FOURTH CIRCUIT FINDS ASSESSMENT UNTIMELY, SECTION 6501 REGS INAPPLICABLE.

In Colony, Inc. v. Commissioner of Internal Revenue, the United States Supreme Court held that an overstatement of basis in assets resulting in an understatement of reported gross income does not constitute an "omission" from gross income for purposes of extending the general three-year statute of limitations for tax assessments. 357 U.S. 28 (1958). Because Colony squarely applies to this case, and because we will not defer to Treasury Regulation § 301.6501(e)-1(e), which was promulgated during this litigation and, by its own terms, does not apply to the tax year at issue, we reverse and hold that the tax assessments at issue here were untimely.

Plaintiff Home Concrete & Supply, LLC ("Home Concrete"), a pass-through entity for tax purposes, was formed on April 15, 1999. Its partners were Mr. Chandler, Mr. Pierce, Home Oil, and two trusts established for the benefit of Mr. Pierce's children (collectively "the taxpayers").

On May 13, 1999, each of the taxpayers initiated short sales¹ of United States Treasury Bonds. In the aggregate, the taxpayers received $7,472,405 in short sale proceeds. Four days later, the taxpayers transferred the short sale proceeds and margin cash to Home Concrete as capital contributions. By transferring the short sale proceeds to Home Concrete as capital contributions, the taxpayers created "outside basis" equal to the amount of the proceeds contributed.² The next day, May 18, 1999, Home Concrete closed the short sales by purchasing and returning essentially identical Treasury Bonds on the open market at an aggregate purchase price of $7,359,043.

On June 11, 1999, Home Oil transferred substantially all of its business assets to Home Concrete as a capital contribution. Three days later, the taxpayers (except Home Oil) transferred percentages of their respective partnership interests in Home Concrete to Home Oil as capital contributions to Home Oil. On August 31, 1999, Home Concrete sold substantially all of its assets to a third-party purchaser for $10,623,348.

In April 2000, Home Concrete and the taxpayers timely filed their tax returns for the 1999 tax year. Home Concrete elected to adjust, or "step-up," its inside basis under 26 U.S.C. ("I.R.C.") § 754 to equal the taxpayers' outside bases. See I.R.C. § 743(b)(1). Home Concrete then adjusted its inside basis to $10,527,350.53, including the amount of short sale proceeds earlier contributed by the taxpayers. As a result, Home Concrete reported a modest $69,125.08 gain from the sale of its assets.

Home Concrete's 1999 tax return reported the basic components of the transactions. Its § 754 election form gave, for each partnership asset, an itemized accounting of the partnership's inside basis, the amount of the basis adjustment, and the post-election basis. The sum of the post-election bases is indicated at the end of the form. On its face, Home Concrete's return also showed a "Sale of U.S. Treasury Bonds" acquired on May 18, 1999 at a cost of $7,359,043, and a sale of those Bonds on May 19, 1999 for $7,472,405. The return also reported the resulting gain of $113,362. Similarly, the taxpayers' individual returns showed that "during the year the proceeds of a short sale not closed by the taxpayer in this tax year were received."

Notwithstanding these disclosures, the Internal Revenue Service ("IRS") did not investigate the taxpayers' transactions until June 2003. The IRS issued a summons to Jenkins & Gilchrist, P.C., the law firm that assisted the taxpayers with the transactions, on June 19, 2003. The parties agree that substantial compliance with the IRS summons did not occur until at least May 17, 2004.

As a result of the investigation, on September 7, 2006 the IRS issued a Final Partnership Administrative Adjustment ("FPAA"), decreasing to zero the taxpayers' reported outside bases in Home Concrete and thereby substantially increasing the taxpayers' taxable income. Specifically, the IRS reasoned that

In response, the IRS contended that the FPAA was timely under the six-year limitations period in § 6501(e)(1)(A). The IRS invoked the extended statute of limitations arguing that Home Concrete "omit[ted] from gross income an amount properly includable therein" and which exceeded 25% of the amount of gross income stated in Home Concrete's 1999 tax return. Home Concrete & Supply, LLC v. United States, 599 F. Supp. 2d 678, 683 (E.D.N.C. 2008). There was no dispute that if an amount had been omitted from Home Concrete's return, that amount exceeded the 25% threshold. Likewise, there was no dispute that the FPAA would have been timely under the six-year statute of limitations, which would have been tolled beginning six months after the date the summons issued to the date of compliance. Id. at 681 n.5; see also I.R.C. § 7609(e)(2). By the district court's calculation, "the limitations period for the 1999 tax returns was suspended from December 20, 2003, until May 17, 2004 . . . . Thus, a six-year statute, tolled, would not have run even under this most restrictive interpretation of the record until" September 14, 2006. Home Concrete & Supply, 599 F. Supp. 2d at 681 n.5.

