Kelley v. C.I.R.

• Decision Date: 07 June 1989
• Docket Number: No. 87-7413,87-7413
• Citation: 877 F.2d 756
• Parties: -5025, 58 USLW 2009, 89-1 USTC P 9360 Daniel M. KELLEY; Nancey N. Kelley, Petitioners-Appellants, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee.
• Court: U.S. Court of Appeals — Ninth Circuit

Page 756

877 F.2d 756

64 A.F.T.R.2d 89-5025, 58 USLW 2009, 89-1

USTC P 9360

Daniel M. KELLEY; Nancey N. Kelley, Petitioners-Appellants, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee.

No. 87-7413.

United States Court of Appeals Ninth Circuit.

Argued and Submitted April 7, 1989.

Decided June 7, 1989.

Arthur H. Boelter and John J. White, Jr., Boelter, Silver & Gale, Seattle, Wash., for petitioners-appellants.

Doris D. Coles, Tax Div., Dept. of Justice, Washington, D.C., for respondent-appellee.

Appeal from a Decision of the Tax Court of the United States.

Before PREGERSON, BOOCHEVER and NOONAN, Circuit Judges.

BOOCHEVER, Circuit Judge:

The Kelleys appeal decisions of the Tax Court that the statute of limitations did not bar an adjustment to their 1980 tax return, and that they were not entitled to have their deficiency determined by use of income averaging because they did not raise the issue in their petition. We reverse on both issues.

I. STATUTE OF LIMITATIONS

The taxpayers, a husband and wife, filed a joint return for 1980. The husband was a fifty percent shareholder in Holly Homes Company (HHC), a subchapter S corporation. On their 1980 tax return the taxpayers deducted $163,933 as their share of a loss passed through HHC.

The Commissioner obtained an extension of the statute of limitations from the taxpayers. The Commissioner obtained an extension from HHC for HHC's 1979 tax year. This extension expired November 30, 1983. The Commissioner did not obtain an extension from HHC for its 1980 tax year.

The Commissioner issued a Notice of Deficiency to the taxpayers on August 14, 1984. This Notice disallowed $140,625 of the losses from HHC's 1980 tax return. The taxpayers petitioned the Tax Court, contending that the statute of limitations barred the adjustment of the loss passed through HHC. The Tax Court ruled that the statute of limitations did not bar the adjustment. The parties agree that if the statute of limitations for an adjustment based on a disallowance of an item on an S corporation's tax return applies at the corporation level the adjustment was barred, whereas if it applies at the taxpayer level, the adjustment was valid.

DISCUSSION

We review the Tax Court's conclusions of law de novo. Vukasovich, Inc. v. Commissioner, 790 F.2d 1409, 1413 (9th Cir.1986). ¹

With certain exceptions an S corporation does not pay taxes. Instead, it files an informational return and its shareholders pay taxes on its income. E.g., Jacobsson v. Commissioner, 87 T.C.M. (P-H) 559 at 3004 (1987). If the corporation is determined not to be a valid S corporation it will be subject to taxation at the corporate level. Certain capital gains and a minimum tax on tax preference items may also subject the S corporation to taxation. Id.

Section 6501 ² provides the statute of limitations for assessment of income tax: "Except as otherwise provided in this section, the amount of any tax imposed by this title shall be assessed within 3 years after the return was filed...." I.R.C. Sec. 6501.

Section 6037 requires S corporations to file returns each year and provides that "[a]ny return filed pursuant to this section shall, for purposes of chapter 66 (relating to limitations), be treated as a return filed by the corporation...." I.R.C. Sec. 6037. The parties dispute the meaning of this section. The Commissioner argues that this provision means that the statute of limitations is triggered by the filing of the informational return only if it is determined that the corporation itself owes a tax because of an invalid election or because one of the exceptions applies. According to this interpretation, items on the informational return can be adjusted at any time, and passed through to the shareholder as long as the limitations period applicable to the shareholder's individual return has not expired. The Tax Court accepts the Commissioner's position. See Jacobsson, supra; Leonhart v. Commissioner, 68 T.C.M. (P-H) 98 (1968), aff'd on other issues, 414 F.2d 749 (4th Cir.1969). The taxpayers contend that the provision means that no adjustments can be made based on any item on the S corporation's return after the statute of limitations has run on the corporation's return, even if the adjustment would create a tax deficiency only at the shareholder level.

