Overstatement of Basis Is Not Omission from Gross Income, Appeals Court Rules

For the second time in a week, a federal circuit court of appeals has handed the IRS a defeat on the issue of whether an overstatement of basis amounts to an omission from gross income for purposes of invoking the longer, six-year limitation period for assessing tax under Sec. 6501(e) (Burks, No. 09-11061 (5th Cir. 2/9/11)). This decision reached the same conclusion as the Fourth Circuit in a case decided on February 7. See “Another Circuit Says Overstatement of Basis Is Not an Omission From Gross Income.”

In 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.

The Fifth Circuit held 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” (slip op. at 9). In this case, the court held, the taxpayers, although they misstated their bases, “disclosed the nature of the items on their tax returns sufficient to notify the Commissioner of the item being reported” (slip op. at 13). The court found that section 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” (slip op. at 19).

The court distinguished the facts of this case from the facts in Phinney v. Chambers, 392 F.2d 680 (5th Cir. 1968), a prior Fifth Circuit case that held that an overstatement of basis does constitute an omission from gross income. 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” (slip op. at 10).

Like the Fourth Circuit, the Fifth Circuit refused to afford recently issued final regulations on the topic deference under Chevron, U.S.A., Inc. v. National Res. Def. Council, 467 U.S. 837 (1984), because it found section 6501(e)(1)(A) to be “unambiguous and its meaning is controlled by the Supreme Court’s decision in Colony [357 U.S. 28 (1958)]” (slip op. at 22). It found the regulations to be “an unreasonable interpretation of settled law” (slip op. at 24).

With this decision, the Fifth Circuit moves into alignment with the Fourth, Ninth and Federal circuits, as well as the Tax Court. However, last month, the Seventh Circuit held in favor of the IRS’ 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)).