Intermountain Insurance Service of Vail, LLC, Thomas A. Davies, TMP, (CA DC 6/21/2011) 107 AFTR 2d ¶2011-964
Widening a split in the Circuits, the Court of Appeals for the District of Columbia has reversed the Tax Court and validated IRS regs providing that a basis overstatement is an omission of income for purposes of the six-year limitations period. The regs qualified for Chevron deference, and passed the two-part Chevron test.
Observation: In upholding the regs, the Court of Appeals for the District of Columbia joins the Court of Appeals for the Federal Circuit and the Courts of Appeals for the Seventh, and Tenth Circuits. The Fourth and Fifth Courts of Appeals have struck down the regs. The Ninth Circuit has found on similar facts, but in a case that pre-dated the regs, that a basis overstatement didn't constitute an income omission for Code Sec. 6501(e) purposes. The Supreme Court may very well be asked to render the final verdict on this contentious issue.
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 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 three 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 six-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.
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))
In Colony Inc v. Com., (1958, S Ct) 1 AFTR 2d 1894, 357 US 28, interpreting the predecessor of Code Sec. 6501(e) in the’39 Code, the Supreme Court held that “omits” means something “left out” and not something put in and overstated. After Colony, Code Sec. 6501(e) was amended to provide that (i) in the case of a trade or business, “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) before diminution by the cost of such sales or services; and (ii) in determining the amount omitted from gross income, there shall not be taken into account any amount which is omitted from gross income stated in the return if the amount is disclosed in the return, or in a statement attached to the return, in a manner adequate to apprise IRS of the nature and amount of such item. (Code Sec. 6501(e)(1)(B))
In Chevron, (S Ct 1984) 467 U.S. 837, the Supreme Court set out a two-step analysis for a court to apply in reviewing an agency's construction of a statute that it administers: (1) if the intent of Congress is clear, IRS and the courts must give effect to the unambiguously expressed intent of Congress; (2) if the statute is silent or ambiguous as to a specific issue, the question for a court is whether the agency's answer is based on a permissible construction of the statute. An agency's regs are given controlling weight unless they are “arbitrary, capricious, and manifestly contrary to the statute.”
Facts. Intermountain Insurance Service of Vail, LLC (Intermountain), engaged in a series of transactions—some of which increased tax basis—culminating in the sale of business assets on Aug. 1,’99, for $1,918,844. It reported the $1,918,844 gross sales price and, after deducting $131,544 of allowed or allowable depreciation, claimed a stepped-up $2,061,808 basis in the assets on a Form 4797, Sales of Business Property, attached to its’99 Form 1065, U.S. Partnership Return of Income. It filed that return on Sept. 15, 2000. Almost six years later, on Sept. 14, 2006, IRS issued an FPAA with respect to Intermountain's’99 tax year. IRS found that some of the transactions Intermountain engaged in were improper and ineffective for Federal income tax purposes and consequently determined that Intermountain had overstated capital contributions by $2,197,696, overstated outside partnership basis by $2,061,808, and improperly claimed an $87,680 loss.
Initial Tax Court case and new temporary regs. In Intermountain I (TC Memo 2009-195), following an earlier Tax Court opinion that a basis overstatement is not an omission of income for purposes of the 6-year limitations period, the Tax Court granted Intermountain summary judgment because IRS made partnership item adjustments after the general three-year period of limitations for assessing tax had expired.
Less than a month after the initial Intermountain decision, IRS issued temporary regs providing 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 “[e]ffective/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)) (In December of 2010, the temporary regs were replaced by final regs to the same effect.)
