Gross Income
The Supreme Court held that Sec. 6501(e)(1)(A), which extends the three-year statute of limitation for assessing a deficiency against a taxpayer to six years where the taxpayer omits from gross income an amount in excess of 25% of the amount of gross income stated in a return, does not apply to an understatement of gross income due to a taxpayer’s overstatement of basis on a return. The Supreme Court’s decision resolved a split on the issue among the federal circuit courts.
Background
In 1999, the owners of Home Oil Co., in anticipation of its sale, devised a plan with the assistance of their accountants and lawyers to increase the basis of the assets of the company and thereby decrease the taxable gain on the sale of the company. To that end, they created Home Concrete and Supply LLC (Home Concrete), which was treated as a partnership for federal tax purposes. The owners initiated short sales of a large amount of Treasury bonds and transferred the proceeds from the short sale to Home Concrete as a capital contribution. The owners claimed the amount contributed as outside basis in Home Concrete, but they did not reduce the basis on account of the outstanding obligation to close the short sales.
Home Concrete used most of the amount contributed by the owners subsequently to close the short sales. Shortly afterward, Home Oil transferred its assets to Home Concrete as a capital contribution, and the owners transferred part of their ownership interests to Home Oil. Home Concrete sold substantially all the Home Oil assets a little more than a month later.
In reporting the sale of the assets on its timely filed 1999 return, Home Concrete elected under Sec. 754 to step up the basis in the Home Oil assets to equal its partners’ basis in their interests in Home Concrete. The partners’ basis in the partnership was much higher than the basis in the assets due to the owners’ capital contributions. After step-up, Home Concrete claimed a basis in the Home Oil assets almost equal to the proceeds from their sale, resulting in Home Concrete’s recognizing only a modest gain from the sale of the assets. The 1999 return properly reflected the basic components of the transactions, including an itemized accounting of Home Concrete’s initial basis in the Home Oil assets, the amount of Sec. 754 adjustments to the assets, and their post-adjustment basis.
Despite the obviously questionable nature of these transactions, the IRS did not investigate them until 2003. As a result of the investigation, on Sept. 7, 2006, the IRS issued Home Concrete a final partnership administrative adjustment (FPAA), decreasing the owners’ outside bases in Home Concrete to zero. This had the result of eliminating the Sec. 754 step-up in basis of the Home Oil assets and substantially increasing Home Concrete’s taxable gain on their sale. The IRS made the adjustments because it found that the series of transactions had no business purpose other than tax avoidance, lacked economic substance, and constituted an economic sham for federal tax purposes.
The District Court’s Decision
Home Concrete deposited $1,392,118 with the IRS and sued for a refund to recover the amount, alleging that the FPAA was barred by the general three-year limitation period on assessments in Sec. 6501(a). The IRS countered that Home Concrete’s understatement of gross income due to its overstatement of the basis of the Home Oil assets constituted an omission from gross income in excess of 25% of the income stated in Home Concrete’s 1999 return and thus, under Sec. 6501(e)(1)(A), the extended six-year statute of limitation on assessment applied.
In response to the IRS’s contentions, Home Concrete argued that the Supreme Court’s decision in Colony Inc., 357 U.S. 28 (1958), in which the Supreme Court held that the predecessor statute to Sec. 6501(e)(1)(A) did not encompass an overstatement of basis, precluded the application of the extended statute of limitation. In addition, Home Concrete (once again, relying on Colony) claimed that even if the overstatement of basis was an omission from gross income, its tax returns, along with those of Home Oil and the owners, collectively made adequate disclosure of the transactions such that they were entitled to the safe harbor for the three-year statute of limitation under Sec. 6501(e)(1)(B)(ii).
The district court held in favor of the IRS, finding that Colony did not apply to the case because its holding is limited to cases in which the taxpayer is a trade or business selling goods or services and that an understatement of gross income due to an overstatement of basis could be an omission of income for purpose of Sec. 6501(e)(1)(A) (Home Concrete & Supply, LLC, 599 F. Supp. 2d 678 (E.D.N.C. 2008)). The court further held that the adequate disclosure safe harbor did not apply. Home Concrete appealed the decision to the Fourth Circuit.
IRS Issues New Regulations
In response to losses on the statute of limitation issue in other circuits, the IRS attempted to shore up its litigating position by issuing a new regulation (Regs. Sec. 301.6501(e)-1(a)(1)(iii)) that clearly states that an understatement of gross income resulting from an overstatement of basis is an omission of gross income for purposes of determining whether the six-year statute of limitation applies. The regulation was applicable to tax years with respect to which the period for assessing tax was open on or after Sept. 24, 2009 (Regs. Sec. 301.6501(e)-1(e)). The regulation became final while Home Concrete’s case was on appeal with the Fourth Circuit, and the IRS incorporated it into its arguments, claiming that it applied in the case because a final opinion had not been rendered as of Sept. 24, 2009. The IRS further argued that the regulation’s interpretation of Sec. 6501(e)(1)(A) was entitled to judicial deference under Chevron U.S.A. Inc. v. Natural Resources Defense Council, Inc., 467 U.S. 837 (1984).
