Statute of Limitations for an Overstatement of Basis

Analyzing the U.S. Supreme Court Ruling and Related Cases

State and local statutes of limitations establish the maximum period of time for bringing a particular action in court or enforcing specified rights. Statutes of limitations set the time limits for both civil and criminal legal cases; once the time granted by a statute expires, it is too late to bring action, even if the case has merit.

Internal Revenue Coode (IRC) section 6501 sets forth three statutes of limitations-the three-year provision, six-year provision, and unlimited provision-that represent the time limits under which the 1RS may assess an additional tax liability. The general rule under IRC section 6501(a) gives the 1RS three years from the filing of a tax return to assess an additional tax burden. This time period normally begins on April 15, the due date for individual income tax returns; even if the return is filed prior to this date, the statute does not start until April 15. If the return is filed later (whether due to an extension or otherwise), the clock starts running from the date the return is filed.

Under IRC section 6501(e)(1)(A), the statute is extended to six years when a taxpayer fails to report gross income amounting to more than 25% of the gross income reported on the return. This "omission from gross income" statute does not apply to an overstatement of deductions and credits, which could similarly result in an understatement of tax liability. Moreover, IRC section 6501(eX 1 )(B)(i) states:

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.

According to IRC section 6501(c), when a fraudulent return is filed, there is no statute of limitations on the IRS's ability to assess additional tax; this applies in instances of tax evasion and where there is intent to defraud the government. The indefinite time period also applies when a taxpayer fails to file a tax return, regardless of whether that failure was willful or based on either negligence or innocence.

One contentious issue in this area surrounds the overstatement of basis-specifically, does the 1RS have the ability in such cases to extend the state of limitations from three years to six? Taxpayers and their advisors should familiarize themselves with the U.S. Supreme Court's recent decision on this issue and its implications. (See the sidebar, Background: The U.S. Supreme Court, for more information on the Court.)

The Question of Overstatement of Basis

In U.S. v. Home Concrete & Supply LLC (Sup Ct, 109 AFTR 2d, 2012-661, Apr. 25, 2012), the Court considered the application of the extended six-year statute under IRC section 6501(e)(1)(A). This case involved a partnership tax return (for the 1999 tax year) that was timely filed in April 2000.

In 1999, Stephen R. Chandler and Robert L. Pierce were the sole shareholders of Home Oil & Coal Company Inc. Pierce desired to sell his shares in the corporation, and he engaged tax professionals for advice on planning techniques to minimize the tax liability from the sale. Pierce and Chandler utilized a variation of the bond and option sales strategy (BOSS)-a "son of BOSS" structure that, through a series of tax shelter transactions, created additional step-up in bases of certain assets, decreased the reported capital gains, and reduced the tax liability surrounding the sale of the business.

The anticipated tax savings were accomplished through the short sale of U.S. Treasury bonds, initiated by Pierce and Chandler. The transaction was structured as follows: the formation of a new partnership, Home Concrete & Supply LLC; tiie transfer of the short sales proceeds to this partnership as capital contributions; the closing of the short sales of bonds by Home Concrete & Supply; the transfer of Home Oil & Coal Company assets to Home Concrete & Supply as a capital contribution; the transfer by the taxpayers (other than Home Oil & Coal Company) of portions of their partnership interests in Home Concrete & Supply as capital contributions to Home Oil & Coal Company; and the sale by Home Concrete & Supply of its assets to an outside party.

This series of complex transactions created an inflated outside basis for each partner in Home Concrete & Supply, as well as the company assets sold. Home Concrete & Supply stepped up its inside basis as well. The partnership tax return for 1999 reflected this activity and reported a modest realized gain on the sale of tiie Home Concrete & Supply assets.

In 2000, the 1RS issued Notice 2000-44, 'Tax Avoidance Using Artificially High Basis," asserting the invalidity of tax strategies that lack economic substance and produce artificially increased bases in assets to avoid taxes. The 1RS commenced its audit of Home Concrete & Supply's 1999 tax return in June 2003, applying the sixyear statute. Upon concluding its examination in September 2006, the 1RS issued a final partnership administrative adjustment (FPAA), reflecting additional taxes due from the partners. In the FPAA, the 1RS decreased the partners' stepped-up bases in their partnership interests, eliminated the losses created, and increased their taxable income.

Home Concrete & Supply paid the assessment and took the 1RS to district court on the grounds that the three-year statute of limitations under IRC section 6501(a) precluded 1RS action under the FPAA. In Home Concrete & Supply LLC v. U.S. (DC NC, 103 AFTR 2d, 2009-465, Nov. 21, 2008), the district court mied in favor of the 1RS, ruling that an overstatement of basis is an omission of gross income under IRC section 6501(e)(1)(A) and that the FPAA was within the six-year statute of limitations.