On the other hand, the taxpayers argued that the six-year statute of limitations was inapplicable because Home Concrete's allegedly overstated basis did not constitute an omission from gross income. And even if it had been an omission, the taxpayers argued, their tax returns collectively made adequate disclosure of the transactions such that they were entitled to the safe harbor of the three-year statute of limitations under § 6501(e)(1)(B)(ii) (hereafter "safe harbor provision"). Id. at 683.

Thereafter, the district court granted partial summary judgment in the IRS's favor, ruling that "where a taxpayer overstates basis and, as a result, leaves an amount out of gross income, the taxpayer 'omits from gross income an amount properly includible therein' for purposes of § 6501(e)(1)(A)." Id. at 687. The court ordered further briefing on, among other issues, whether the taxpayers adequately disclosed any omitted amount such that the safe harbor provision applied. After considering the supplemental briefs,³ the district court ruled that the taxpayers failed to make adequate disclosure and therefore could not invoke the safe harbor provision. Accordingly, the district court concluded that the FPAA was timely under the six-year statute of limitations in § 6501(e)(1)(A). Home Concrete and the taxpayers appealed.

In Colony, the IRS alleged that a taxpayer "understated the gross profits on the sales of certain lots of land for residential purposes as a result of having overstated the 'basis' of such lots by erroneously including in their cost certain unallowable items of development expense." 357 U.S. at 30. The IRS further contended that the amount left out of gross income because of the overstated basis exceeded 25% of the amount of gross income stated in the relevant tax returns. The IRS argued that its assessments were therefore timely under the extended five-year statute of limitations in former I.R.C. § 275(c). Id. at 30-31. That section stated that:

The Supreme Court in Colony acknowledged that former § 275(c) was ambiguous and did not clearly answer whether Congress intended an overstated basis to constitute an omission from gross income stated in the return. The Court found in the legislative history "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." Id. at 33. According to the Court, "in enacting [former § ] 275(c) Congress manifested no broader purpose than 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." Id. at 37. The Court therefore refused to construe "omits" broadly and instead restricted its applicability to situations where taxpayers actually fail to report income.

Notably, in dicta, the Supreme Court also stated that its conclusion was "in harmony with the unambiguous language of section 6501(e)(1)(A)" -- the section at issue in this case. Id. (emphasis added). In 1954, Congress recodified former § 275(c) at § 6501(e)(1)(A). Congress extended the limitations period from five years to six, and added the following additional subsections:

In this case, the district court distinguished Colony on the ground that its holding is limited to cases in which the taxpayer is a trade or business selling goods or services. Home Concrete & Supply, 599 F. Supp. 2d at 685-86; accord, e.g., Beard v. Comm'r, No. 09-3741, slip op. at 8-9 (7th Cir. Jan. 26, 2011) (holding that Colony only applies in the trade or business context); CC&F W. Operations Ltd. P'ship v. Comm'r, 273 F.3d 402, 406 n.2 (1st Cir. 2001) (noting, in dicta, the "arguable implication" that the holding of Colony applies only to sales of goods or services by a trade or business). In doing so, the district court relied heavily upon the Court of Federal Claims' decision in Salman Ranch, Ltd. v. United States, 79 Fed. Cl. 189 (2007), which has since been reversed by the Federal Circuit. 573 F.3d 1362 (Fed. Cir. 2009). The Federal Circuit expressly refused to limit Colony's application to sales of goods or services by a trade or business because nothing in Colony suggests such a limitation. Salman Ranch, 573 F.3d at 1373; see also Bakersfield Energy Partners, L.P. v. Comm'r, 568 F.3d 767, 778 (9th Cir. 2009) ("There is no ground for suggesting that the [ Colony ] Court intended the same language in § 275(c) to apply differently to taxpayers in a trade or business than to other taxpayers."); Grapevine Imports, Ltd. v. United States, 77 Fed. Cl. 505, 511 (2007) ("[T]his court sees no basis for limiting the Supreme Court's decision [in Colony ] to sales of goods or services by a trade or business."); UTAM, Ltd. v. Comm'r, 98 T.C.M. (CCH) 422, *3 (2009) (same).