The Fourth Circuit’s Decision
The Fourth Circuit reversed the district court’s decision and held that an overstatement of basis was not an omission of gross income for purposes of Sec. 6501(e)(1)(A) (Home Concrete & Supply, LLC, 634 F.2d 249 (4th Cir. 2011)). It found that the Supreme Court’s holding in Colony was controlling, agreeing with the Ninth and Federal Circuits that the Supreme Court had interpreted the phrase omits from gross income “unhinged from any dependency on the taxpayer’s identity as a trade or business selling goods or services” and thus there were no grounds to conclude that the holding in Colony was limited to cases involving a trade or business selling goods or services.
With respect to the new regulations issued by the IRS, the court held they did not apply to the transactions at issue and were not entitled to deference. It held that the regulations did not apply in Home Concrete’s case because the IRS position, that the period for assessing tax remained open as long as litigation was pending, was contrary to the clearly and unambiguously expressed intent of Congress in Sec. 6501. In addition, the court found that even if the regulation applied, it was entitled to deference only if it was an interpretation of an ambiguous statute. The court held that the Supreme Court had declared that Sec. 6501(e)(1)(A) was unambiguous in Colony, and therefore the regulation was not entitled to deference.
After the Fourth Circuit refused the IRS’s request to rehear the case en banc, the IRS appealed the case to the Supreme Court, which granted certiorari.
The Supreme Court’s Decision
In a 5–4 decision, the Supreme Court affirmed the Fourth Circuit. The Court held that its interpretation of the predecessor statute to Sec. 6501(e)(1)(A) in Colony was controlling and that new Regs. Sec. 301.6501(e)-1(a)(1) did not overrule the Court’s interpretation of the statute in that case. Thus the extended statute of limitation under Sec. 6501(e)(1)(A) did not apply where there was an understatement of gross income due to an overstatement of basis on a return.
The Court determined that Colony applied largely on the basis of the doctrine of stare decisis, under which courts will not lightly overturn established precedent. The Court noted that while there had been changes made to the predecessor statute of Sec. 6501 when Congress reenacted the statute as part of the Internal Revenue Code of 1954, the language at issue in Sec. 6501(a)(1)(E) was identical to the corresponding section of the predecessor statute. According to the Court,
It would be difficult, perhaps impossible, to give the same language here a different interpretation without effectively overruling Colony, a course of action that basic principles of stare decisis wisely counsel us not to take. [Slip op. at 4]
While the IRS pointed to differences in other nearby parts of the 1954 Code that it claimed supported a different interpretation of Sec. 6501(e)(1)(A) than that found in Colony, the Court concluded that the IRS’s various arguments with respect to the language differences were weak and did not justify overturning Colony and reinterpreting the statute.
With respect to new Regs. Sec. 301.6501(e)-1(a)(1), the IRS argued that under the Court’s decision in National Cable & Telecommunications Ass’n v. Brand X Internet Services, 545 U.S. 967 (2005), a court’s interpretation of a statute trumped an agency’s interpretation of the statute only if the statute was unambiguous. Otherwise, under Chevron, the court must give deference to the agency’s interpretation as long as it is a permissible construction of the statute. The IRS contended that the Colony Court had found that Sec. 6501(e)(1)(A) was ambiguous, and that its interpretation of the statute in Regs. Sec. 301.6501(e)-1(a)(1) was a permissible construction of the statute. Therefore, the IRS asserted that the Court must give the new regulation deference. The Court rejected the IRS’s argument, stating, “In our view, Colony has already interpreted the statute, and there is no longer any different construction that is consistent with Colony and available for adoption by the agency” (slip op. at 8).
Reflections
In Part IV-C of the opinion, Justice Stephen Breyer, writing for a plurality of the Court (which included all the justices that joined the majority opinion, except for Justice Antonin Scalia), explained the plurality’s reasoning why the IRS’s interpretation of Sec. 6501(e)(1)(A) did not overrule the Court’s holding in Colony. The plurality explained that, as the Court had stated in Brand X Internet Services, as well as Chevron and other cases, it was for agencies through regulations, not the courts, to fill statutory gaps. If a statute was unambiguous, there is no statutory gap for an agency to fill and no room for agency discretion. The plurality determined (despite the statement in Colony that the statutory language at issue was not unambiguous) that the opinion in Colony made it clear that the Court had found that the statute was unambiguous and had left no statutory gap for the IRS to fill with regulations.
In a separate concurring opinion, Justice Scalia sharply criticized Part IV-C of the opinion, in which he did not join. He agreed that the Court’s decision in Colony was controlling and said, “That should be the end of the matter.” He asserted that in order to come to its conclusion that Regs. Sec. 301.6501(e)-1(a)(1) did not overrule the Court’s decision in Colony, it had revised the meaning of Chevron “yet again [as in Brand X] in a direction that will create confusion and uncertainty” (emphasis in original).
Home Concrete & Supply, LLC, Sup. Ct. Dkt. 11-139 (U.S. 4/25/12)
