In its Home Concrete decision last year, the Supreme Court limited the ability of Treasury, through regulations, to define the meaning of "omits from gross income" differently than the Court had previously construed. But due to plurality and concurring decisions with different analyses, only limited inferences can be made as to how the courts will rule in future cases involving Treasury regulations and other IRS pronouncements. The perennially nettlesome issue of when Treasury regulations have the force of law remains an open question, with conflicting Supreme Court guidance.
The 5–4 decision in Home Concrete & Supply, LLC, 132 S. Ct. 1836 (2012), reaffirmed the Court’s 1958 precedent in Colony, Inc., 357 U.S. 28 (1958), holding that a taxpayer who understates income by more than 25% on a tax return because of an overstatement of the basis of property in a sale of the property reported on the return is subject to the normal three-year statute of limitation, not the six-year period under Sec. 6501(e)(1)(A) for a substantial omission from gross income. The taxpayers in this case had used the son-of-boss tax shelter scheme (described later); thus, the case has major implications for those taxpayers involved in son-of-boss litigation who chose not to settle with the IRS. From a taxpayer’s and tax professional’s perspective, the decision underscores the general rule that the IRS must raise most tax issues in such cases within three years after a tax return is properly filed (or due, if later). A resource-limited IRS must relatively quickly identify and pursue most tax deficiencies. The decision might unintentionally encourage tax advisers and taxpayers who play the “audit lottery” to continue this strategy.
STATUTE OF LIMITATION
Secs. 6501(a) and (b) generally preclude the IRS from pursuing tax deficiencies against taxpayers after three years from a return’s filing or due date, if later. However, Sec. 6501(e) permits the IRS to assess tax deficiencies within a six-year period “if the taxpayer omits” from a return an amount that was properly includible in gross income where the omitted amount is more than 25% of the gross income stated in the return. The limitation period of six years, or in some cases longer, also applies in certain other areas, such as omitted gift and estate items and certain foreign transactions. Sec. 6501(c) provides that where a taxpayer files a false or fraudulent return with intent to evade tax, willfully attempts to evade taxes, or fails to file a return, the statute of limitation is unlimited.
COLONY'S TROUBLED LEGACY
In Colony, the Supreme Court considered the application of the predecessor statute to Sec. 6501(e)(1)(A) in the 1939 Code, which, in substantially identical language, provided for a longer (then five years) limitation period for examination of returns. The Court said the statute was “not unambiguous” on its face but added that its legislative history clearly demonstrated that Congress had intended the longer statute of limitation to apply only to “situations in which specific receipts or accruals of income items are left out of the computation of gross income.” The Court ruled in favor of the taxpayer, which had overstated the basis of real estate it sold by erroneously including in its cost certain unallowable development expenses. In so holding, the Court reversed the Tax Court and resolved a circuit court split. However, the IRS and taxpayers continued to disagree on Colony’s application, for reasons that included subsequent revisions in the Code (although not of the operative phrase).
SON OF BOSS
Another factor after Colony in the ongoing dispute was the rise of marketed tax shelters that purposely and artificially inflated basis, usually through a complex chain of transactions, to offset what otherwise would be large taxable gains. One became known as bond option sales strategy, or BOSS, with variants referred to as son of boss.
The IRS contended that because of these shelters’ convoluted nature, involving the use of multiple tax returns, it had difficulty discovering, identifying, and tracking them. As a consequence, the IRS failed to notify within three years most such taxpayers of an additional assessment of taxes. Several cases, including Home Concrete, arose because of the taxpayers’ use of son of boss and the IRS’s consequent assertion of the longer period.
A prominent factor in Home Concrete was whether another Supreme Court decision gave the IRS authority, despite the Court’s holding in Colony, to issue regulations providing that an understatement of gross income due to an overstatement of the basis of property sold is an omission from gross income for purposes of the extended limitation period. That decision, Chevron U.S.A., Inc. v. Natural Resources Defense Council, Inc., 467 U.S. 837 (1984), established a two-step analysis for determining the power of administrative agencies to interpret statutes. In step one, a reviewing court is to determine congressional intent. If it determines that congressional intent is clear and the statute is unambiguous, then there is no room for agency interpretation of any sort.
