In a sharply-divided 5-4 opinion, the Supreme Court of the United States in United States v. Home Concrete & Supply LLP (1) rejected the Internal Revenue Service's position that an understatement of gain resulting from an overstatement of basis constitutes an amount "omitted from gross income" within the meaning of section 6501(e)(1)(A) of the Internal Revenue Court. The Court followed its 1958 decision in Colony, Inc. v. Commissioner, (2) which involved a predecessor statute involving almost identical operative language, and held that its interpretation of the language in that case was controlling. It further held that, because its interpretation was controlling, the IRS's contrary construction of section 6501(e) (1)(A) in its "fighting regulations" could not prevail.
Home Concrete is a significant victory, both for taxpayers caught in the basis overstatement saga (3) and for taxpayers generally. The decision's reach is not limited to IRS-labeled "tax shelters" or "listed transactions." It affects all taxpayers and all transactions in which basis is a factor, from an individual's sale of a rental property to partnership transfers, redemptions, or contributions involving a section 754 election that results in a step-up in basis under section 734 or 743.
More fundamentally, Home Concrete provides guidance on coordinated efforts by taxpayers against IRS positions, the importance of administrative law principles in tax disputes, and current IRS litigation strategies on deference issues. That said, given the sharp divide among the Justices and the failure of a majority to clarify the application of Brand X or to address several arguments briefed by the parties, several questions remain. For example, the Court did not address the issues raised under the Administrative Procedure Act (APA) about the manner in which the IRS promulgated the regulations. Inasmuch as the APA is being implicated in more and more tax cases--as demonstrated by lower court decisions in the basis overstatement saga, (4) the Supreme Court's decision in Mayo Foundation for Medical Education & Research v. United States, (5) and recent opinions involving the telephone excise tax, this is unfortunate. The Court in Home Concrete also did not address several other administrative issues, including the proper deference due to so-called fighting regulations (i.e., regulations issued in the midst of litigation, supporting the government's position), the definition of retroactivity and when it is permissible, and whether Congress's 1996 amendments to section 7805(b) were intended to preclude retroactivity for all regulations promulgated after 1996 or just those relating to statutory provisions enacted after 1996. Thus, it remains unclear whether Home Concrete will change the way government agencies, particularly the IRS, approach the rulemaking process.
The government's approach on the basis overstatement/understatement of income issue--and the courts' response--has been the subject of numerous articles in recent years. (7) This article does not attempt the analysis of those articles, but instead strives to provide the story behind the basis overstatement saga, starting with the enactment of the operative statutory language in 1934 and culminating with the decision in Home Concrete. The article examines unanswered questions raised by the parties and some interesting points in the public record that have not been widely discussed. It concludes with suggestions for tax professionals regarding coordinated efforts against IRS positions, applying administrative law principles in tax disputes, and current IRS litigation strategies that, if successful, could significantly change the deference landscape and guidance process.
Former Section 275(c): The Genesis of the Dispute
In 1934, Congress enacted former section 275(c) of the Code, providing for an extended five-year limitations period where a taxpayer omitted from gross income an amount in excess of 25 percent of the amount of gross income stated in the return. The provision was reenacted in the 1939 Code without change. Uncertainly regarding the proper scope of the extended limitations period surfaced almost immediately, leading to a split among the circuit courts of appeals.
The Tax Court and the Sixth Circuit interpreted the new provision broadly, holding that it applied to situations where a taxpayer overstated his basis, leading to an understatement of gross income in excess of 25 percent. (8) Other Courts of Appeals disagreed, focusing on whether an overstated amount was an omission, whether disclosure trumped any omission, and whether the extended limitations period could apply when the dispute centered on the legal characterization of a transaction reported on the return. (9) The factual scenarios varied, from sales of goods or services in a trade or business to sales of real property (not a good or service) to an individual's failure to report wages as taxable income.
