Five years ago, Spyros Dietrich wanted to sell IMPEXT, Inc., his wholly owned importexport business. He also wanted to avoid recognizing the substantial gain that would result from his selling his IMPEXT shares on the open market. Spyros' basis in the shares ($100,000) was well below their market value ($600,000).
To avoid gain recognition, Spyros formed the SH Partnership with his brother Hussein. To capitalize the partnership, Spyros transferred all his IMPEXT shares to SH in exchange for 99 SH Partnership units. Hussein transferred $100 cash in exchange for one SH Partnership unit. Subsequently, Spyros formed Fu Yung, Inc., an S corporation, and transferred his 99 SH Partnership units to Fu Yung in exchange for 99 Fu Yung shares.
Under Sec. 708, the transfer to Fu Yung technically caused a dissolution of SH.
However, Spyros and Hussein agreed to continue the SH "business" in reconstituted form as the FYH Partnership. Thereupon, FYH elected under Sec. 754 to step up its basis in the IMPEXT shares from $100,000 to $600,000. Then FYH sold the IMPEXT shares to disinterested investor Gonzalez for $615,000, thereby realizing only a $15,000 gain. Ninetynine percent of this gain passed through to Spyros' separate return via Fu Yung and FYH.
The series of transactions went unnoticed by the IRS until the current year, when it audited Spyros' return. On that return, Spyros reported $525,000 of ordinary income and $14,850 (i.e., 99% of $15,000) of capital gain. When the IRS alleged that Spyros had substantially understated his income, Spyros raised the "statute of limitations" as a defense.
Is the IRS correct in its allegation? If so, is it precluded by the statute of limitations from collecting additional taxes from Spyro? Before answering these questions, please consult the following sources:
• IRC Secs. 708, 704, 6501
• Brandon Ridge Partners v. U.S., 100 AFTR 2d 2007-5347, 2007-2 USTC ¶50,573 (DC FL, July 30, 2007)