Circuit Split Deepens on Six-Year Period for Basis Overstatements

The Federal Circuit Court of Appeals joined the Seventh Circuit in holding that an overstatement of basis can be construed as an omission from gross income for purposes of the extended six-year limitation period for assessment of tax, while the Fourth and Fifth circuits reached the opposite conclusion, ruling in taxpayers’ favor. The Fourth and Fifth circuits relied on the Supreme Court’s decision in Colony Inc. v. Commissioner (357 U.S. 28 (1958)), and both determined that new Treas. Reg. § 301.6501(e)-1, regarding omission from income, was not applicable. The Federal Circuit, on the other hand, said that Colony did not conclusively resolve legislative ambiguity on this issue. In deferring to the new regulations, it cited the recent endorsement by the U.S. Supreme Court in Mayo Foundation v. U.S. (docket no. 09-837) of the Chevron standard of review (Chevron U.S.A. Inc. v. Nat. Res. Def. Council Inc., 467 U.S. 837 (1984)) and called them the “new controlling authority.” (For Tax Matters coverage of Mayo Foundation, see April 2011, page 51.)

IRC § 6501(e)(1)(A) provides an extension to six years from the general three-year period for assessment of tax if a taxpayer omits from gross income more than 25% of the amount of gross income stated in the return.

In Colony, the Supreme Court determined that an overstatement of basis was not an omission from gross income under the predecessor to current section 6501(e)(1)(A), a finding the court said also was supported by the unambiguous language of the then newly codified section.

The IRS issued final Treas. Reg. § 301.6501(e)-1 in December 2010 (see prior Tax Matters coverage March 2011, page 57), providing that, for amounts relating to dispositions of property, an understatement of gross income caused by an overstated basis is an omission of gross income for purposes of section 6501(e)(1)(A).

In the Federal Circuit case, Grapevine Imports Ltd. engaged in a Son of BOSS transaction for tax year 1999 that the IRS said had overstated basis and understated gain on the sale of a business. The taxpayer won its challenge of a final partnership administrative adjustment in the Court of Federal Claims (77 Fed. Cl. 505), and the IRS appealed. The Federal Circuit said that Colony did not bar its finding that the statute is ambiguous with respect to the question at hand. Thus, it said, the first step of the Chevron test was met. The court then found in the second step that the regulations were a reasonable interpretation of the statute. It also found that the IRS did not abuse its discretion in applying them retroactively.

In the Fourth Circuit case, Home Concrete & Supply LLC (Home Concrete) similarly sought to minimize taxes on the sale of a business by using short sales of Treasury bonds. Home Concrete and its partners filed timely returns for the 1999 tax year, disclosing the transactions. More than three years later, the IRS disregarded the transactions as lacking economic substance and adjusted the returns by reducing what it said was an overstated basis. Home Concrete paid the additional tax and sued for a refund in the District Court for the Eastern District of North Carolina. That court in 2008 found that Colony did not bar an overstated basis as constituting an omission from gross income for purposes of the statute and concluded that the adjustment was timely (599 F. Supp. 2d 678). Home Concrete and the partners appealed.

The Fourth Circuit concluded that Colony did foreclose the argument that overstated basis is an omission of gross income, and the six-year statute of limitation did not apply. The IRS had further argued that the new Treas. Reg. § 301.6501(e)-1 should apply retroactively to clarify the ambiguity in Colony. The court stated that the new regulation did not apply by the plain terms of its applicability clause and was not entitled to deference because the Supreme Court had declared the statute unambiguous in Colony. Consequently, the district court’s judgment was reversed.

In the Fifth Circuit, Burks v. U.S. involved two consolidated cases concerning Son of BOSS transactions. The IRS issued partnership adjustments more than three but less than six years after the taxpayers filed their returns. On appeal, the Fifth Circuit concluded that Colony applied, making the adjustments untimely. The court found that its 1968 decision in Phinney v. Chambers (392 F.2d 680) did not limit the Colony decision because Phinney dealt with an issue of misreporting rather than an overstatement of basis. The court also rejected the IRS argument that Colony no longer applies to all taxpayers in light of revisions in the statute. In addition, the court determined that the new regulations did not apply to the cases at hand for the same reasons as the Fourth Circuit did in Home Concrete.

These holdings of the Fourth and Fifth circuit courts are consistent with those of the Ninth Circuit in Bakersfield Energy Partners LP v. Commissioner (568 F.3d 767), the Federal Circuit in Salman Ranch, Ltd. v. U.S. (573 F.3d 1362), and the Tax Court in Intermountain Insurance Service of Vail LLC v. Commissioner (134 TC no. 11). However, in Grapevine Inc., the Federal Circuit noted that its holding in Salman Ranch predated the issuance of the new regulations and said the earlier decision therefore did not control its holding in Grapevine.

Earlier, a three-judge panel of the Seventh Circuit Court of Appeals in Beard v. Commissioner (docket no. 09-3741, see Tax Matters, March 2011, page 57), reversed the Tax Court and held that an overstatement of basis qualified for the six-year limitation period because of what the Seventh Circuit said is the plain meaning of the statute, without analyzing the regulations’ validity. The taxpayers have petitioned for a rehearing of that case by the Seventh Circuit en banc.

• Grapevine Imports Ltd. v. U.S., docket no. 2008-5090 (Fed. Cir. 3/11/2011)
• Home Concrete & Supply LLC v. U.S., docket no. 09-2353 (4th Cir. 2/7/2011)
• Burks v. U.S., docket no. 09-11061 (5th Cir. 2/9/2011)

By Karyn Bybee Friske, CPA, Ph.D., Pickens Professor of Business and associate professor of accounting, and Darlene Pulliam, CPA, Ph.D., McCray Professor of Business and professor of accounting, both of the College of Business, West Texas A&M University, Canyon, Texas.

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