Federal tax accounting, passive activity losses, and Tax Court jurisdiction recently collided in Milton v. Commissioner, T.C. No. 19188-23 (Feb. 3, 2024). The Internal Revenue Service (IRS) had audited Joseph Milton and an S corporation in which he was a shareholder. The S corporation audit led to an IRS-imposed accounting method change for 2015, which resulted in an adverse section 481(a) adjustment and a favorable current-year adjustment. Part of each flowed to Milton and netted $5.1 million of additional 2015 income. The IRS issued a notice of deficiency to Milton reflecting this additional income but also allowing the same amount of previously suspended passive activity losses. The result was no deficiency for 2015 (albeit deficiencies for 2016 and 2017). Milton petitioned the Tax Court and the IRS moved to dismiss with respect to 2015 on the ground that there was no deficiency over which the court had jurisdiction. The Tax Court granted the IRS's motion.

The Tax Court began by observing that its jurisdiction depends on both (1) the IRS issuing a valid notice of deficiency and (2) a taxpayer filing a valid petition. The court held that the first requirement was not satisfied for 2015 because the notice of deficiency showed no additional tax due. "When [the IRS] makes adjustments to a taxpayer's income which are completely offset by other adjustments, such that the... deficiency calculation indicates no additional tax due for that year, the Court lacks jurisdiction." Id. "Although petitioner may disagree with respondent's [section 481(a)] adjustment, this adjustment did not result in a deficiency" and so does not satisfy the prerequisites for Tax Court jurisdiction. Id.

So where does this leave Milton? If 2015 were the only year at issue, the Tax Court proceeding would be over. A refund suit would also be unavailable because Milton does not assert that he overpaid his 2015 taxes. Instead, Milton would have to wait for a dispute with the IRS to arise in a future year in which he seeks to use the passive activity losses that the notice of deficiency treated as having been absorbed in 2015. Thankfully for Milton, it appears this issue will come to a head for 2016, for which the IRS has asserted additional income that exceeds what the IRS believes to be Milton's remaining passive activity losses. The 2016 tax year remains pending before the Tax Court.

The order in Milton serves as a good reminder to taxpayers with tax attribute carryovers that disputes over the propriety of IRS adjustments may not ripen into a "deficiency" providing access to Tax Court for several years. "As the burden of proof is on the taxpayer to disprove the presumptively correct assertions of [the IRS's] deficiency notice, it is the taxpayer on whom this passage of time will fall hardest: memories may fade, documents may be lost—all to the prejudice of [the taxpayer's] case." Martz v. Commissioner, 77 T.C. 749 (1981). The Tax Court has expressed sympathy for this taxpayer plight, but is ultimately powerless to offer an alternative given existing statutory limits on the court's jurisdiction. While taxpayers often chomp at the bit for their day in court, Milton illustrates that a taxpayer's particular facts and circumstances can delay this day far into the future.

For more information, please contact:

James R. Gadwood, jgadwood@milchev.com, 202-626-1574

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