Another Circuit Says Overstatement of Basis Is Not an Omission from Gross Income

The ongoing controversy over whether a taxpayer’s overstatement of basis triggers a six-year statute of limitation period continues as the Fourth Circuit has held that the extended period does not apply (Home Concrete & Supply, LLC, No. 09-2353 (4th Cir. 2/7/11)). The taxpayers had artificially overstated the bases 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 that therefore the longer six-year period to assess the tax due applied.

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)(B) defines the term “gross income.”

The IRS has 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 section 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)).

Courts have split over whether this is the correct treatment, and the final regulations conflict with federal court decisions that have 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); and Salman Ranch Ltd., 573 F.3d 1362 (Fed. Cir. 2009)). The Fourth Circuit has now agreed with the position upheld by the Ninth and Federal Circuits, as well as the Tax Court (Intermountain Ins. Serv. of Vail, LLC, 134 TC No. 11 (2010)). These decisions rely on 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.

However, the Seventh and Fifth Circuits have agreed with the position in the regulations that an overstatement of basis amounts to an omission from gross income (Beard, No. 09-3741 (7th Cir. 1/26/11); Phinney v. Chambers, 392 F.2d 680 (5th Cir. 1968)). The IRS has argued that the Supreme Court said in Colony that the statutory phrase “omits from gross income” is ambiguous and that the Supreme Court’s interpretation of the phrase is therefore not the only permissible interpretation.

The Fourth Circuit did not agree with this stance and held that the final regulations were not entitled to deference under Chevron because the Supreme Court’s Colony decision “squarely applies to this case.” (The final regulations were issued while this case was being litigated and do not apply to the tax year at issue, but the IRS had argued for their retroactive application.)

The court therefore held that the taxpayers’ overstated bases did not trigger the six-year limitation period and that the IRS’ assessment was barred by the applicable three-year statute of limitation in Sec. 6501(a).