Like the Ninth and Federal Circuits, we hold that the Supreme Court in Colony straight-forwardly construed the phrase "omits from gross income," unhinged from any dependency on the taxpayer's identity as a trade or business selling goods or services. There is, therefore, no ground to conclude that the holding in Colony is limited to cases involving a trade or business selling goods or services. See Salman Ranch, 573 F.3d at 1373 ("We are not prepared to conclude -- based simply upon the Court's reference to ambiguity in § 275(c) and the lack thereof in § 6501(e)(1)(A) -- that the Court's facially unqualified holding nevertheless carries with it a qualification.").

Further, the Supreme Court's discussion of the legislative history behind former § 275(c) is equally compelling with regard to current § 6501(e)(1)(A). The language the Court construed in former § 275(c) -- "omits from gross income an amount properly includable therein" -- is identical to the language at issue in § 6501(e)(1)(A). Because there has been no material change between former § 275(c) and current § 6501(e)(1)(A), and no change at all to the most pertinent language, we are not free to construe an omission from gross income as something other than a failure to report "some income receipt or accrual." Colony, 357 U.S. at 33; see also Bakersfield Energy Partners, L.P., 568 F.3d at 778 (concluding that Colony forecloses the argument that an overstated basis can constitute an omission from gross income for purposes of extending the statute of limitations under § 6501(e)(1)(A)); Salman Ranch, 573 F.3d at 1377 (same). Thus, we join the Ninth and Federal Circuits and conclude that Colony forecloses the argument that Home Concrete's overstated basis in its reporting of the short sale proceeds resulted in an omission from its reported gross income.

Perhaps in response to the Ninth Circuit's cue, the IRS promulgated a temporary regulation on September 28, 2009, which became final during the pendency of this appeal. Treas. Reg. § 301.6501(e)-1. The IRS claims that this regulation is entitled to controlling deference under Chevron U.S.A. Inc. v. Natural Resources Defense Council, Inc., 467 U.S. 837 (1984).

The regulation states that:

First, the 1999 tax year at issue in this case, for which tax returns were due by April 2000, is well beyond the reach of the regulation's express period of applicability. Even assuming arguendo that the six-year statute of limitations applied, pursuant to the regulation, the "period for assessing tax" would have expired, according to the district court's unchallenged finding, on September 14, 2006. Thus, the period for assessing tax for the 1999 tax year expired long before September 24, 2009. By its own terms, the regulation does not apply here.⁴

The IRS urges a different interpretation of the regulation's applicability clause in the preamble to Treasury Decision 9511. The preamble suggests that the "six-year period for assessing tax" in § 6501(e)(1) remains open for "all taxable years . . . that are the subject of any case pending before any court of competent jurisdiction (including the United States Tax Court and Court of Federal Claims) in which a decision had not become final (within the meaning of [26 U.S.C. § ] 7481)." Because this case was not finally resolved as of September 24, 2009, the IRS argues that § 6501(e)(1)'s six-year period for assessing tax remains open and Treasury Regulation § 301.6501(e)-1(e) applies. We cannot agree.

With this logic, the IRS attempts to re-draft I.R.C. § 6501. In the statute, Congress made clear that the window for tax assessments, barring special circumstances, closes after three years. I.R.C. § 6501(a). In the event of an omission, the window closes after six years. I.R.C. § 6501(e). And Congress specifically listed circumstances, such as fraud, in which the assessment window remains open without limitation. Id. § 6501(c). Congress unambiguously stated its intent to close the period for assessing tax within six years after a return is filed, except in cases of fraud. Accordingly, the IRS's argument that the period for assessing tax is open -- or indeed may be re-opened, as would be the case here -- so long as litigation is pending is contrary to the clearly and unambiguously expressed intent of Congress and must fail. United States v. Mead, 533 U.S. 218, 227 (2001) (stating that an agency's interpretation is not binding on courts if it is "manifestly contrary to the statute"). Not surprisingly, the Tax Court rejected the same argument as to the substantially identical applicability clause in the temporary regulation. Intermountain Ins. Serv. of Vail, LLC v. Comm'r, 134 T.C. No. 11, *4-6 (2010) (rejecting the IRS's argument as circular and contrary to the plain language of the regulations).