In Intermountain II ((2010) 134 TC 211), IRS asked the Tax Court to vacate and reconsider its Intermountain I decision in light of the temporary regs, but the Tax Court refused to do so. The Tax Court concluded that IRS's interpretation of the temporary regs' effective date and date of applicability was erroneous and inconsistent with the regs. Specifically, the Court found that IRS's interpretation was irreparably marred by circular, result-driven logic and the wishful notion that the temporary regs should apply to Intermountain because it was involved in what IRS believed was an abusive tax transaction. Accordingly, the Tax Court refused to accord IRS's interpretation deferential treatment. It found that the plain meaning of the temporary regs' effective/applicability date provisions indicated that they do not apply to Intermountain because the applicable period of limitations expired before Sept. 24, 2009.
The Court also concluded that the Supreme Court's opinion in Colony unambiguously foreclosed IRS's interpretation of Code Sec. 6229(c)(2) and Code Sec. 6501(e)(1)(A) and displaced IRS's temporary regs.
Tax Court reversed. In the continuing Intermountain saga, the Court of Appeals for the District of Columbia, in a detailed, closely reasoned opinion, has reversed the Tax Court and upheld the regs that treat a basis overstatement as triggering the six-year limitations period.
Chevron applicability. Intermountain argued that Chevron didn't apply at all because IRS impermissibly stacked the deck in its favor by issuing retroactive regs after its initial losses on the basis issue. However, the Appellate Court pointed out that the Supreme Court, most recently in Mayo Foundation v. U.S., (S Ct 1/11/2011) 107 AFTR 2d 2011-341, had made it clear that in granting Chevron deference, it was immaterial that a reg was prompted by litigation. It didn't matter that IRS was a party in a case that prompted the reg and that it sought by issuing the reg to reverse its earlier losses on appeal.
Regs entitled to Chevron deference. After a detailed analysis of the’39 Code's earlier version of the rule in Code Sec. 6501(e)(1), and the rule that applied in’99 in Intermountain's situation, the Appellate Court held that the Colony decision never purported to interpret Code Sec. 6501(e)(1)(A). Because the “omits from gross income” language in Code Sec. 6501(e)(1)(A) is at least ambiguous, if not best read to include overstatements of basis, and because its structure, legislative history, the context in which it was passed, and its reenactment history didn't remove this ambiguity, the Appellate Court concluded that, outside of the trade or business context, nothing in Code Sec. 6501(e)(1)(A) unambiguously prevented IRS from interpreting “omissions from gross income” as including basis overstatements. The Court reached the same conclusion with respect to Code Sec. 6229(c)(2) in light of Intermountain's failure to timely raise any argument that the two provisions should be interpreted differently outside the trade or business context. Having held that Colony applied neither to Code Sec. 6501(e)(1)(A) nor Code Sec. 6229(c)(2), the Court saw nothing unreasonable in IRS's decision to diverge from Colony's holding.
Other arguments. IRS has interpreted the effective/applicability language in the regs to mean that they apply to any docketed Tax Court case in which the period of limitations under Code Sec. 6501(e)(1)(A) or Code Sec. 6229(c)(2), as interpreted in the temporary regs, did not expire with respect to the tax years at issue, before September 24, 2009, and in which no final decision has been entered. Intermountain argued, as it had before the Tax Court, that this required the application of the regs before determining whether they are even applicable—an approach the Tax Court characterized as “irreparably marred by circular, result-driven logic.” Although the Appellate Court agreed that Intermountain's argument had some force, it ultimately decided that it was insufficient to overcome the “extraordinarily deferential standard of review” to be accorded IRS's regs.
The Appellate Court also gave short shrift to Intermountain's contention that the regs changed settled law and therefore were impermissibly retroactive, and an objection to the effect that IRS had not kept “an open mind” during the regs' notice-and-comment period.
In sum, the Court of Appeals for the District of Columbia held that the regs were validly promulgated, applied to Intermountain, qualified for Chevron deference, and passed the two-part Chevron test.
It's not over yet. The Appellate Court remanded the case back to the Tax Court to consider Intermountain's alternative argument (made in the Tax Court but unaddressed there), that it triggered the extended statute of limitations by adequately disclosing to IRS the basis amount it applied in connection with the transaction at issue.
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.