Split Widens as Courts Hold Basis Overstatement Is Not Income Omission

By James A. Beavers, J.D., LL.M., CPA

Procedure & Administration

The ongoing controversy over whether a taxpayer’s overstatement of basis triggers a six-year statute of limitation period continues as the Fourth Circuit and Fifth Circuit both held within days of each other that the extended period does not apply. These decisions are at odds with a Seventh Circuit opinion issued in January and with regulations finalized in December (T.D. 9511).

Background

The taxpayers in the Fourth Circuit case, Home Concrete, had artificially overstated their basis in their LLC interests through a series of transactions that, according to the IRS, lacked economic substance and therefore had underreported gain from the sale of those interests. The IRS argued that this amounted to an omission from gross income, and therefore the longer six-year period to assess the tax due applied. In the Fifth Circuit case, Burks, the taxpayers had engaged in a son-of-boss tax shelter to create artificial tax losses to offset capital gains. As a result of various transactions, the taxpayers ended up with inflated bases in their partnership assets.

Under Sec. 6229(c)(2), if a partnership “omits from gross income” an amount that should be included and that exceeds 25% of the amount of gross income stated in its return, the period for assessing tax attributable to its partnership items is extended to six years. Similarly, Sec. 6501(e)(1)(A) provides that if a taxpayer omits from gross income an amount that should be included and that exceeds 25% of the amount of gross income stated in the return, the period of time for assessment is extended to six years. Sec. 6501(e)(1)(A) also defines the term “gross income.”

After losing earlier litigation on the topic, the IRS issued final regulations that define gross income, as it relates to a trade or business, as “the total of the amounts received or accrued from the sale of goods or services, to the extent required to be shown on the return, without reduction for the cost of those goods or services” (Regs. Secs. 301.6229(c)(2)-1(a)(1)(ii) and 301.6501(e)-1(a)(1)(ii)). The regulations further state that gross income, as it relates to any income other than from the sale of goods or services in a trade or business, “has the same meaning as provided under Sec. 61(a), and includes the total of the amounts received or accrued, to the extent required to be shown on the return” (Regs. Secs. 301.6229(c)(2)-1(a)(1)(iii) and 301.6501(e)-1(a)(1)(iii)).

Previous Court Decisions

Prior to the Burks and Home Concrete cases, the courts had split over whether the IRS’s position was correct. The Ninth Circuit, the Federal Circuit, and the Tax Court all have held that an overstatement of basis does not constitute an omission from income (Bakersfield Energy Partners, 568 F.3d 767 (9th Cir. 2009); Salman Ranch Ltd., 573 F.3d 1362 (Fed. Cir. 2009); Intermountain Ins. Serv. of Vail, LLC, 134 T.C. No. 11 (2010)). These courts relied on the Supreme Court’s opinion in Colony, 357 U.S. 28 (1958), in their decisions.

However, in a much earlier case, the Fifth Circuit held in Phinney, 392 F.2d 680 (5th Cir. 1968), that an overstatement of basis could be an overstatement of income for purposes of the statute of limitation where there was a fundamental misstatement of the nature of an item reported in a tax return. The Seventh Circuit also recently held that an overstatement of basis amounts could be treated as an omission from gross income in cases where the omission was not in the course of a trade or business (Beard, No. 09-3741 (7th Cir. 1/26/11)). The court concluded that with respect to an omission not in the course of a trade or business, the plain meaning of the statute indicated that an overstatement of basis should be considered an omission from gross income.

Fourth and Fifth Circuit Decisions

The Fourth and Fifth Circuits adopted the majority view and held that an overstatement of basis does not constitute an omission from income. Both circuits also held that the final regulations were not entitled to deference from the courts and did not apply to the tax years at issue in the cases.

In Home Concrete, the district court held, as did the Seventh Circuit in Beard, that Colony did not apply in the case because the taxpayer was not in the trade or business of selling goods. However, the Fourth Circuit found that the Supreme Court did not make its interpretation of an omission from gross income in Colony dependent on whether the omission was related to a trade or business of selling goods, so its holding in the case was not limited to such cases. Therefore, the court held that the Colony decision foreclosed the government’s argument that an overstatement of basis was an omission from gross income.