Second, even putting the applicability clause aside, Chevron deference is warranted only when a treasury regulation interprets an ambiguous statute. Mayo Found. for Med. Educ. & Research v. United States, 562 U.S. ___, ___, No. 09-837, slip op. at 6-7 (Jan. 11, 2011); see also Brand X Internet Servs., 545 U.S. at 980; Chevron, 467 U.S. at 842-43. While we are aware that lower courts are divided regarding whether an overstated basis constitutes an omission from gross income, the Supreme Court's reference to "the unambiguous language of section 6501(e)(1)(A)" cannot be ignored. Colony, 357 U.S. at 37 (emphasis added). Because the regulation here interprets "omits from gross income" under § 6501(e)(1)(A), and the Supreme Court declared that statute unambiguous, we do not believe that the regulation is entitled to controlling deference. See Chevron, 467 U.S. at 842-43 ("If the intent of Congress is clear, that is the end of the matter; for the courts, as well as the agency, must give effect to the unambiguously expressed intent of Congress.").

Finally, we are not persuaded by the IRS's argument that the regulation should apply retroactively to this case as a clarification of law established in Colony and other cases. The Supreme Court has acknowledged that a subsequent agency interpretation of an ambiguous statute may displace an earlier judicial construction of the same provision. Brand X Internet Servs., 545 U.S. at 982-83. But again, the Supreme Court stated in Colony that § 6501(e)(1)(A) is unambiguous as to the very issue to which the regulation purports to speak. The regulation is not, therefore, a mere clarification. Rather, if applied, the regulation would change the law governing the taxpayers' 1999 tax returns and thereby subject the taxpayers to liability to which they would not have been subject under pre-regulation law. See United States v. Capers, 61 F.3d 1100, 1110 (4th Cir. 1995) (declining to apply an amendment to the United States Sentencing Guidelines retroactively because the amendment changed Fourth Circuit law so as to deprive the defendant of a benefit to which he would have been entitled under pre-amendment law).

Because Colony was established law when the taxpayers filed their returns in April 2000, we refuse to apply Treasury Regulation § 301.6501(e)-1(e), which purports to establish a rule contrary to Colony to subject the taxpayers to the extended limitations period ten years later. See Levy v. Sterling Holding Co., 544 F.3d 493, 506 (3d Cir. 2008) ("[W]here a new rule constitutes a clarification -- rather than a substantive change -- of the law as it existed beforehand, the application of that new rule to pre-promulgation conduct necessarily does not have an impermissible retroactive effect"); cf. Smiley v. Citibank (South Dakota), N.A., 517 U.S. 735, 744 n.3 (1996) (stating that an agency interpretation does not have an impermissible retroactive effect where there was previously no clear agency guidance).

REVERSED

I am happy to concur in Judge Wynn's fine opinion in this case. The Chevron test is straightforward enough when it comes to post-Chevron cases. But it is sometimes difficult to determine whether pre-Chevron decisions are based upon "Chevron step one" (the plain command of the statute) or upon "Chevron step two" (a permissible construction of the statute). Mayo Found. for Med. Educ. & Research v. United States, No. 09-837, slip op. at 6-7 (U.S. Jan. 11, 2011). Certainly Justice Harlan in Colony, Inc. v. Commissioner, 357 U.S. 28 (1958), had no occasion to ponder the permutations of the Chevron test, which came down in 1984.

Here, however, I am persuaded that the Supreme Court rested its judgment in Colony on the plain language of the statute, which then, as now, stated that the extended statute of limitations for assessing tax liability applies "[i]f the taxpayer omits from gross income an amount properly includible therein." 26 U.S.C. § 275(c) (1939) (emphasis added); see 26 U.S.C. § 6501(e)(1)(A) (current version). In other words, I believe that Colony was decided under Chevron step one.

Lawyers of course are adept at finding ambiguity, and language of course is by its nature imprecise. One need not consult a dictionary, however, to understand that the plain meaning of "omit" is "to leave out" or "to fail to mention." The taxpayers here did not omit, leave out, or fail to mention their transaction. Instead, they provided the details on their returns. See Majority Op. at 4. To be sure, the IRS asserts that the returns overstated Home Concrete's basis and thus understated the overall tax liability resulting from the sale of its assets. But as the Court noted in Colony, if Congress had been concerned with that problem, "it could have chosen another verb such as 'reduces' or 'understates,' either of which would have pointed significantly in the Commissioner's direction." Colony, 357 U.S. at 32.

I recognize there is some language in Colony suggesting that the Court looked at legislative history or thought that § 275(c) was ambiguous. See Colony, 357 U.S. at 33 ("Although we are inclined to think that the statute on its face lends itself more plausibly to the taxpayer's interpretation, it cannot be said that the language is unambiguous. In these circumstances we turn to the legislative history of § 275(c)."). But that language seems to me secondary in importance to the thrust of the opinion and to the Court's argument that "in enacting § 275(c) Congress manifested no broader purpose than to give the Commissioner [additional time] 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." Id. at 36. More importantly, as Judge Wynn notes, the Court observed that its decision was "in harmony with the unambiguous language of" 26 U.S.C. § 6501(e)(1)(A), the successor provision to § 275(c) and the provision at issue here. See id. at 37 (emphasis added).

