Grapevine Imports Ltd. v. U.S., (CA FC 03/11/2011) 107 AFTR 2d ¶2011-564
The Court of Appeals for the Federal Circuit, reversing the Court of Federal Claims, has held that an overstatement of basis is an omission of gross income for purposes of the 6-year limitations period of Code Sec. 6501(e)(1)(A). In reaching this result, the Court declined to follow a contrary decision of another panel in the Federal Circuit because that case had been decided before IRS issued regs. The current panel sustained the regs under Chevron and Mayo and held that IRS could properly apply them retroactively in this case.
Observation: This case is very well-reasoned and represents a big win for IRS which has lost on this issue in other circuits. But those decisions were decided before the Supreme Court's recent decision in Mayo, which held that IRS regs are to be interpreted under the standards set forth in Chevron. The Federal Circuit's reasoning, buttressed by Mayo, may now tip the scales in favor of IRS should the issue arise in other circuits or reach the Supreme Court.
Background on TEFRA audit rules. Under the TEFRA partnership audit rules, the tax treatment of any partnership item (and the applicability of any penalty, addition to tax, or additional amount that relates to an adjustment to a partnership item) generally is to be determined at the partnership level. (Code Sec. 6221)
If IRS decides to adjust any “partnership items,” it must notify the individual partners through a notice of a final partnership administrative adjustment (FPAA). (Code Sec. 6226) Various Code provisions define the limitations on assessments made with respect to FPAA adjustments, and the tolling of those periods (see, e.g., Code Sec. 6229, Code Sec. 6501)
Background on limitation periods. Code Sec. 6501(a) generally provides that a valid assessment of income tax liability may not be made more than 3 years after the later of the date the tax return was filed or the due date of the tax return. However, under Code Sec. 6501(e)(1)(A), a 6-year period of limitations applies when a taxpayer omits from gross income an amount that's greater than 25% of the amount of gross income stated in the return. Code Sec. 6501(e)(1)(B)(i) provides that “in the case of a trade or business, the term “gross income” means the total of the amounts received or accrued from the sale of goods or services (if such amounts are required to be shown on the return) prior to the diminution by the cost of such sales or services.”
Subject to exceptions and special rules, the period for assessing tax attributable to a partnership item (or affected item), for a partnership tax year won't expire before the date that is three years after the later of: (1) the date the partnership return was filed, or (2) the last day for filing the return for that year (without regard to extensions). (Code Sec. 6229(a)) The period is six years where the partnership omits from its gross income an amount which is more than 25% of the amount of gross income stated in its return. (Code Sec. 6229(c))
Facts. Joseph and Virginia Tigue were partners in Grapevine Imports, Ltd. (Grapevine). On Apr. 19, 2000, Grapevine filed its partnership return (Form 1065) for’99, showing a net short-term loss of $21,884. The following day the Tigues filed their’99 joint tax return which, owing in part to transactions involving Grapevine, showed a total loss for’99 of $973,087. They carried this loss forward to future tax years, along with a $1,127,481 net operating loss (NOL) carried forward from’98. On Aug. 17, 2001, they filed their 2000 joint tax return in which the’98 NOL had the effect of eliminating what otherwise would have been taxable income of $730,161.
On Dec. 17, 2004, IRS issued an FPAA to Grapevine's tax matters partner, T-Tech, adjusting the partners' basis in Grapevine by $10 million for the’99 tax year. No statutory notices of deficiency were issued to the Tigues. On Mar. 8, 2005, Joseph Tigue, as the sole owner of T-Tech, remitted deposits of $1,594,205 and $221,170 for tax years’99 and 2000, respectively, to gain jurisdiction in the Court of Federal Claims under Code Sec. 6226(e). On Mar. 11, 2005, the Tigues filed a complaint in the Court of Federal Claims for readjustment of partnership items under Code Sec. 6226(a), requesting that the court either declare the FPAA invalid or, alternatively, order IRS to reverse the adjustments in it. Subsequently, on Oct. 21, 2005, they filed a motion for summary judgment asserting that the FPAA's proposed adjustment was time-barred under Code Sec. 6229(a). In its first decision in the case, the Court of Federal Claims held that the adjustments for 2000 were not time-barred under Code Sec. 6229(a) but it left open the question of whether a basis omission can trigger the six-year limitations period in Code Sec. 6229(c). Then, in 2007, the Court of Federal Claims held that a basis overstatement is not an omission of gross income for this purpose. As a result, the 6-year Code Sec. 6229(c) statute of limitations did not apply and IRS could not reach the partners' returns for’99.
In deciding the issue, the Court of Federal Claims examined legislative history and a number of cases. But in reaching its conclusion that an overstatement of basis is not an omission of gross income under Code Sec. 6229(c), it primarily relied on the Supreme Court's decision in Colony Inc v. Com., (1958, S Ct) 1 AFTR 2d 1894, 357 US 28. In that case, the Supreme Court, in interpreting the predecessor of Code Sec. 6501(e) in the’39 Code, held that “omits” means something “left out” and not something put in and overstated.
