
the federal definition. For example, Minnesota law
defines gross income as:
the gross income as defined in section 61 of the
Internal Revenue Code of 1986, as amended
through the date named in subdivision 19 for
the applicable taxable year, plus any additional
items of income taxable under this chapter but
not taxable under the Internal Revenue Code,
less any items included in federal gross income
but of a character exempt from state income
tax under the laws of the United States.9
The inclusion of state modifications in determining gross income is potentially a fairly significant
deviation from federal gross income. Thus, it is
important for taxpayers to consider each state’s
definition of gross income insofar as the definition is
relevant to determining substantial omissions.
items: (1) Compensation for services, including fees,
commissions, fringe benefits, and similar items; (2)
Gross income derived from business; (3) Gains derived
from dealings in property; (4) Interest; (5) Rents; (6)
Royalties; (7) Dividends; (8) Alimony and separate
maintenance payments; (9) Annuities; (10) Income from
life insurance and endowment contracts; (11) Pensions;
(12) Income from discharge of indebtedness; (13) Distributive share of partnership gross income; (14) Income in respect of a decedent; and (15) Income from an
interest in an estate or trust.
7
D.C. Code section 47-4301(d)(2).
8
Id. The statute provides that ‘‘in the case of a trade or
business, the term ‘Gross income’ means the amount received
or accrued from the sale of goods or services (if the amounts
are required to be shown on the return) before diminution by
the cost of the sales or services.’’
9
Minn. Stat. section 290.01 (Subd. 20); Minn. Stat. section
289A.38 (Subd. 6)(1); Minn. Stat. section 289A.02.
(Footnote continued in next column.)
24
State Tax Notes, October 3, 2011
(C) Tax Analysts 2011. All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content.
Now consider a taxpayer that has a significant
amount of income it considers to be nonbusiness,
unapportionable income. Further assume that it
allocates the nonbusiness income to a state other
than State A or State B. Suppose that State A
extends its general statute of limitations of three
years to six years if a taxpayer understates its
federal gross income by more than 25 percent. The
determination of whether income is business income
or nonbusiness income does not affect federal gross
income. Accordingly, State A cannot attempt to assess tax after the three-year statute runs on the sole
basis that the taxpayer should have reported the
nonbusiness income as apportionable business income. However, suppose that State B extends its
general three-year statute of limitations to six years
if a taxpayer understates its state taxable income
after allocation and apportionment by more than 25
percent. Because State B’s extended-statute provision depends on state taxable income rather than
federal gross income, State B could potentially assess tax after the three-year statute of limitations
has run on the basis that the income should have
been reported as business income (assuming, of
course, that the resulting omission is more than 25
percent).
Special Report
If the taxpayer omits from base income an
amount properly includible therein which is in
excess of 25% of the amount of base income
stated in the return, a notice of deficiency may
be issued not later than 6 years after the
return was filed. For purposes of this paragraph, there shall not be taken into account
any amount which is omitted in the return if
such amount is disclosed in the return, or in a
statement attached to the return, in a manner
adequate to apprise the Department of the
nature and the amount of such item.10
Base income is defined as ‘‘an amount equal to the
taxpayer’s [federal] taxable income for the taxable
year’’ after state modifications.11 Notice that the
state modifications may implicate a host of items
that have no bearing on gross income. For example,
the Illinois base on which a substantial omission is
determined would include the amount of some NOL
deductions, the amount of bonus depreciation, and
some amounts paid to related parties.12
C. State Taxable Income After Allocation and
Apportionment
Some states determine whether a substantial
omission exists on the basis of state taxable income
after allocation and apportionment. For example,
Nebraska law provides:
If the taxpayer omits from Nebraska taxable
income an amount properly includable therein
which is in excess of twenty-five percent of the
amount of taxable income stated in the return
or a corporate return omits a properly includable member of the unitary group as defined in
section 77-2734.04, a notice of a deficiency
determination may be mailed to the taxpayer
within six years after the return was filed.13
Taxable income is defined as ‘‘federal taxable
income as adjusted, and, if appropriate, as apportioned.’’14 Although substantial omission bases discussed earlier do not implicate allocation and apportionment provisions, some bases do, such as
Nebraska’s. For example, improper sourcing of sales
in constructing the sales factor or inappropriate
categorization of an income item as nonbusiness
income could cause (or contribute to) a substantial
omission.
D. State Tax Liability
A few states use state tax liability to determine
whether a substantial omission exists. For example,
under New Mexico law:
If a taxpayer in a return understates by more
than twenty-five percent the amount of his
liability for any tax for the period to which the
return relates, appropriate assessments may
be made by the department at any time within
six years from the end of the calendar year in
which payment of the tax was due.15
It is also worth noting that when a state that
bases substantial omission on state tax liability
determines the amount of understatement relative
to the tax liability, a taxpayer’s application of state
tax credits toward its liability could affect whether a
substantial omission exists.
E. Miscellaneous
Some states use other substantial omission bases.
