IRS Cannot Extend Three-Year Limitation Due to Overstatement of Basisby
By Anne Rosivach
In a recent decision that considers the authority of the IRS to issue retroactive regulations, the Supreme Court ruled in United States v. Home Concrete that the IRS may not apply an extended six-year limitations period in certain tax shelter cases. The extended limitation period applies under IRC 6501(e) when a taxpayer "omits from gross income an amount properly includible" in excess of 25 percent of gross income. The court's decision in Home Concrete has reversed cases where the government won in lower courts.
In 2009, the IRS issued temporary and final regulations that reinterpreted the established precedent for IRC 6501(e), Colony Inc. v. Commissioner, where the court had ruled on the language of the Code. The IRS regulation claimed that an overstatement of basis in property was an "omission" of gross income under the statute. The regulation would apply to any taxpayer whose statute of limitations remained open at the time the regulation was issued. The IRS then used this regulation as the basis for challenges to certain taxpayers. The Supreme Court rejected the 2009 IRS interpretation and reaffirmed its ruling in Colony.
In a recent exchange with AccountingWEB, Todd Welty, a partner in the Tax Litigation practice of SNR Denton in Dallas, reviewed the facts of United States v. Home Concrete and discussed its significance for the IRS and accountants. In 2007 through 2009, Welty, along with Senior Managing Associate Laura Gavioli, achieved rare taxpayer victories under the IRS's six-year statute of limitations, including Grapevine Imports, Ltd. v. United States and MITA Partners v. Commissioner. These cases – like Home Concrete – test the boundaries of an agency's authority to issue retroactive regulations, and the consequences have broad-reaching effects beyond tax law.
Q: What were the facts of the Home Concrete case? What was the government's argument? What did the court conclude?
A: These cases began because the government alleged that the taxpayers had engaged in Son of Boss transactions, which the IRS has characterized as abusive tax shelters. Most taxpayers at issue disputed this characterization. Despite the IRS's claim that failing to audit these taxpayers would result in massive losses of government revenue, the IRS had failed to open examinations against these taxpayers within the normal three-year window for examination and assessment under IRC 6501. According to a Treasury Inspector General report, the IRS "deliberately delayed" examining these taxpayers and allowed the three-year statutes to lapse, citing a need for further issue development.
The IRS instead sought to rely on a statutory exception under IRC 6501(e), which gives the IRS six years to pursue taxpayers who "omit" items of income exceeding 25 percent of the amount shown on the return. According to the IRS, since the taxpayers substantially underreported their taxable income due to the alleged Son of Boss transactions, the taxpayers met the statutory test, and the IRS argued it was entitled to three additional years to audit them.
Q: What was the problem with this view?
A: The IRS's position was in direct conflict with the Supreme Court's interpretation of the predecessor statute to IRC 6501(e) in Colony Inc. v. Commissioner, 357 U.S. 28 (1958). In that case, the Supreme Court had examined the exact same language relied on by the IRS and reviewed the legislative history of the statute. The court concluded that the statute was designed to give the IRS additional time to examine returns not just because the amount at issue was large. Rather, the statute gave the IRS this additional time only when the taxpayers' reporting left the IRS at a "special disadvantage" in detecting errors. Thus, the focus was not on the size of the amount at issue, but on what the IRS could have known or should have known from looking at the return.
Consequently, the Supreme Court in the Colony case held that the term "omits" in the statute should have its plain meaning, that is, to "leave out" entirely. Since the taxpayer in the Colony case had adequately disclosed the disputed transaction and his tax position – even though that position disagreed with the IRS's view – the IRS had no recourse in the extended statute of limitations. At the end of Colony, the court noted that the predecessor statute had been recently replaced with the current IRC 6501(e) and that the court's result was "in harmony" with the current statute.
The present taxpayers further argued that Colony was directly on point because, like the taxpayer in Colony, all of the present taxpayers were alleged to have underreported their income due to an overstatement of their basis in property. In Colony, the property was a series of residential lots. In the present cases, the property usually was a short position in Treasury notes. Many of the taxpayers' disclosures on their returns met or exceeded the disclosures that the taxpayer had made in Colony.
In 2009, after the IRS had lost numerous high-profile cases on this issue, the IRS issued temporary and final regulations that purported to reinterpret IRC 6501(e) in a manner that directly conflicted with the central holding of Colony. The regulations explicitly held that an overstatement of basis in property was an "omission" of gross income under the statute. This regulation purported to apply to any taxpayer whose statute of limitations remained open at the time the regulation was issued. In other words, the regulation was intended to apply to any pending cases that had not become final following an appeal, even if the IRS had already litigated and lost these cases. Essentially, the regulation was meant to undo unfavorable judicial decisions that the IRS had received.
The Supreme Court decision in Home Concrete soundly refused to deviate from Colony. The regulation at issue was an act of overreaching on the government's part. In particular, the majority noted that it would be difficult to distinguish between the predecessor statute and IRC 6501(e) because they use identical language, the term "omits." Further, because the court in Colony found the language of IRC 6501(e) to be "unambiguous" on this issue, the court held that the IRS had no discretion to issue a regulation that contradicted a prior controlling interpretation from the court.
Q: On May 1, CCH published a list of cases: Supreme Court Docket: Cert Granted and Cases Remanded Due to Home Concrete. Does this mean that the cases are no longer before the court?
A: This means that the cases are no longer before the court and that the IRS has effectively lost all of the cases. The Supreme Court has reversed any cases where the government won in lower courts and has sent instructions to the lower courts to enter judgment for the taxpayers.
Q: How should accountants use this case in their practice?
A: This case has several important consequences for accountants. First, it is an important reminder that when the IRS intends to rely on an exception to the statute of limitations to audit your client beyond the normal three-year window, the IRS must have a sound argument for relying on that exception and must be able to back that up with solid proof. Accountants should seriously scrutinize any late-received audit notices and carefully consider whether to advise their clients to consent to extending any statutes of limitations in this situation.
Further, this case will have implications for the proper deference to give any Treasury Regulation or other administrative regulation. Under the court's decision last year in Mayo Foundation v. United States, 562 U.S. (2011), Treasury Regulations are generally entitled to heightened deference. However, Home Concrete shows that not all regulations are created equal and not all are infallible. A regulation issued much later than its originating statute (here, more than fifty years later) may be subject to greater scrutiny. Also, a regulation motivated by an improper purpose (here, interfering with unfavorable judicial decisions) may also be subject to challenge.
Todd Welty is US head of Tax Controversy and Litigation for SNR Denton. He is also a fellow of the American College of Tax Counsel. Todd's practice is both national and international in scope. Approximately 95 percent of his professional time is spent on tax controversy and litigation. Todd has extensive experience in resolving civil tax matters at all stages of a tax dispute, including IRS examinations, fast-track appeals, administrative appeals, post-appeals mediation and, if necessary, litigation in the US Tax Court, the US Court of Federal Claims, and US district courts.