Home Concrete & Supply appealed the decision to the Fourth Circuit Court of Appeals (encompassing North Carolina, South Carolina, Virginia, and West Virginia). In Home Concrete & Supply LLC v. U.S. (CA 4, 107 AFTR 2d, 2011-767,2/7/2011), tiie court ruled for the taxpayer, concluding that an overstated basis is not an omission of gross income and does not extend the statute of limitations to six years under IRC section 6501(e)(1)(A); therefore, the threeyear statute of limitations under IRC section 6501(a) was applicable, and the FPAA was not issued in a timely fashion. This decision-that an overstatement of basis does not amount to an omission of income triggering the six-year time period under IRC section 6501(e)(1)(A)-was supported by holdings of the Fifth Circuit (Louisiana, Mississippi, and Texas), the Ninth Circuit (Arizona, California, Idaho, Montana, Nevada, Oregon, and Washington), and the Tax Court. The opposite holding was found in cases decided by the Seventh Circuit (Illinois, Indiana, and Wisconsin), the Tenth Circuit (Colorado, Kansas, New Mexico, Oklahoma, Utah, and Wyoming), the District of Columbia Circuit, and the Federal Circuit.

On December 14, 2010, the 1RS issued Final Treasury Regulations section 301.6501 (e)-l, effective for taxable years with respect to which the period for assessing tax was open on or after September 24, 2009. It states-

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 section 6501(e)(l)(A)(i).

In 2012, the Supreme Court agreed to hear Home Concrete & Supply in order to resolve the split among the circuits. In a 5-4 decision, the justices ruled that an overstatement of basis is not an omission of gross income for purposes of IRC section 6501(e)(1)(A); therefore, it does not trigger the six-year statute of limitations. Justice Stephen G. Breyer wrote the ruling, which represented the views of Chief Justice John G. Roberts and Justices Samuel A. Alito, Clarence Thomas, and Antonin Scalia (modified-Justice Scalia concurred in the judgment, but had different reasoning).

In affirming the Fourth Circuit's decision, the five justices based their decision on Colony Inc. v. Comm V (S Ct, 1 AFTR 2d, 1958-1894), which had limited the application of the six-year statute only in instances involving the underreporting of gross income that should have been reported on the tax return. The justices relied on the legal principle of stare decisis-that is, judges are oblig3ted to follow the precedents established in prior decisions-to resolve the issue of statutory interpretation. Though they admitted that the six-year statute of limitations is ambiguous, the justices strongly felt that Colony had already interpreted the statute, leaving no room for the 1RS to reach a contrary result. Although a basis overstatement might have the same impact as an understatement of gross income, it does constitute an omission of income, according to the Supreme Court majority. Congress, of course, has the authority to write a different law.

Justice Anthony Kennedy wrote the dissenting opinion for Justices Ruth Bader Ginsberg, Elena Kagan, and Sonia Sotomayor. These four justices thought that Treasury Regulations section 301.6501(e)-1 should be controlling; they did not think that Colony precluded the Treasury Department from interpreting IRC section 6501(e)(1)(A) as it did in Treasury Regulations section 301.6501(e)-l.

Related Supreme Court Cases

The 1958 Colony case involved the negligent overstatement of basis in the sale of real estate by the taxpayer. The case was decided under the 1939 version of the IRC (section 275 [c]) regarding the failure to report gross income (substantially identical to the statute at issue in Home Concrete & Supply). The Court decided the statute was ambiguous in its use of the term "omits"; however, the legislative history clearly reflected that Congress had intended for the longer statute of limitations to apply solely to situations involving the failure to report receipts or accruals of income. Colony made a distinction between income underreported and income indirectly underreported through the overstatement of basis. Significantly, Colony held that there was no gap in the statute for a governmental agency to fill; thus, the Court ruled for the taxpayer.

In Chevron U.S.A. Inc. v. National Resources Defense Council Inc., 467 U.S. 837 (1984), the Supreme Court considered the subject of government agency regulations regarding the Clean Air Act and the Environmental Protection Agency. The Court established a two-step process for determining the validity of administrative regulations that interpret statutes. In the first step, the reviewing court determines the intent of Congress with respect to the statute at issue (statutory construction). If the intent is deemed to be clear and the statute is unambiguous, there is no room for agency interpretation; if there is a perceived ambiguity, the court proceeds to the second step, which requires it to determine if the agency's interpretation of the statute is permissible and reasonable. If this test is satisfied, the court must grant judicial deference to the agency's interpretation.

