Supreme Court Urged to Review Whether Basis Overstatements Are Omissions From Gross Income

The questions presented in this case are:

1. Whether the overstatement of the basis of an asset in reporting a taxable transaction on an income tax return constitutes an omission "from gross income" that extends the limitations period for the assessment of tax from three to six years under Section 6501(e)(1)(A) of the Internal Revenue Code.

2. Whether a temporary regulation adopted by the Treasury without notice or the opportunity for public comment and for the purpose of reversing longstanding decisions of the Supreme Court and several courts of appeals that have rejected the government's litigating position under Section 6501(e)(1)(A) of the Internal Revenue Code is entitled to any deference.

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2. The Beards contested the asserted deficiency in the United States Tax Court. In a motion for summary judgment, the Beards claimed that the three-year statute of limitations for the assertion of tax deficiencies provided by Section 6501(a) of the Internal Revenue Code, 26 U.S.C. 6501(a), had expired prior to the date that the notice of deficiency was issued by the IRS. (App., infra, 19a.)

The Commissioner agreed that the generally applicable three-year statute of limitations under Section 6501(a) had expired. The Commissioner asserted, however, that the special six-year statute of limitations provided by Section 6501(e)(1)(A) of the Internal Revenue Code applies instead. (App., infra, 20a.) The Commissioner argued that the special six-year statute applies because, by overstating their basis in the stock, the Beards had understated their income from the sales and thereby "omit[ted] from gross income an amount properly includible therein * * * in excess of 25 percent of the amount of gross income stated in the return." 26 U.S.C. 6501(e)(1)(A). (App., infra, 21a.)

3. On August 11, 2009, the Tax Court granted summary judgment to the Beards. (App., infra, 17a-26a.) The court concluded that, even if the Beards had overstated their basis in the stock, the over-statement of basis does not constitute an "omi[ssion] from gross income" within the meaning of the statute. (Id. at 25a.) In so ruling, the Tax Court followed the decision of this Court interpreting the same statutory language in Colony, Inc. v. Commissioner, 357 U.S. 28 (1958). The Tax Court also relied on the recent decision of the Ninth Circuit in Bakersfield Energy Partners, LP v. Commissioner, 568 F.3d 767 (2009), aff'g 128 T.C. 207 (2007), which also reached the same conclusion. Having concluded that the six-year statute of limitations does not apply to this case, the Tax Court held that the notice of deficiency was untimely and therefore entered judgment in favor of the taxpayers. (App., infra, 25a.)

4. On September 28, 2009, after the Tax Court rendered its decision in this case, the Secretary of the Treasury sought to alter the result of this decision, and other similar decisions, by promulgating a new, temporary Treasury Regulation. 26 C.F.R. § 301.6501(e)-1T. That regulation states the Treasury's conclusion that "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)(1)(A)." This temporary regulation, which was made immediately effective by the agency, was issued without notice or an opportunity for public comment. 74 Fed. Reg. 49321-23. On the same date that the temporary regulation was issued, the Secretary published a notice proposing a permanent adoption of the same rule and invited public comments. The Secretary thereafter published the regulation in final form -- without any material changes -- on December 17, 2010. 75 Fed. Reg. 78897-99.

5. The IRS appealed the decision of the Tax Court to the Seventh Circuit. On January 26, 2011, the court of appeals reversed the judgment of the Tax Court and held that an overstatement of basis constitutes an "omi[ssion] from gross income" for purposes of Section 6501(e)(1)(A). (App., infra, 13a-15a.) The court of appeals stated that, "[a]lthough it is clearly a contentious issue and a close call, the plain meaning of the Code and a close reading of Colony lead us to the conclusion that, given [revisions made to Section 6501(e)(1)(A) in 1954], [the decision of the Supreme Court in] Colony does not control here and an overstatement of basis can be treated as an omission from gross income under the 1954 Code." (App., infra, 7a.) In reaching that decision, the Seventh Circuit cited and relied on the decision of the Fifth Circuit in Phinney v. Chambers, 392 F.2d 680 (1968), as the only direct appellate support for its holding. (App., infra, 9a.)

The Seventh Circuit went on to state that, if it had been required to reach the issue, it "would have been inclined to grant the temporary regulation Chevron deference, just as we would be inclined to grant such deference to [the final regulation]." (App., infra, 14a.) Because the court rested its holding entirely on its reading of the plain text of the statute, however, the court concluded that it was not necessary for it to consider or address the applicability, if any, of the temporary regulation to this case. (Id.)

6. Less than two weeks after the decision of the court of appeals in this case, the Fourth Circuit expressly disagreed with the Seventh Circuit decision in Home Concrete & Supply, LLC v. United States, 634 F.3d 249 (2011). In Home Concrete, the Fourth Circuit held that, under the 1958 decision of the Supreme Court in the Colony case, and also under the uniform decisions of several other circuit courts, an overstated basis does not constitute an omission from gross income for purposes of Section 6501(e)(1)(A).

Similarly, in Burks v. United States, 633 F.3d 347 (2011), which was entered only three days after the decision of the Fourth Circuit in Home Concrete, the Fifth Circuit squarely rejected the reasoning of the Seventh Circuit. In addition, the Fifth Circuit held in Burks that the Seventh Circuit in Beard had erred in "incorrectly read[ing the earlier Fifth Circuit] decision in Phinney as limiting Colony's holding." Id. at n.5.