If it determines that the statute is ambiguous, then step two requires the court to determine whether the agency based its interpretation on a permissible construction of the statute. If the agency’s interpretation is based on a permissible construction of the statute (i.e., it is reasonable), the court must defer to the agency’s interpretation. When issuing regulations, the agency must explain its interpretation to better enable the courts to determine its reasonableness. In Mayo Foundation for Medical Education and Research, 131 S. Ct. 704 (2011), the Supreme Court ruled that Chevron analysis is to be applied to Treasury regulations in the same manner as to any other governmental agency’s regulations.
The government argued in Home Concrete that despite the precedent of Colony, statutory changes in “nearby parts of the 1954 Code” resulted in a sufficiently new law, with a new congressional intent, to permit the IRS to issue the new interpretive regulation. In December 2010, the IRS finalized Regs. Sec. 301.6501(e)-1(a)(1)(iii), which interpreted an omission from gross income that is within the meaning of Sec. 6501(e) and subject to the six-year period as including amounts realized from dispositions of property (other than from the sale of goods or services in a trade or business) that are understated as the result of an overstated basis.
CHEVRON DEFERENCE AND HOME CONCRETE
In Home Concrete, the Supreme Court found that the regulation was subject to the two-step Chevron analysis. The Court also considered the applicability of its 2005 Brand X decision (National Cable & Telecommunications Ass’n v. Brand X Internet Services, 545 U.S. 967 (2005)), which held that prior judicial construction of a statute trumps an agency interpretation only when the prior court has found the statutory language to be unambiguous, that is, when the prior court has found that its interpretation of the statute under Chevron’s step one is the only possible interpretation.
To base its decision on the clear precedent of Colony meant that the Court must engage in some strained logic to also follow the rule it had promulgated in Brand X. As Justice Antonin Scalia commented in his concurring opinion, the plurality opinion’s discussion of the role of regulations “yet again” created a situation that “will create confusion and uncertainty.”
For more on Chevron deference and Home Concrete, see “Judicial Deference to Regulations: Home Concrete & Supply, LLC,” The Tax Adviser, Jan. 2013, page 36.
THE MAJORITY OPINION
Three Supreme Court opinions were filed in Home Concrete—a majority/plurality opinion, a concurring opinion, and a dissent. Five of nine justices agreed that an understatement of gross income resulting from an overstatement of the basis of property sold does not constitute an omission from gross income for purposes of Sec. 6501(e)(1)(A). However, because only four justices joined the portion of the opinion discussing Chevron deference, practitioners are limited in what they can conclude about the long-running and difficult question of the legal weight afforded to Treasury regulations.
The majority opinion by Justice Stephen Breyer upheld the Colony ruling that for purposes of extending the general three-year statute of limitation for tax assessment, an omission from gross income does not include an understatement of reported gross income due to an overstatement of the basis of property sold. While the net effect on taxable income is the same whether one directly underreports income or indirectly does so by overstating the basis in property sold, the Colony court clearly distinguished between the two in regard to the statute of limitation.
The central problem of the Colony decision, from the perspective of a Chevron analysis, is the characterization by the Court in Colony of the 1939 law’s use of the word “omit” as “not unambiguous.” The Home Concrete majority conceded that the Court in Colony did in fact find the word “omit” to be “not unambiguous” and thus arguably subject to IRS interpretation. However, the Home Concrete plurality ultimately concluded that “the [Colony] Court thought that Congress had ‘directly spoken to the question at hand,’ and thus left ‘[no] gap for the agency to fill.’ ” The majority concluded that judicial principles of stare decisis (to follow previous judicial decisions) “wisely counsel us not” to overturn Colony.
The Home Concrete majority opinion emphasized that although Colony was decided under the 1939 Code, the Colony decision took note of the recently enacted 1954 law and found its interpretation of the 1939 Code “in harmony with the unambiguous language” of the 1954 Code, which at a minimum suggests that the Colony court saw nothing in the 1954 Code as inconsistent with its conclusion. However, Colony was reviewing the 1939 Code, and its dictum about the lack of ambiguity in the 1954 law was not binding on later courts.
The government also argued in Home Concrete that Brand X supported its claim to interpret an ambiguous statute. Brand X held that “a court’s prior judicial construction of a statute trumps an agency construction otherwise entitled to Chevron deference only if the prior court decision holds that its construction follows from the unambiguous terms of the statute.” The Home Concrete decision conceded statutory ambiguity but rejected this argument, reiterating that Colony “has already interpreted the statute, and there is no longer any different construction … available.”