In interpreting a statute we look first to its language. E.g., Hughes Air Corp. v. Public Utilities Comm'n, 644 F.2d 1334, 1337 (9th Cir.1981). Section 6037 says that a return filed by an S corporation must be treated, for purposes of the statute of limitations, as a return filed by a regular corporation. With certain inapplicable exceptions a corporation's income tax return cannot be questioned after three years from the date the return is filed. See I.R.C. Sec. 6501. A literal construction of section 6037 would similarly seem to bar adjustments to an S corporation's return after the three year period.

The shareholder can defend against such an adjustment only by resort to the corporation's books and records. The statute of limitations exists, in part, so that after some time persons can be confident that their affairs are closed and they can dispose of old records. An S corporation should be entitled to the same finality as others, yet if any of the shareholders has given an extension of the statute of limitations to the IRS the shareholder's ability to defend against the adjustment would depend upon whether the corporation has retained the records.

Barring adjustment of a shareholder's return based on an item from an S corporation's return when the statute has run on the corporate return should not prejudice the IRS. As demonstrated in this case, the Service can obtain an extension of the statute of limitations if it determines that it needs more time to determine the accuracy of the corporate return. A requirement that the Service obtain an extension of the statute of limitations from the S corporation serves to place the corporation on notice that it should retain the materials necessary to substantiate its return.

The Tax Court in this case relied on Leonhart, which justified its position as follows:

It is only where the election of the corporation is for some reason determined to have been ineffective that section 6037 is intended to provide that the information return filed by the corporation will be treated as a corporate return for the purposes of the statute of limitations. That is clearly indicated by that portion of the Senate Report on the Technical Amendments Act of 1958, which added section 6037, relating to that section, which reads as follows:

IV. TECHNICAL EXPLANATION

Section 68. Election of Certain Small Business Corporations

....

Annual returns required

Notwithstanding the fact that an electing small-business corporation is not subject to the tax imposed by chapter 1 of the 1954 Code, such corporation must make a return for each taxable year in accordance with new section 6037 as added by subsection (c) of section 68 of the bill. Such return will be considered as a return filed under section 6012 for purposes of the provisions of chapter 66, relating to limitations. Thus, for example, the period of limitation on assessment and collection of any corporation tax found to be due upon a subsequent determination that the corporation was not entitled to the benefits of subchapter S, will run from the date of filing of the return required under the new section 6037. Senate Report No. 1938, 85th Cong., 2d Sess. (1958), 1958-3 C.B. 922, at 1147.

Leonhart, 68 T.C.M. (P-H) 98 at 515 (footnote omitted). Treasury Regulation 1.6037-1(c) essentially mirrors the legislative history quoted in Leonhart. We disagree with the Tax Court's reading of this legislative history. This Senate Report does not indicate that section 6037 means the S corporation's return is treated as a corporate return only if the corporation itself is determined to owe tax. While it refers to an unqualified corporation as an example, it leaves open whether the statute of limitations applies in other situations. If Congress had intended the example to swallow the language of the text, Congress could easily have written the statute to provide that the period of limitations will run from the date of filing of the return required under section 6037 only in instances of a subsequent determination that a corporation was not entitled to the benefits of subchapter S.

In addition to relying on the reasoning of Leonhart, the Tax Court accepted the following argument: "Because a valid S corporation is not liable for income taxes, there is no 'amount' to be assessed under section 6501(a) and therefore no occasion for a period of limitations on assessment with respect to the corporation's return. Thus, the statute of limitations must be applied at the shareholder level." This reasoning, however, is not dispositive of the issue. The language of section 6501 ("the amount of any tax imposed by this title shall be assessed within 3 years after the return was filed") indicates that the tax imposed (in the case of an S corporation the tax owed by the shareholder on account of the S corporation's activities) must be assessed within 3 years after the filing of some return, but does not indicate whether the relevant return is the taxpayer's or the corporation's.

We hold that the IRS may not adjust a shareholder's return based on an adjustment to an S corporation's return when the statute of limitations has run on the S corporation's return. We reverse the Tax Court's determination that the adjustment was not barred by the statute of limitations.

II. THE INCOME AVERAGING ELECTION

In 1981, before the Notice of Deficiency was sent, the taxpayers had filed an amended return for 1980 electing to use income averaging. The Notice of Deficiency listed four adjustments to the 1980 return, including the disallowance of the HHC loss discussed above. No mention was made of income averaging. On the attached Statement...