Because the basis overstatement could not be taken into account under Code Sec. 6229(c), the conditions for triggering it were not met. As a result, the Court of Federal Claims held that the assessment of tax against the Tigues for their’99 tax year was barred by the normal statute of limitations found in Code Sec. 6501(a).
Intervening developments. In 2009, in another case, another panel of the Federal Circuit held that an overstatement of basis wasn't an omission of gross income for purposes of the extended limitations period. See Salman Ranch Ltd. et al. v. U.S., (CA FC 7/30/2009) 104 AFTR 2d 2009-5640.
In December of 2010, IRS issued final regs under which an understated amount of gross income resulting from an overstatement of unrecovered cost or other basis constitutes an omission of gross income for purposes of the 6-year period for assessing tax and the minimum period for assessment of tax attributable to partnership items. The final regs adopt the position IRS had held in temporary regs.
Parties' arguments. IRS contended that the new regs should control the outcome of the present appeal. Grapevine resisted, arguing that the new regs couldn't change the Federal Circuit's interpretation of the limitations statutes—and even if they could, they regs didn't apply in this case.
Presence of intervening authority. The first issue was whether this case was governed by the Federal Circuit's decision in Salman Ranch. The Court observed that it is ordinarily bound to follow a prior precedential decision of another panel unless there are intervening circumstances, such as new controlling authority. As made clear in the Supreme Court's recent decision in Mayo, IRS regs are to be interpreted under the standards set forth in Chevron. Thus, said the Federal Circuit, if the new regs are entitled to Chevron deference, then they are new intervening authority, which could require a departure from Salman Ranch.
Chevron analysis. The Federal Circuit observed that the Chevron analysis has two steps. First, the Court had to determine if there is an ambiguity in the statute such that an agency has room to interpret. Second, it had to determine whether the agency's action is a reasonable interpretation of Congress's intent.
Grapevine contended that, under Colony and Salman Ranch, the statutes' meaning is clear: overstatement of basis does not constitute an “omission from gross income.” IRS disagreed and argued that those cases do not control this one. The Federal Circuit agreed with IRS. It said that those cases are instructive, but they do not resolve the question for purposes of Chevron step one. It then found that Code Sec. 6501(e)(1)(A) and Code Sec. 6229(c)(2) are ambiguous as to the intent of Congress for treatment of basis overstatement outside the trade or business context. The Court therefore concluded that IRS is entitled to promulgate its own interpretation of these statutes, and to have that interpretation given deference by the courts so long as it is within the bounds of reason. Applying Chevron step two, the Court determined that the regs are a reasonable interpretation of Code Sec. 6501(e)(1)(A).
Regs could be applied retroactively. Grapevine contended that even if the new regs control assessments for future tax years, they do not meet the legal requirements for retroactive application to’99 tax assessments. The Federal Circuit observed that Code Sec. 7805 empowers IRS to issue retroactive regs and concluded that the new regs may properly be applied to returns from past tax years whose limitations periods (as recomputed) has not yet expired.
Assessment period was not closed. Grapevine next argued that the regs, by their terms, did not apply to its’99 return because they apply to tax years with respect to which the period for assessing tax was open on or after Sept. 24, 2009. (Reg. §301.6229(c)(2)-1(b), Reg. §301.6501(e)-1(e)) Grapevine said that the period for assessing Grapevine's tax closed on Apr. 19, 2003, pursuant to the judgment of the Court of Federal Claims and the Federal Circuit's subsequent decision in Salman Ranch. IRS argued that Code Sec. 6229(d) extends the period of assessment being litigated until the decision of the court becomes final. According to IRS, final means for tax assessment purposes that all appeals have been exhausted. The Federal Circuit held that the limitations period for Grapevine's’99 tax return remains open until the case reaches unappealable termination. The case was open when the Court issued its opinion and it was open on Sept. 24, 2009. Thus, the regs apply to Grapevine's’99 return.
Application of the regs was not improper. Finally, Grapevine argued that IRS was trying to change the rules in the middle of the game. Having failed to prevail at the Court of Federal Claims, and having had the limitations period construed against it by the Federal Circuit in Salman Ranch, Grapevine argued that IRS shouldn't be permitted to transform a lower court loss into an appellate win via new regs. The Federal Circuit disagreed that this was an improper outcome. That IRS had not exercised its interpretive authority over the relevant language until after the Court of Federal Claims granted summary judgment to Grapevine does not diminish IRS's authority, nor its right to have its interpretations, when promulgated, respected by the judiciary so long as they are reasonable.
Bottom line. The Federal Circuit concluded that the regs were new controlling authority that could change the Court of Federal Claims' judgment. The Appeals Court further concluded that the basis overstatement was an omission of income under the regs and that the basis overstatement triggered the extended limitations periods of Code Sec. 6229(c) and Code Sec. 6501(e)(1)(A).
References: For the six-year assessment period, see FTC 2d/FIN ¶T-4201; United States Tax Reporter ¶65,014.15; TaxDesk ¶838,016; TG ¶70538.