Many of those bases do not fit neatly into one of the
categories above. For example, Georgia law extends
its statute of limitations for assessment and collections to six years ‘‘if the taxpayer omits from gross
income an amount properly includable in gross income which exceeds 25 percent of the amount of
gross income less business expenses stated in the
return.’’16 Under Missouri law, the statute for notices of deficiency is extended to six years ‘‘if a
taxpayer corporation omits from its return an
amount of income that is properly includable in its
gross income from all sources within this state which
is in excess of twenty-five percent of the amount of
gross income stated in its return from all sources
within this state.’’17
F. Multiple Bases
To complicate matters further, some states provide more than one base on which to determine
whether a substantial omission exists. For example,
North Dakota law provides for a six-year statute of
limitations ‘‘if there is a change in taxable income or
income tax liability by an amount which is in excess
of twenty-five percent of the amount of taxable
income or income tax liability stated in the return as
filed.’’18 Accordingly, it appears that if either taxable
income or income tax liability is understated by
more than 25 percent, the statute of limitations is
extended to six years in North Dakota.
10
35 Ill. Comp. Stat. 5/905(b)(1).
35 Ill. Comp. Stat. 5/203(b)(1); 35 Ill. Comp. Stat.
5/203(e)(1).
12
35 Ill. Comp. Stat. 5/203(b)(2).
13
Neb. Rev. Stat. section 77-2786(2).
14
316 Neb. Admin. Code section 24-058.11.
11
State Tax Notes, October 3, 2011
15
N.M. Stat. Ann. Section 7-1-18(D).
Ga. Code Ann. section 48-7-82(b)(2), emphasis added.
17
Mo. Rev. Stat. section 143.711(2), emphasis added.
18
N.D. Cent. Code section 57-38-38(3), emphasis added.
16
25
(C) Tax Analysts 2011. All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content.
B. State Taxable Income Before Allocation
and Apportionment
Several states provide that the base on which a
substantial omission is determined is state taxable
income before allocation and apportionment. For
example, Illinois law provides:
Special Report
in determining the amount omitted from gross
income, there shall not be taken into account
any amount which is omitted from gross income stated in the return if the amount is
disclosed in the return, or in a statement
attached to the return, in a manner adequate
to apprise the Franchise Tax Board of the
nature and amount of the item.19
These provisions provide an extra layer of analysis in determining whether a substantial omission
has occurred. First, one must ascertain whether a
substantial omission exists, absent disclosure. If so,
one must determine whether the item has been
disclosed either on the face of the return or in an
attached statement that sufficiently discloses the
amount. If so, the taxpayer may be protected from
the extended statute of limitations.
II. Effect on Income Tax Provision
If state extended statutes of limitation may be of
considerable importance in state tax controversies,
those statutes may have a significant effect on a
company’s income tax provision. Uncertain tax benefits not recognized under ASC 740 can be recognized when the statute of limitations has expired or
when the matter has been ‘‘effectively settled’’ with
the taxing authority.20 The potential for application
of an extended statute of limitations can therefore
affect when uncertain tax benefits can be recognized
based on the expiration of the statute of limitations.
The interaction of the extended statute of limitations and whether a matter is effectively settled can
raise some interesting questions. ASC 740-10-25-10
enumerates three conditions needed to consider a
matter effectively settled: (1) the taxing authority
has concluded its examinations, including any appeals and administrative reviews; (2) the taxpayer
does not intend to litigate or appeal any aspect of the
tax position; and (3) the likelihood that the taxing
authority will reopen the tax year is remote.21 Further, in determining whether chances are remote
that the taxing authority will reopen the tax year,
the taxpayer must assume that the taxing authority
has full knowledge of the facts. If a taxpayer has
been audited and its position has been examined
and upheld, it generally may be safe to assume that
19
Cal. Rev. & Tax. Code section 19058(b)(2).
ASC 740-10-25-8. There are other events that may
trigger the recognition of uncertain tax benefits, but those
situations are beyond the scope of this article.
21
ASC 740-10-25-10.
20
26
that tax year will not be reopened. In that situation,
the extended statute of limitations might not have
any effect on the timing of the recognition of the tax
benefits. However, what if a taxpayer is examined,
the issue is not specifically addressed by the taxing
authority, and the regular statute of limitations
expires? In that situation, the taxpayer would have
to consider whether the position at issue is effectively settled.
Whether an uncertain tax benefit
can be recognized may depend on
whether the position taken would
result in the application of a state
extended statute of limitations.
As discussed above, whether an uncertain tax
benefit can be recognized may depend on whether
the position taken would result in the application of
a state extended statute of limitations. Below, we
address some of the more common kinds of state
uncertain tax positions.
A. Forced Combination/Non-Unitary Affiliates
Some interesting issues arise if the benefits associated with an uncertain tax position are not recognized on the basis that (1) an entity could be forcibly
combined with one or more affiliates or (2) the
taxpayer is not engaged in a unitary business with
an affiliate, and thus cannot be combined. First,
because the omission presumably affects gross income, state taxable income before allocation and
apportionment, state taxable income after allocation
and apportionment, and tax liability, the omission
likely implicates all potential measures used by the
states for computing a substantial omission. Second,
for states with exceptions for disclosure, there may
be an argument (depending on the state’s specific
requirements) that the exclusion of the gross income
is disclosed in the return. For example, it may be
clear that an affiliate’s income is not included in the
return if the state requires federal Form 851, ‘‘Affiliations Schedule,’’ to be attached to the return and
the affiliate in question is listed on Form 851 but is
not included in the computation of the state tax
liability.