THE PLURALITY OPINION
In the last part of his opinion, speaking only for the plurality and not joined by Justice Scalia, Justice Breyer discussed the Brand X test for determining when an agency’s determination can trump a prior court decision and why it did not apply in the case. The Court agreed that Brand X would control if the statute were ambiguous, but it found that the language of Sec. 6501(e)(1)(A) was not ambiguous. Justice Breyer stated:
As the Government points out, the Court in Colony stated that the statutory language at issue is not “unambiguous.” [Citation omitted.] But the Court decided that case nearly 30 years before it decided Chevron. There is no reason to believe that the linguistic ambiguity noted by Colony reflects a post-Chevron conclusion that Congress had delegated gap-filling power to the agency. At the same time, there is every reason to believe that the Court thought that Congress had “directly spoken to the question at hand,” and thus left “[no] gap for the agency to fill.”
After discussing some of the specific points from the Colony decision that led the plurality to believe that the Colony court had concluded the statute was unambiguous and there was not a gap to fill, Justice Breyer further stated, “It may be that judges today would use other methods to determine whether Congress left a gap to fill. But that is beside the point. The question is whether the Court in Colony concluded that the statute left such a gap.” Because the plurality concluded that Colony made clear that Congress did not leave a gap to be filled in Sec. 6501(e)(1)(A), it therefore found that, “the Government’s gap-filling regulation cannot change Colony’s interpretation of the statute.”
THE CONCURRING OPINION
The concurring opinion by Justice Scalia derided the plurality for its insistence on reviewing the Colony court’s determination of the 1939 Code language as either ambiguous or unambiguous. He stated that prior to Chevron, the Court
had no inkling that it must utter the magic words “ambiguous” or “unambiguous” in order to (poof!) expand or abridge executive power, and (poof!) enable or disable administrative contradiction of the Supreme Court. Indeed, the Court was unaware of even the utility (much less the necessity) of making the ambiguous/nonambiguous determination in cases decided pre-Chevron. [Emphasis in original.]
Justice Scalia argued that for all pre-Chevron cases it will be difficult, if not impossible, for a later court to determine whether the earlier decision was intentionally opening the door to administrative interpretation by its characterization of statutory language as ambiguous. Justice Scalia lamented “the ugly and improbable structure that our law of administrative review has become.” He found it impossible to reconcile the role of judicial precedent, as represented by Colony, with the rule of Brand X and thus said that that “Colony determines the outcome in this case” and that Brand X (from which he had dissented) should be overturned.
THE DISSENTING OPINION
The dissenting opinion by Justice Anthony Kennedy, joined by Justices Ruth Bader Ginsburg, Elena Kagan, and Sonia Sotomayor, sided with the government’s view that the 1954 Code is sufficiently different in “nearby sections” from its 1939 predecessor to open the door to a new interpretive Treasury regulation with respect to the word “omit.” The dissent challenged Justice Breyer’s characterization of the 1954 changes in statutory language as “too fragile to bear the significant argumentative weight the Government seeks to place upon them.”
Justice Kennedy agreed with the government that, with its changes in nearby sections of the 1954 Code, Congress intended that an understatement of income due to an overstatement of the basis of property sold could be subject to a six-year limitation. Congress’s specific exclusion of the cost of goods sold in the 1954 Code revision suggests that an understatement of gross income caused by an overstatement of basis could be subject to an extended period for examination by Treasury. These changes, argued the dissent, opened the door for an agency to adopt a reasonable interpretation of what, in the government’s view, was essentially a new law. Kennedy argued that agencies must have “latitude and discretion … [in] filling statutory gaps.” When Congress enacts amended statutes containing ambiguous language, the courts should defer to the agencies’ updated interpretations, he stated.
IRS COMMENTS ON HOME CONCRETE
IRS Chief Counsel William Wilkins publicly commented on the Home Concrete decision at the American Bar Association Tax Section’s meeting in May 2012. While his comments at this meeting are not official IRS pronouncements, they likely indicate how the IRS views the ramifications of the case. Wilkins conceded that for unsettled son-of-boss cases, taxpayers will probably prevail unless the IRS can make another statute of limitation argument (“IRS Chief Counsel Questions Effect of Home Concrete on IRS Guidance,” RIA’s Federal Taxes Weekly Alert Newsletter (May 17, 2012)).
