Procedure & Administration
The Tax Court handed the IRS a double loss, holding that temporary regulations it issued after an earlier adverse decision did not apply to that case and that the temporary regulations were invalid because they were contrary to the Supreme Court’s opinion in Colony, Inc ., 357 U.S. 28 (1958).
Background
Intermountain Insurance Service of Vail, LLC (Intermountain), engaged in a series of transactions—some of which increased tax basis—culminating in the sale of business assets on August 1, 1999, for $1,918,844. It reported the $1,918,844 gross sales price and, after deducting $131,544 of allowed or allowable depreciation, claimed a stepped-up $2,061,808 basis in the assets on its 1999 return filed on September 15, 2000.
Almost six years later, on September 14, 2006, the IRS issued a notice of final partnership administrative adjustment (FPAA) with respect to Intermountain’s 1999 tax year. The IRS found that some of the transactions Intermountain engaged in were improper and ineffective for federal income tax purposes and consequently determined that Intermountain had improperly overstated capital contributions by $2,197,696 and overstated outside partnership basis by $2,061,808.
The IRS asserted that because of Intermountain’s understatement of income due to its substantial basis overstatements on the 1999 return, the return’s period of limitation for assessment was extended to six years under Secs. 6229(c)(2) and 6501(e)(1)(A). These sections state that the period of limitation for assessment remains open for six years if a taxpayer (Sec. 6501(e)(1)(A)) or a partnership (Sec. 6229(c)(2)) omits an amount from gross income in excess of 25% of reported gross income. Intermountain challenged the timeliness of the FPAA in Tax Court, arguing that the general three-year limitation period had already expired when the IRS issued the FPAA and that, consistent with the Tax Court’s earlier opinion in Bakersfield Energy Partners, LP , 128 T.C. 207 (2007), an omission from gross income does not include an understatement of income caused by an overstatement of basis, so the six-year limitation period did not apply.
The Tax Court’s Initial Decision
The Tax Court declined to reverse its holding in Bakersfield and held that the six-year limitation period did not apply ( Intermountain Ins. Serv. of Vail, LLC , T.C. Memo. 2009-195). It explained that in Bakersfield it had applied the Supreme Court’s holding in Colony , stating that “the extended period of limitations applies to situations where specific income receipts have been ‘left out’ in the computation of gross income and not when an understatement of gross income resulted from an overstatement of basis.” The Tax Court further noted that the Ninth Circuit had affirmed its Bakersfield decision ( Bakersfield Energy Partners, LP , 568 F.3d 767 (9th Cir. 2009)).
IRS Issues New Regs.
Foiled by the Tax Court’s and the Ninth Circuit’s literal application of the Supreme Court’s holding in Colony , the IRS took a different tack. A month after the Tax Court’s decision in favor of Intermountain, it issued temporary regulations (T.D. 9466) that state in part that an understatement of gross income “resulting from an overstatement of unrecovered cost or other basis constitutes an omission from gross income” with respect to Secs. 6229(c)(2) and 6501(e)(1)(A) (Temp. Regs. Secs. 301.6229(c)(2)-1T and 301.6501(e)-1T). The IRS then filed a motion asking the Tax Court to vacate its earlier decision and reconsider its opinion, arguing that the new temporary regulations were controlling and thus Intermountain was subject to the six-year limitation period due to its overstatements of basis. The Tax Court agreed to entertain the IRS’s motions so that it could consider the effect of the temporary regulations on the case.
The Tax Court’s Decision
The Tax Court held that the temporary regulations did not apply to Intermountain’s case because the tax year in question was before the effective date of the regulations. The Tax Court also held that the temporary regulations were invalid because they were contrary to the Supreme Court’s Colony decision.
With respect to the effective date, the Tax Court stated that its starting point in interpreting a regulation is the regulation’s plain meaning. The effective date provisions in the temporary regulations state that “[t]he rules of this section apply to taxable years with respect to which the applicable period for assessing tax did not expire before September 24, 2009.” Having concluded in its prior opinion that the general three-year limitation period applied to Intermountain’s case and that this period ended sometime before September 14, 2006, the Tax Court held that the plain meaning of the effective date provisions in the temporary regulations indicated that they did not apply to the case.
The IRS had argued that the temporary regulations should apply to Intermountain’s 1999 tax year (notwithstanding the effective date provision) because the period of limitation under Secs. 6229(c)(2) and 6501(e)(1)(A), as interpreted in the temporary regulations, remained open for that year. The Tax Court blasted this argument, stating:
Specifically, we find the interpretation to be irreparably marred by circular, result-driven logic and the wishful notion that the temporary regulations should apply to this case because Intermountain was involved in what he [the Commissioner] believes was an abusive tax transaction.
With respect to the validity of the regulations, the Tax Court, citing National Cable & Telecomms. Ass’n v. Brand X Internet Servs. , 545 U.S. 967 (2005), stated that it was not obliged to give deference to the IRS’s regulatory interpretation of the statutes if the Supreme Court had held in Colony that its interpretation of the statutes followed from the unambiguous terms of the statutes and left no room for agency discretion. The Tax Court found that in Colony , the Supreme Court, after reviewing the applicable legislative history, held that Congress’s intent was that the six-year statute of limitation applies only to an omission of taxable income. Thus, it does not apply to an understatement of income caused by an overstatement of basis. According to the Tax Court, the Colony opinion foreclosed the IRS from interpreting in regulations that the statute applied to understatements of income caused by overstatements of basis. Consequently, it held that the temporary regulations were invalid.
Reflections
In issuing the temporary regulations, the IRS was following a suggestion by the Ninth Circuit in its Bakersfield opinion that the IRS might have authority to reinterpret an ambiguous Code provision even if its reinterpretation was contrary to a prior Supreme Court interpretation of the provision. Presumably the Ninth Circuit believed that the Code was ambiguous in this case, so it is possible that it and other circuits might disagree with the Tax Court’s holding that the temporary regulations were invalid based on the Colony decision.
However, it is hard to see how the IRS thought it could convince the Tax Court to apply the temporary regulations to the Intermountain case (and several other similar cases) when the regulations were issued after the original decisions in the cases and had an effective date that required circular logic to bring the taxpayers within their scope. Although the IRS is justified in pursuing its interpretation of the six-year statute of limitation in cases where the tax year in question falls within the effective date of the temporary regulations, it should not be attempting to use the temporary regulations to revive cases where the tax year in question clearly does not fall within their effective date.
Intermountain Ins. Serv. of Vail, LLC , 134 T.C. No. 11 (2010)
