Three Years is the Normal Statute of Limitations, But Not Always

Published on: 15:20PM Aug 12, 2014

I get a phone call or email many times during the year asking how long a taxpayer needs to keep documents. The answer is "it depends" as is usually the answer for all tax questions. The IRS generally has three years from the due date of your tax return to assess additional tax. Therefore, if you filed your 2013 tax return without an extension, the IRS has until April 15, 2017. With an extension, the date would be October 15, 2017.

Now, in the case of fraud (assuming the IRS can prove fraud), the IRS has six years to assess additional tax. Now, if you invest in a partnership that is subject to certain rules that were put into place many years ago, this 3 or 6 year period can be dramatically longer as was shown in an US Tax Court case released today.

In the McElroy case, the taxpayers had invested $37,500 each year during 1996, 1997 and 1998 in partnerships. The partnerships took the money from the partners, acquired cemetery sites, held them for a year and then donated them to qualified cemeteries to pass through a charitable donation. For example, in 1999, the partnership acquired sites with a value of about $95,000. Without waiting a year, the partnership then donated the sites and then passed-through to the partners a charitable donation of $1,864,850 or about 20:1. As you can probably guess this was sham and the operator of the partnerships suddenly found himself in hot water and finally ended up serving some type in the Federal Pen.

The taxpayer had invested $37,500 each year expecting net tax benefits of at least $50,000 a year. He filed his returns and the normal 3 year statute passed fairly quickly. The partnerships were subject to rules passed back in 1982 that required a tax matters person (TMP) to be appointed. That person was Mr. Johnson who agreed with the IRS to extend the statute of limitations through 2008 as the TMP for the partnership. After being sent to jail, the TMP was transferred to Mr. McElroy who continued as the TMP until he declared bankruptcy in 2010.

The partnership audits were finally settled in 2013 (at least 15 years after the first individual return was filed) and the IRS then assessed additional taxes on Mr. McElroy. He claimed that the statute of limitations had expired clear back in 2002. However, one of the nasty features about these types of partnerships is that any item that is ultimately resolved at the partnership level is then passed through to the partner (assuming the IRS assesses the liability within a year of the final assessment). That happened in this case and the Tax Court agreed with the IRS that Mr. McElroy owed the additional tax assessment even though it happened more than 15 years after the deduction.

When investing in any partnership where you are a limited partner or member, the fine print will usually spell out the possibility of this happening, although most people never read or understand those sections. Therefore, this can happen to you. If you invest in a partnership that promises substantial tax benefits; don't breathe a sigh of relief when the normal three-year statute of limitations passes since you may be required to pay your tax savings plus interest plus penalties more than 15 years down the road.