With regard to the final regulations, the court held that even if the regulations were valid, they did not apply to the transaction in question because it occurred in a tax year that was outside the reach of the regulations’ express period of applicability. The court further found that the final regulations were not entitled to deference under Chevron U.S.A., Inc. v. Natural Res. Def. Council, Inc., 467 U.S. 837 (1984), because a regulation is entitled to Chevron deference only when it interprets an ambiguous statute, and the Supreme Court had already declared the statute unambiguous in Colony.

The Fifth Circuit melded the precedents set by Colony and Phinney in its decision, finding that the holdings in the two cases were consistent. Echoing Phinney, the court found that “both an actual omission of an amount from the tax return or a fundamental misstatement of the nature of an item reported in a tax return that places the Commissioner at a disadvantage in detecting the error may result in application of the extended limitations period.” In this case, the court held, the taxpayers, although they had misstated their bases, “disclosed the nature of the items on their tax returns sufficient to notify the Commissioner of the item being reported.” The court found that Sec. 6501(e)(1)(A)(ii) creates a safe harbor for “omissions of amounts which, though not included in the gross income as stated in the tax return, are adequately disclosed such that the IRS has sufficient notice.”

Although using basically the same standards it had set out in Phinney, the court came to the opposite conclusion by distinguishing the facts of this case from the facts in Phinney. In Phinney, the court said, the taxpayer “did not merely misstate an amount but rather misrepresented the very nature of the item reported such that the IRS could not have reasonably known what was actually being reported.”

Like the Fourth Circuit, the Fifth Circuit refused to afford the final regulations on the topic deference under Chevron because it found Sec. 6501(e)(1)(A) to be “unambiguous and its meaning is controlled by the Supreme Court’s decision in Colony” and that the regulations were “an unreasonable interpretation of settled law.” It also held that the regulations by their express terms of applicability did not apply to the tax years in question.

Reflections

With four of five circuits and the Tax Court weighing in against it, the IRS faces tough sledding in the future litigating this issue. However, the Supreme Court’s recent decision in Mayo Found. for Med. Educ. and Research, 131 S. Ct. 704 (2011) (see Tax Trends, 42 The Tax Adviser 205 (March 2011)), could possibly give the regulations a new lease on life, although the Fifth Circuit stated in a footnote to the Burks opinion that Mayo would not save the regulations because they were not subject to notice and comment before they were issued (Burks, slip op. at 23–24, n. 9).

The Burks court also claimed that Mayo stood for the proposition that the IRS could not issue regulations in response to litigation. It noted in the footnote that the Mayo Court was not faced with regulations issued in response to “prior adverse judicial decisions on the identical legal issue.” In support of its position, the court cited in the footnote earlier decisions holding that deference to “an agency’s convenient litigating position” is “entirely inappropriate” (Bowen v. Georgetown Univ. Hosp., 488 U.S. 204, 213 (1988)) and that the IRS cannot “promulgate regulations during the course of a litigation for the purpose of providing [itself] with a defense based on the presumption of validity accorded to such regulations” (Chock Full O’ Nuts Corp., 453 F.2d 300, 303 (2d Cir. 1971)).

However, in the Mayo opinion, the Supreme Court clearly states that the IRS could issue regulations in response to litigation, and cites its own decisions in which it has found the fact that regulations were prompted by litigation immaterial (Smiley v. Citibank (South Dakota), N. A., 517 U.S. 735, 740 (1996)) and in which it expressly invited the IRS to amend its regulations if it did not like the Court’s resolution of the case (United Dominion Indus., Inc., 532 U.S. 822, 838 (2001)). It therefore seems that the Fifth Circuit may have overreached in stating that under the Mayo standard, regulations issued in response to litigation would not also be accorded Chevron deference, as long as they were issued after appropriate notice and comment.

Home Concrete & Supply, LLC, No. 09-2353 (4th Cir. 2/7/11); Burks, No. 09-11061 (5th Cir. 2/9/11); Beard, No. 09-3741 (7th Cir. 1/26/11)

Newsletter Articles

AWARD

James M. Greenwell Wins 2014 Best Article Award

The winner of The Tax Adviser’s 2014 Best Article Award is James M. Greenwell, CPA, MST, a senior tax specialist–partnerships with Phillips 66 in Bartlesville, Okla., for his article, “Partnership Capital Account Revaluations: An In-Depth Look at Sec. 704(c) Allocations.”

 

FEATURE

How Legal Marijuana Businesses Are Treated Federally

This article examines the tax problems that these businesses face and warns that professionals may provide services to them at their peril.