IRS Maintains Stance on Omissions from Gross Income and Overstatement of Basis

Regulations

On December 15, the IRS released final regulations defining an omission from gross income for purposes of the six-year minimum period for assessment of tax attributable to partnership items and the six-year period for assessing tax (T.D. 9511). The regulations are designed to resolve whether an overstatement of basis in a sold asset results in an omission from gross income. However, the regulations finalize without change temporary regulations (T.D. 9466) that the Tax Court held to be invalid last May (Intermountain Ins. Serv. of Vail, LLC, 134 T.C. No. 11 (2010)).

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.” The regulations confirm that the Sec. 6501(e)(1)(A) definition of an omission from gross income applies for purposes of Sec. 6229.

The final regulations 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)). They 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)).

Under Regs. Sec. 1.61-6(a), gross income includes gains derived from dealings in property, which are defined as “the excess of the amount realized over the unrecovered cost or other basis for the property sold or exchanged.” The final regulations provide that, outside the trade or business context, “an understated amount of gross income resulting from an overstatement of unrecovered cost or other basis constitutes an omission from gross income” for purposes of Secs. 6229(c)(2) and 6501(e)(1)(A) (Regs. Secs. 301.6229(c)(2)-1(a)(1)(iii) and 301.6501(e)-1(a)(1)(iii)).

In so defining overstated basis as an omission from gross income, the final regulations conflict with prior federal court decisions, which held, in cases outside the trade-or-business context, 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)). The IRS disagrees with those decisions and asserted in the preamble to the temporary regulations that the “reasonable interpretation of the provisions under sections 6501(e)(1)(A) and 6229(c)(2) provided in these temporary regulations . . . is entitled to deference even if the agency’s interpretation may run contrary to the opinions in Bakersfield and Salman Ranch.”

In ruling that the temporary regulations were invalid, the Tax Court in Intermountain held that the Supreme Court’s opinion in Colony, 357 U.S. 28 (1958), which held that a basis overstatement is not an omission from gross income and that Congress did not intend for a basis overstatement to be an omission from gross income, was the only permissible interpretation of the statutory phrase “omits from gross income.” The IRS disagrees with this holding. In the preamble to the final regulations, the IRS notes that the Supreme Court said in Colony that the statutory phrase “omits from gross income” is ambiguous. The IRS argues that the Supreme Court’s interpretation of the phrase is therefore not the only permissible interpretation. The IRS states that it is allowed to adopt another reasonable interpretation of “omits from gross income,” under the authority of National Cable & Telecomms. Ass’n v. Brand X Internet Servs., 545 U.S. 967 (2005). (For a discussion of the Tax Court decision, see Tax Trends, “Temporary Regs. Held Invalid,” 41 The Tax Adviser 503 (July 2010).)

The final regulations are effective December 14, 2010, and for income tax purposes will apply to tax years for which the period for assessing tax was open on or after September 24, 2009 (the date the temporary regulations were issued).