In the midst of this litigation, Congress enacted the Internal Revenue Code in 1954. (10) As part of this comprehensive reenactment of tax law, former section 275(c) was recodified as section 6501(e)(1) (A). The operative language was virtually untouched, but two new subparagraphs were added. In an apparent nod to the Uptegrove case, which held that former section 275(c) applied when a taxpayer fails "to include some receipt or accrual in his computation of gross income and not in a more general ways to errors of whatever kind in that computation," subparagraph (i) provided that for trades and business, "gross income" meant the total of the amounts received or accrued from the sales of goods or services before the diminution by the cost of such sales or services. Subparagraph (ii) encapsulates the position that items that were adequately disclosed by the taxpayer are not included in calculating "the amount omitted from gross income."
The Colony Decision
After the enactment of the 1954 Code, the Supreme Court granted certiorari in the Colony case to resolve whether an understatement of gross income resulting from an overstatement of basis was an omission from gross income under former section 275(c). Colony involved a developer that subdivided and sold lots of real property. In calculating the gain on the sale of the lots, the taxpayer understated its gross income by incorrectly including certain expenses in basis. Although the developer on his returns may have treated the lots as goods or inventory, these sales of real property were not sales of goods and the lots were not inventory. (11)
Siding with the majority of the circuits, the Supreme Court held that the taxpayer's overstatement of basis did not constitute an omission from gross income. It reasoned that the "critical statutory language" was "omits," and that this meant "[t]o leave out or unmentioned; not to insert, include, or name." (12) It also considered the legislative history and found persuasive evidence that--
Congress was addressing itself to the specific situation where a taxpayer actually omitted some income receipt or accrual in his computation of gross income, and not more generally to errors in that computation arising from other causes. (13) Thus, Congress's intent was "to give the Commissioner an additional two years to investigate tax returns in cases where, because of a taxpayer's omission to report some taxable item, the Commissioner is at a special disadvantage in detecting errors." (14) The Court found that the Commissioner's position would "create a patent incongruity in the tax law" by treating overstated basis differently from overstated deductions and noted that its holding was "in harmony with the unambiguous language" of section 6501(e)(1)(A). (15) In essence, the Court rejected the IRS's interpretation as contrary to the plain language of the statute and Congress's intent.
Post-Colony Action (or Inaction)
Little occurred during the next half a century, and all indications were that Colony governed disputes under section 6501(e)(1)(A). In 1965 Congress changed the heading of section 6501(e) from "Omission from Gross Income" to "Substantial Omission of Items," and made no reference to the Colony decision.
In 1968, the Fifth Circuit in Phinney v. Chambers (16) held that "either a complete omission of an item of income of the requisite amount or misstating of the nature of an item of income" can give rise to the extended six-year limitations period. The court found that the taxpayer's listing of an item on the wrong schedule did not overcome the income's being left out of the proper schedule of the tax return. Because of this misrepresentation of the nature of the income item, and because the 25-percent threshold was satisfied, the court held that the six-year limitations period applied. Referring to the Supreme Court's statement of Congress's intent, the Fifth Circuit intimated that "that language of the court's opinion in Colony should control here." Over the years, several other courts applied Colony's "clue test" for purposes of determining whether the adequate disclosure safe harbor of subparagraph (ii) was met, indicating that the courts generally believed that Colony's holding and rationale remained controlling after the enactment of the 1954 Code. (17)
In 1982, as part of the enactment of the Tax Equity and Fiscal Responsibility Act of 1982, Congress enacted section 6229(c)(2), the partnership-equivalent of section 6501(e)(1)(A) for partnerships, but did not include subparagraphs (i) and (ii) in the new section. The IRS initially accorded this omission significance, stating in 1995 that the disclosure exception did not apply to section 6229(c) (2). (18) It later changed course, however, stating that subparagraphs (i) and (ii) should be read into section 6229(c)(2). (19)
In 1986, Congress re-enacted the Code again, retaining the same operative language in sections 6229(c)(2) and 6501(e)(1)(A). (20) In 1997, Congress enacted section...