I appreciate that Chevron and National Cable & Telecommunications Ass'n v. Brand X Internet Services, 545 U.S. 967 (2005), afford agencies considerable discretion in their areas of expertise. As Brand X put it, "Chevron established a presumption that Congress, when it left ambiguity in a statute meant for implementation by an agency, . . . desired the agency (rather than the courts) to possess whatever degree of discretion the ambiguity allows." Brand X, 545 U.S. at 982 (internal quotations and citation omitted). The Supreme Court's recent decision in Mayo Foundation likewise affords full Chevron deference to Treasury Regulations, concluding that the Treasury Department's interpretations of ambiguous statutes will stand if they are "a 'reasonable interpretation' of the enacted text." Mayo Found., slip op. at 12 (quoting Chevron, 467 U.S. at 844). Given the fact that government today is an enterprise of unprecedented complexity, this makes perfect sense. Nor do judges harbor any desire to impair the mission of the IRS in a day of staggering budget deficits.

Yet it remains the case that agencies are not a law unto themselves. No less than any other organ of government, they operate in a system in which the last words in law belong to Congress and the Supreme Court. What the IRS seeks to do in extending the statutory limitations period goes against what I believe are the plain instructions of Congress, which have not been changed, and the plain words of the Court, which have not been retracted. See Colony, 357 U.S. at 37.

This seems to me something of an inversion of the universe and to pass the point where the beneficial application of agency expertise gives way to a lack of accountability and a risk of arbitrariness. We do not stand alone in reaching this determination; other courts have similarly rebuffed the IRS's repeated attempts to adopt the six-year statute of limitations for omissions of gross income so as to cover misleading statements in tax returns that would result in tax deficiencies. See Salman Ranch Ltd. v. United States, 573 F.3d 1362, 1372-74 (Fed. Cir. 2009); Bakersfield Energy Partners, L.P. v. Comm'r, 568 F.3d 767, 778 (9th Cir. 2009); Grapevine Imports, Ltd. v. United States, 77 Fed. Cl. 505, 511-12 (2007); Intermountain Ins. Serv. of Vail, LLC v. Comm'r, 134 T.C. No. 11, at *6-*8 (2010). These courts have recognized that regardless of whether the IRS's position is sound as a matter of policy, it is simply not the law.

We have been told many times to leave to the Court "the prerogative of overruling its own decisions." See Rodriguez de Quijas v. Shearson/Am. Express, Inc., 490 U.S. 477, 484 (1989). If that injunction has been issued to the circuit courts, it assuredly applies to agencies in situations where the Court has interpreted the plain language of a statutory command. Maybe Congress will conclude at some point that the six-year period should apply to declarations that fall short of omissions or the Court may decide that Colony was somehow, after all, a Chevron step two case. But those decisions are neither ours nor the agency's to make. Chevron, Brand X, and more recently, Mayo Foundation rightly leave agencies with a large and beneficial role, but they do not leave courts with no role where the very language of the law is palpably at stake. There is a balance to be struck here, and courts still must play a part in determining where "here" is. The disruption of that balance in this case seems clear and evident.

² A partner's basis in her partnership interest is called "outside basis," and a partnership's basis in its assets is referred to as its "inside basis." Kornman, 527 F.3d at 456 n.12; see also 26 U.S.C. §§ 722-23.

³ In their supplemental brief to the district court, the taxpayers stipulated "for purposes of resolving the [cross-motions for summary judgment] only, that 'they overstated the tax basis of the assets that [Home Concrete] sold in 1999 resulting in an omission [ ] from gross income in excess of 25 percent of the stated gross income amount.'"

⁴ In UTAM, the Tax Court noted that the IRS (curiously) did not rely on the temporary regulation, even though it had been promulgated while that case was still pending. 98 T.C.M. (CCH) at *1 n.2. We observe that the timeline in this case is virtually identical to the timeline in UTAM: The IRS issued an FPAA on October 13, 2006, alleging that the taxpayer had omitted gross income by overstating basis in its tax return for the 1999 tax year. Id. at *1-2. The IRS did not ask the Tax Court to apply the temporary regulation retroactively in UTAM yet asks this Court to do so in this factually analogous case.

⁵ In light of this holding, we need not reach the parties' arguments regarding the safe harbor provision.