National Cable & Telecommunications Association v. Brand X Internet Services, 545 U.S. 967 (2005), addressed a dispute concerning the doctrine of judicial deference to the Telecommunications Act and related regulations promulgated by the Federal Communications Commission (FCC). The Court determined under the first step of the Chevron test that the law distinguishing telecommunication services from information services was ambiguous (statutory text); therefore, the Court granted the FCC authority to interpret the statute. But the Court ruled that if the findings of a prior court determine that the statutory language under consideration is not ambiguous, then this trumps the interpretation of the government agency.

Mayo Foundation for Medical Education and Research v. U.S. (Sup Ct, 107 AFTR 2d 2011-341,1/11/2011), which involved medical residents, represents yet another example of a dispute focusing on a federal statute and a federal agency. In this particular case, the term "student" was not defined in the Federal Insurance Contribution Act (FICA) for the purpose of Social Security taxes. Regulations issued by the Treasury Department in 2004 clarified the distinction between students studying and working in terms of specific hours worked. The Court upheld the regulation as a reasonable interpretation of the statute. The Court clarified that Chevron applies to Treasury Regulations.

In Home Concrete & Supply, the government's argument relied on the 2010 regulation, Chevron, Brand X, and Mayo. In writing for the five justices Justice Breyer succinctly stated, "We do not accept this argument. In our view, Colony has clearly interpreted the statute, and there is no longer any different construction that is consistent with Colony and available for adoption by the agency"; however, Justice Breyer was unable to attract a majority of the justices to support his discussion on why the 2010 regulation failed to override Colony. This leaves the door open, to a degree, for future litigation involving deference issues (e.g., a regulation overruling a prior judicial interpretation of a statute).

Implications

An overstatement of basis does not constitute an omission of gross income for purposes of the six-year statute of limitations. The Supreme Court's decision in Home Concrete & Supply gives taxpayers confidence that the use of Son of BOSS transactions should not trigger the sixyear statute of limitations. Congress could, however, use its legislative power to rewrite the tax laws and remedy this situation with respect to Son of BOSS transactions or even other means by which basis might be overstated.

The Supreme Court's decision in Home Concrete & Supply has profound implications for taxpayers, the 1RS, and tax professionals. The 1RS might pursue Son of BOSS transactions vigorously under the unlimited statute of limitations covering fraudulent tax returns and tax evasion schemes. Fraud-based assessments of penalties, interest, and additional taxes could result. The 1RS has already tested this legal avenue and has seen some favorable outcomes-as reflected in 106 Ltd. v. Comm 'r, 684 F. 3d 84 (D.C. Cir., 2012), which involved a limited partnership, Son of BOSS techniques, and accuracy-related penalties.

Another factor to be considered is the legal weight carried by Treasury Regulations-that is, do they indeed possess the force of law? Only in cases of statutory ambiguity will Treasury Regulations be granted judicial deference. Generally speaking, however, additional issues complicate this notion of ambiguity: Must a tax statute be found ambiguous by the Supreme Court or by a lower court? Must the finding of ambiguity occur after the Chevron case? How will preChevron cases be decided? It is clear that questions remain.

For all post-Chevron (and post-Brand X) cases, the principles of ambiguity discussed in those cases should guide the Treasury Regulations deference determination. Courts need not defer to Treasury Regulations if a prior court determined that Congress intended to resolve the issue, rather than leave a gap to be filled by agency regulation.

In Home Concrete & Supply, the Court failed to rule on the retroactive application of Treasury Regulations. The regulation at issue was finalized in 2010, but the tax year in question for the audit was 1999; therefore, the Home Concrete & Supply decision provides no guidance on the validity of applying regulations to earlier periods. In addition, it upheld Mayo because the Court did not indicate any intent to modify that 2011 decision.

The 1RS possesses wide-ranging authority to issue administrative sources of tax law (e.g., Treasury Regulations); however, such authority is subject to certain parameters. Although Treasury Regulations are interpretive in nature (specifically, interpreting the IRC), they do not stand alone; rather, they must be considered along with the related judicial sources of tax law (e.g., court cases) in the tax arena. ?

BACKGROUND: THE U.S. SUPREME COURT

The term of the U.S. Supreme Court begins in October of each year. Recently, approximately 8,000 cases per year have been appealed to the Court through a writ of certiorari, and the Court has granted certiorari in an average of about 85 of those cases. Historically, the Court hears only 1 %-2% of the cases submitted on appeal; thus, In the vast majority of cases, it denies certiorari. This denial does not mean that the Court agrees with a lower court's decision, but merely implies that the Court did not find the case significant enough or interesting enough to devote time to it in its limited session.

Andrew D. Sharp, PhD, CPA, is a professor of accounting in the division of business at Spring Hill College, Mobile, Ala.