Judicial deference to regulations: Home Concrete & Supply L.L.C.

• Author: Williamson, Donald T.

Generally, the IRS must assess a deficiency against a taxpayer within three years after the filing of an income tax return or the return's due date if filed early. (1) However, Sec. 6501(e)(1)(A) extends the statute to six years when the taxpayer "omits from gross income an amount properly includible therein" that is "in excess of 25 percent of the amount of gross income stated in the return."

Last April, the Supreme Court in Home Concrete & Supply, LLC, (2) resolved a split among the circuit courts of appeal as to whether the six-year statute applies when the taxpayer overstates basis in property sold, thereby understating gain and gross income by more than 25%. While the Court's ruling that the six-year statute does not apply clarifies the statute, of greater significance is its finding that prior court decisions will prevail under certain circumstances over the general judicial doctrine of deference to Treasury regulations. Thus, where a court, or at least the Supreme Court, has ruled on a specific controversy interpreting the Code, leaving no ambiguity in the meaning of the statute, that ruling may not be reversed by subsequent regulations, despite the general judicial principle that courts should defer to regulations when interpreting a statute.

This article reviews the Supreme Court opinions and IRS regulations that gave rise to Home Concrete and analyzes how a deeply divided Supreme Court resolved the issue. It concludes with a discussion of how taxpayers and their advisers should weigh conflicting court cases and IRS pronouncements in light of the Home Concrete decision.

Background of Home Concrete

The transaction from which Home Concrete arose was the infamous son-of-boss tax shelter in which the IRS alleged a partner had overstated his partnership basis in connection with the sale of his interest. (3) The facts of Home Concrete are identical to those of cases in several other circuits, some of which held that an overstatement of basis triggered the six-year statute, (4) while others, including the Fourth Circuit's Home Concrete decision, sided with the taxpayer. (5)

The split among the circuits arose because of the conflict between the Supreme Court's 1958 ruling in Colony, (6) which held the six-year statute did not apply to understatements of income caused by overstatements of basis, and a 2010 regulation, which was finalized while the issue was being litigated, holding that an understatement of basis does trigger the six-year statute. (7) In Colony, the Supreme Court interpreted a provision of the Internal Revenue Code of 1939, the operative language of which is identical to that of the current statute, finding the phrase "omits from gross income" did not include an overstatement of basis. Therefore, the extended six-year statute did not apply. Simply stated, Colony found that the extended statute applied only to cases where income is left off the return, not where something on the return is misstated. The Colony court also noted that, while the statute was not "unambiguous," it could, after examining the law's legislative history, conclude that Congress intended no exception to the three-year statute for an understatement of income caused by an overstatement of basis.

In response to several Tax Court and district court decisions holding that Colony prevented the IRS from applying the six-year statute to son-of-boss transactions, the IRS and Treasury Department finalized Regs. Sec. 301.6501(e)-1 in December 2010, declaring the regulation retroactive for all tax years that would still be open employing the rule. (8) The regulation flatly contradicts the result in Colony, stating "an understated amount of gross income resulting from an overstatement of unrecovered cost or other basis constitutes an omission from gross income." (9) The government also asserted that Colony did not apply to Sec. 6501(e)(1)(A) because the statute involved in the case had been amended since the decision, thereby permitting the six-year statute to apply to son-of-boss transactions.

Judicial Deference to Regulations

While the Colony case is seemingly on point, the Supreme Court has stated that the judiciary must generally defer to administrative regulations, including those of the IRS, whenever the statute interpreted by the regulations is not silent or ambiguous and the regulation is not arbitrary or capricious. Specifically, the Supreme Court in Chevron U.S.A. Inc. v. Natural Resources Defense Council (10) declared the degree of deference courts must give to regulations as follows:

When a court reviews an agency's construction of the statute which it administers, it is confronted with two questions. First, always, is the question whether Congress has directly spoken to the precise question at issue. If the intent of Congress is clear, that is the end of the matter; for the court, as well as the agency, must give effect to the unambiguously expressed intent of Congress. If, however, the court determines Congress has not directly addressed the precise question at issue, the court does not simply impose its own construction on the statute, as would be necessary in the absence of an administrative interpretation. Rather, if the statute is silent or ambiguous with respect to the specific issue, the question for the court is whether the agency's answer is based on a permissible construction of the statute. ... If Congress has explicitly left a gap for the agency to fill, there is an express delegation of authority to the agency to...