With respect to Treasury regulations, Wilkins indicated that pre- and post-Chevron case criteria may apply in judging whether a regulation is valid. He stated that it is likely that in the future, “we will find that pretty much all pre-Chevron Supreme Court [opinions] should be read as final determinations that cannot be changed through regulations.” As was noted in the oral arguments in Home Concrete, these cases most likely got to the Supreme Court because an ambiguity in the statute resulted in a split among the circuits, and, Wilkins stated, “I sense that the Court is reluctant to say that any ambiguity remains after the highest Court in the land interprets the statute.”
Wilkins indicated that it was unclear how this would apply to pre-Chevron lower court decisions. These decisions, he opined, must now be examined to determine whether courts believed the “statute speaks for itself,” which is to say, is unambiguous. However, as Wilkins pointed out, lower court decisions “cannot remove ambiguity in the way that a Supreme Court decision does.”
For post-Chevron judicial pronouncements, the key will be the characterization of the statute as ambiguous or unambiguous. For now, the rule of Brand X remains the law of the land. If a lower court has found a statute ambiguous, this may allow for the Treasury to issue regulations differing from the lower court’s decisions.
IMPLICATIONS FOR THE FUTURE
Now that the Supreme Court has held the three-year statute of limitation applies to an understatement of gross income caused by an overstatement of the basis of property sold, one can only wonder if the IRS will adopt a new avenue of attack on son-of-boss tax schemes. As observed earlier, Sec. 6501(c) specifically allows for an assessment “at any time” for a “false return” or “willful attempt to evade tax.” In his remarks described earlier, William Wilkins has left open the possibility of fraud-based assessments.
The IRS has had some recent success in litigating son-of-boss tax cases. In 106 Ltd., 684 F.3d 84 (D.C. Cir. 2012), the District of Columbia Circuit affirmed a penalty against a taxpayer who had participated in a son-of-boss transaction. The record showed that the taxpayer had sufficient business experience and sophistication that he should have known that his attorney and tax adviser were not providing independent advice but were promoters of a transaction with clear conflicts of interest.
Unfortunately, Home Concrete’s split decision gives little guidance to tax advisers and taxpayers when assessing whether a particular Treasury regulation or other pronouncement has the force of law. The decision is a missed opportunity by the Supreme Court to bring some clarity to the issue of judicial deference to Treasury regulations interpreting ambiguous statutory language. In the wake of Home Concrete, it appears that one standard may apply to regulations reviewed by the Supreme Court before the Chevron decision and another to post-Chevron cases. The plurality opinion and concurring opinion taken together do not satisfactorily reconcile upholding the precedent of Colony with the judicial deference called for in Brand X. The practitioner is left to speculate whether it is because Chevron does not apply to pre-Chevron decisions; because Home Concrete concluded (through strained logic) that Colony had found the statute to be unambiguous; or because the Court has now concluded that its own decisions are not subject to Brand X deference.
The normal three-year statute of limitation to contest most tax filings was reaffirmed by the Supreme Court in Home Concrete & Supply, LLC in April 2012. The taxpayers did not “omit” income when they artificially inflated basis in the sale of property.
Use of the son-of-boss scheme does not trigger the longer six-year statute of limitation applicable to omitted income. The difficulty of detecting this scheme within the normal three-year period will likely curtail IRS pursuit of it unless the IRS contends it is a fraudulent return (which has an unlimited statute of limitation).
The doctrine of judicial deference to agency expertise continues to authorize Treasury to enact “gap-filling” regulations where a tax statute is ambiguous. However, the Court has narrowed the instances in which a statute is to be characterized as ambiguous.
A judicial finding that a tax statute is ambiguous implies different authority of the government to issue regulations depending on whether the finding was reached by the Supreme Court or a lower court and whether the finding was before or after the Supreme Court’s landmark 1984 Chevron decision, which articulates the power of federal agencies to clarify statutory ambiguities.
Practitioners can conclude little from this decision about the long-running and difficult question of the legal weight afforded to Treasury regulations.
Arthur J. Hamilton ( email@example.com ) is a professor of business law, and William M. VanDenburgh ( firstname.lastname@example.org ) is the Robinson, Farmer, Cox Faculty Scholar Associate Professor of Accounting, both at James Madison University in Harrisonburg, Va.
To comment on this article or to suggest an idea for another article, contact Paul Bonner, senior editor, at email@example.com or 919-402-4434.
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“Judicial Deference to Regulations: Home Concrete & Supply, LLC,” Jan. 2013, page 36
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