Tax Court Again Holds Basis Overstatement Didn't Trigger 6-Year Limitations Period

Carpenter Family Investments, LLC, (2011) 136 TC No. 17

The Tax Court has held on summary judgment that a notice of final partnership administrative adjustment (FPAA) issued to a limited liability company (LLC) after the expiration of the general 3-year limitations period on assessment was untimely, and again rejected IRS's argument to apply the extended 6-year period on the grounds of the LLC's basis overstatement. In so holding, the Court acknowledged that IRS had since issued final regs to the contrary, and considered the effect of the recent Mayo decision on the level of deference to which they are entitled, but nonetheless reaffirmed its prior conclusion based on Ninth Circuit and Supreme Court precedent.

Background. 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 an 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)

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), 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.

Procedural history. In Intermountain Insurance Service of Vail, LLC, TC Memo 2010-195, which involved a partnership that engaged in several basis-increasing transactions that IRS determined were improper and ineffective for tax purposes, the Tax Court followed its earlier decision in Bakersfield Energy Partners, LP, et al., (2007) 128 TC 207 and granted Intermountain summary judgment because IRS's partnership item adjustments were made after the general 3-year period of limitations for assessing tax had expired. IRS asked the Tax Court to overrule its decision in Bakersfield and find that the 6-year limitations period applied in this situation, but the Court declined to do so.

Less than a month after the initial Intermountain decision, IRS issued temporary regs that provided that an understated amount of gross income resulting from an overstatement of unrecovered cost or other basis constitutes an omission from gross income for purposes of Code Sec. 6229(c)(2) and Code Sec. 6501(e)(1)(A). (Reg. §301.6229(c)(2)-1T, Reg. §301.6501(e)-1T) The “Effective/applicability date” provisions of the temporary regs provided that “The rules of this section apply to taxable years with respect to which the applicable period for assessing tax did not expire before September 24, 2009.” (Reg. §301.6229(c)(2)-1T(b), Reg. §301.6501(e)-1T(b)) Bolstered by the temporary regs, IRS asked the Tax Court to vacate and reconsider it previous Intermountain decision, but it declined to do so, instead concluding that IRS's interpretation of the temporary regs' effective date and date of applicability was erroneous and inconsistent with the regs.

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 Court of Appeals for the Fourth and Fifth Circuits and the Tax Court have rejected the regs. On the other hand, the Federal Circuit has upheld them and the Seventh Circuit has viewed them favorably.

In Mayo Foundation for Medical Education and Research, et al. v. U.S. (S Ct 1/11/2011) 107 AFTR 2d 2011-341, the Supreme Court stated that interpretive IRS regs are entitled to heightened Chevron deference. In general, under Chevron, a regulation that is reasonable and not contrary to the “unambiguously expressed intent of Congress” will be given controlling weight.

Facts. Carpenter Capital Management, LLC, is an LLC classified as a partnership for tax purposes, and it serves as the tax matters partner (TMP) for Carpenter Family Investments, LLC (Partnership).

During its 2000 taxable year, Partnership sold shares of stock of American Tower Corp. (ATC), a publicly traded corporation listed on the New York Stock Exchange, for total proceeds of $29,608,861 (the stock sale). On or before Oct. 15, 2001, Partnership timely filed Form 1065, U.S. Return of Partnership Income, for its taxable year ending Dec. 31, 2000. On this information return, it reported gross proceeds of $29,608,861, an adjusted tax basis of $23,285,745, and gain of $6,323,116 from the stock sale. On or before Oct. 15, 2001, the partners timely filed a joint income tax return on Form 1040, U.S. Individual Income Tax Return, for calendar year 2000, reporting all of the $6,323,116 gain from the stock sale.

On Apr. 10, 2007, the TMP sent IRS a Form 872-P, Consent to Extend the Time to Assess Tax Attributable to Partnership Items, executed on behalf of Partnership. Also on Apr. 10, 2007, the partners sent IRS an executed Form 872-I, Consent to Extend the Time to Assess Tax As Well As Tax Attributable to Items of a Partnership. IRS issued an FPAA to the TMP on Oct. 2, 2008, for thePpartnership's taxable year ending Dec. 31, 2000.

In the FPAA, IRS alleged that “the partnership exploited a complex series of basis-inflating tax avoidance transactions (a variant of the Son-of-BOSS shelter described in Notice 2000-44, 2000-2 CB 255) beginning in December 1999.” IRS asserted that, as a result of the artificial step-up in basis in the ATC stock, the partnership's total net long-term gains in 2000 were significantly understated.

Parties' arguments. The TMP moved for summary judgment, arguing that the FPAA was untimely issued after the 3-year limitations period in Code Sec. 6501 expired and that the consents to extend the limitations period were invalid because they weren't executed within the 3-year period. However, IRS claimed that under Reg. §301.6229(c)(2)-1T and Reg. §301.6501(e)-1T, the 6-year limitations period applied, and the FPAA was timely issued thereunder.

Conclusion. The Tax Court, acknowledging that IRS's regs have since been finalized and that the Supreme Court's decision in Mayo states that Treasury regs are entitled to Chevron deference, nonetheless reaffirmed the holding of its earlier Intermountain decision.

The Court looked to precedent of the Ninth Circuit, to which an appeal of this case would lie, and noted that the Ninth Circuit affirmed the Tax Court's decision in Bakersfield. (Bakersfield Energy Partners v. Comm. (CA 9 6/17/2009)) Further, the Ninth Circuit rejected the argument that the Supreme Court's decision in Colony, Inc. v. Com., (S Ct 1958) 1 AFTR 2d 1894, which held that the extended period of limitations applies to situations where specific income receipts have been “left out” in the computation of gross income and not to something put in and overstated, was limited to the sale of goods and services in a trade or business. The Tax Court observed that the Fourth and Fifth Circuits also reached similar post-Mayo conclusions. Ultimately, the Tax Court stood by its earlier decision and concluded that Colony isn't limited to a trade or business and thus controls the Court's interpretation of Code Sec. 6501(e)(1)(A).

The Court then turned to the regs and noted that, under National Cable & Telecomm. Ass'n v. Brand X Internet Servs., (2005) 545 U.S. 967, a court's prior interpretation of a statute can override an agency's contrary interpretation if the prior judicial construction “follows from the unambiguous terms of the statute.”

The Court determined that, even if IRS intended to repudiate the Supreme Court's holding in Colony, it failed to unequivocally do so. Unless and until it does, that decision remains binding, and IRS's discretion in interpreting Code Sec. 6501(e)(1)(A) remains limited. Thus, in accord with the Ninth Circuit's holding in Bakersfield, and the Supreme Court's holding in Colony, the Tax Court held that a basis overstatement does not constitute a gross omission for Code Sec. 6501(e) purposes. The FPAA was accordingly untimely.

Observation: There were also two concurring opinions filed with this decision. One emphasized that prior decisions on this subject have been decided based on the unambiguous terms of Code Sec. 6501(e)(1)(A), and that such provided sufficient grounds for granting summary judgment in favor of the taxpayer in this case without the need to even address the regs. The second stated simply that there was “no compelling reason for this Court to abandon its precedents in this case” since the Ninth Circuit had previously affirmed the Court's Bakersfield decision, albeit before the issuance of the final regs.

References: For the 6-year assessment period, see FTC 2d/FIN ¶T-4201; United States Tax Reporter ¶65,014.15; TaxDesk ¶838,016; TG ¶70538.