B. Related-Party Expenses
The disallowance of expenses paid to related
parties is another area in which a taxpayer may not
have recognized uncertain tax benefits. States that
compute a substantial omission relative to gross
income are unlikely to extend the statute of limitations since the denial of an expense does not affect
gross income. However, the denial of an expense
would affect state taxable income before allocation
State Tax Notes, October 3, 2011
(C) Tax Analysts 2011. All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content.
G. Exceptions for Disclosure
A significant number of states do not include
items that are disclosed via the taxpayer’s return in
determining whether a substantial omission exists.
California law, for example, provides that:
Special Report
C. Sales Factor Sourcing
Another common area of unrecognized tax benefits relates to sales factor sourcing, particularly for
sales of services and intangibles. It may be unclear
whether, under a particular state’s sourcing method,
a specific type of receipt is included in the numerator of the state’s sales factor.24 Generally, a position
that a particular type of receipt is includible (or
excludable) from the sales factor does not affect
gross income or state taxable income before apportionment. Rather, it could affect either state taxable
income after allocation and apportionment, or tax
liability.
There may be a legitimate debate regarding
whether a position related to sales factor sourcing is
disclosed on the return. On one hand, schedules
included in the tax form for computing the sales
factor may provide some detail on how the sales
factor is computed, but those forms likely do not
disclose the sourcing method used. As a result, it
may be difficult to argue that the sales factor sourc-
22
If a state includes credits in the computation of state
liability, a taxpayer could theoretically have expenses denied
but have adequate credits to cover the increase in tax.
23
For example, Wisconsin requires the attachment to the
corporate income tax return for related party expenses
(Schedule RT, available at http://www.revenue.wi.gov/forms/
2010/10ic-175.pdf), and Massachusetts requires the attachment of a schedule of intercompany receivables (Schedule A-2,
http://www.mass.gov/Ador/docs/dor/Forms/Corp10/355/sch_A_
2.pdf) and payables (Schedule A-3, http://www.mass.gov/Ador/
docs/dor/Forms/Corp10/355/sch_A_3.pdf).
24
Under nearly identical facts and statutory law, courts
from two different states came to drastically different conclusions on proper sales factor inclusion of a telecommunication
company’s sales of services. AT&T Corp. v. Comm’r of Revenue, No. C293831, 2011 Mass. Tax LEXIS 45 (Mass. App. Tax
Bd., June 8, 2011); AT&T Corp. v. Dep’t of Revenue, No. TC
4814, 2011 Ore. Tax LEXIS 270 (Ore. Tax Ct. June 28, 2011).
State Tax Notes, October 3, 2011
ing method is disclosed on the face of the return
itself. Alternatively, a taxpayer could include a
statement or additional detail with the return that
would arguably alter the taxing authority’s view of
the position and constitute disclosure.
D. Business vs. Nonbusiness Income
A final common area of unrecognized state tax
benefits concerns positions over whether an item of
income is considered apportionable business income
or allocable nonbusiness income. Typically, those
positions do not implicate gross income or state
taxable income before allocation and apportionment
but will affect state taxable income after allocation
and apportionment. Most states provide a place on
the return or a supporting schedule to account for
nonbusiness income that is not allocable to the state.
Accordingly, those positions may be deemed to be
disclosed on the return.
Conclusion
State extended statutes of limitations related to
substantial omissions vary greatly. Further, one
should not assume that all state extended statutes
of limitations mirror IRC section 6501(e). Rather,
each state statute should be analyzed individually in
conjunction with the particular uncertain tax position. With the above principles in mind, taxpayers
should determine whether some tax benefits should
be recognized because of the inapplicability of a
state extended statute of limitations. That is, a
taxpayer may have incorrectly assumed that a state
extended statute of limitations applies to a particular uncertain tax position and, in that case, may be
able to recognize the associated benefit. In the
applicability of the state extended statute of limitations, a taxpayer should consider the following questions:
Does the state have an extended statute of limitations?
• If so, what is the state’s base for the substantial
omission (for example, gross income, state taxable income before allocation and apportionment, and so on)?
• Given the uncertain tax position at issue, does
the position implicate the state’s substantial
omission base?
• If so, based on the state threshold, does a
substantial omission potentially exist?
• If so, does the state provide an exception for
disclosure?
• If so, has the item been disclosed?
✰
27
(C) Tax Analysts 2011. All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content.
and apportionment, state taxable income after allocation and apportionment, and potentially the state
tax liability.22
There may be a legitimate debate regarding
whether related-party expenses are disclosed and
are thus not considered for purposes of determining
whether the understatement was substantial. Many
states require specific forms that must be attached
to the return when a taxpayer has related-party
expenses.23 In states that require those forms, inclusion of the form might be considered adequate
disclosure (depending on the state’s specific requirements).