Tax Court Holds Invalid Temporary Regulations on Overstatement of Partnership Basis

On Thursday, the Tax Court held that temporary regulations issued by the IRS last year that defined an overstatement of partnership basis as an omission from gross income are invalid (Intermountain Ins. Serv. of Vail, LLC, 134 TC no. 11).

In an earlier round of litigation, the Tax Court had held that the IRS could not make adjustments to Intermountain’s final partnership administrative adjustment (FPAA) because the three-year statute of limitation under IRC § 6501(a) had already run (Intermountain Ins. Serv. of Vail, LLC, TC Memo 2009-195). (For prior JofA coverage, see “Application of Six-Year Statute of Limitations Denied Again.”)

The case turned on whether Intermountain’s alleged overstatement of partnership basis resulted in an understatement of gross income. Under IRC § 6229(c)(2), if a partnership improperly omits from gross income an amount in excess of 25% of the gross income stated in its return, the period for assessing tax attributable to its partnership items is extended to six years. The Tax Court held that an overstatement of basis did not equal an understatement of gross income for these purposes, and so the extended six-year statute of limitation did not apply.

After the first Intermountain decision, the IRS issued temporary regulations (TD 9466) that redefined the definition of omission from gross income for purposes of section 6229 to include an overstatement of basis: “[A]n understated amount of gross income resulting from an overstatement of unrecovered cost or other basis constitutes an omission from gross income …” (Temp. Treas. Reg. §§ 301.6229(c)(2)-1T and 301.6501(e)-1T).

Based on the rules in the new temporary regulations, the IRS filed motions with the Tax Court, asking the court to vacate its earlier decision and reconsider the case. Intermountain countered that the temporary regulations were inapplicable, invalid or otherwise not entitled to deference.

The court addressed both the applicability and potential impact of the temporary regulations to the case. First, the court looked at the temporary regulations’ effective date. It determined that the applicable period for assessing tax in the case had expired some time before Sept. 14, 2006. The temporary regulations were effective for tax years for which the applicable period for assessing tax did not expire before Sept. 24, 2009. Therefore, the temporary regulations on their face did not apply to this case. The IRS argued that if, under the standard set forth in the temporary regulations, the six-year extended period would apply in the case, the temporary regulations are applicable. The court refused to accept this interpretation, which it characterized as “marred by circular, result-driven logic …”

The Tax Court then weighed the temporary regulations against the Supreme Court’s decision in Colony, Inc., 357 U.S. 28 (1958), in which the Court held 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. The Tax Court held that the Supreme Court’s interpretation of the statute forecloses the IRS’ interpretation as put forth in the temporary regulations: “[T]here is no gap left for the temporary regulations to fill with respect to the statutory provisions at issue here.” Therefore, the court held, the temporary regulations are “invalid and are not entitled to deferential treatment.”