7. On March 7, 2011, the Beards filed a petition for rehearing with suggestion for rehearing en banc. In the petition, the Beards pointed out (i) that the decision of the Seventh Circuit conflicted with the decision of this Court in the Colony case and with the decisions of the Fourth, Fifth, Ninth, and Federal Circuits on the same statutory issue; and (ii) that the Seventh Circuit had erred in relying on the decision of the Fifth Circuit in the Phinney case for the reasons subsequently and clearly explained by the Fifth Circuit in the Burks decision. On April 8, 2011, the Seventh Circuit denied the petition for rehearing and suggestion for rehearing en banc without comment. (App., infra, 16a.)

Notwithstanding the impressive weight of precedent contrary to its decision, the court of appeals asserted that its conclusion in this case was compelled by the "clear" meaning of the statute. (App., infra, 14a.) Based on this reading of the statute, the court stated that it did not "need [to] reach" the question of what, if any, deference was due to the temporary regulation that the Treasury had adopted in its effort to overturn the several court of appeals decisions that had ruled adversely to the government's position on this frequently recurring issue. (Id.) While the court thus acknowledged that its discussion of this issue was dicta, the court nonetheless stated that, if the controlling statute were regarded as ambiguous and the issue were therefore presented, it would give "Chevron" deference to the temporary regulation which purports retroactively to treat an overstatement of basis as if it were an omission from gross income for purposes of this statute. 26 C.F.R. § 301.6501(e)-1T(a)(1)(iii). (App., infra, 14a.) In reaching this conclusion, the court did not address the fact that the Treasury had adopted that regulation without notice or an opportunity for public comment as belated support for the government's litigating position in this very case.

This aspect of the Seventh Circuit decision conflicts directly with the decision of the Fourth Circuit in Home Concrete & Supply, LLC v. United States, 634 F.3d 249 (2011), and the Fifth Circuit in Burks v. United States, 633 F.3d 347 (2011). In each of those cases, the courts of appeals held that the regulation was invalid as a matter of law and was entitled to no deference. The United States Tax Court has also held, in two "fully reviewed" decisions, that the temporary and final versions of this regulation are invalid. See Carpenter Family Invs., LLC v. Commissioner, 136 T.C. No. 17 (2011); Intermountain Ins. Serv. v. Commissioner, 134 T.C. 211 (2010). In two subsequent, recent decisions, however, the Federal and the Tenth Circuits upheld and deferred to the final regulation in Grapevine Imports, Ltd. v. United States, 636 F.3d. 1368 (2011), and Salman Ranch v. United States, __ F.3d. __, 2011 WL 2120044 (May 31, 2011), which has further deepened the embedded split among the courts of appeals on this important and recurring statutory issue.

1. a. The Seventh Circuit erred in failing to follow the binding precedent of this Court in Colony, Inc. v. Commissioner, 357 U.S. 28 (1958). In the Colony case, this Court reviewed the same language in the predecessor version of this statute from the 1939 Code and squarely held that an overstated basis of an asset in a transaction reported in a tax return is not an "omission" of gross income from that return within the meaning of the extended statute of limitations.¹ The Court held that to "omit" an item of income for purposes of the statute means "to leave [it] out or unmentioned; not to insert, include, or name." Id. at 32.

In Colony, the taxpayer had calculated its gain from the sale of properties on its tax return by using a basis that included the costs that had been incurred in developing the properties. 357 U.S. at 30. The IRS determined that such development costs were not properly included in basis. The IRS therefore concluded that the taxpayer had overstated its basis and, as a result, had understated the amount of gain to be included in gross income. The IRS mailed notices of deficiency to the taxpayer more than three years, but less than five years, after the taxpayer filed the returns.² The question before the Supreme Court was whether the notices were timely. Id.

In the Colony case, the Tax Court had held -- like the Seventh Circuit in the present case -- that the statutory language "'omits from gross income an amount properly includible therein,' embraced not merely the omission from a return of an item of income received by or accruing to a taxpayer, but also an understatement of gross income resulting from a taxpayer's miscalculation of profits through the erroneous inclusion of an excessive item of cost." 357 U.S. at 31. The Sixth Circuit had agreed with the Tax Court's conclusion in Colony. This Court granted certiorari because the decision of the Sixth Circuit "conflicted with rulings in other Courts of Appeals on the same issue." Id.

This Court held in Colony that the term "omits" -- as used in "the critical statutory language, 'omits from gross income an amount properly includible therein' -- must be given its ordinary meaning as "to leave out or unmentioned; not to insert, include, or name." 357 U.S. at 32. The Court further held that this "ordinary meaning" was reinforced by the legislative history of Section 275(c), which provides "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.

Based on its analysis of the text of the statute and its review of the legislative history, the Court described the congressional purpose of the extended statute of limitations as follows:

The Court also noted in Colony that, even though it was interpreting the text of the version of this statute contained in the 1939 Code, "the conclusion we reach is in harmony with the unambiguous language of § 6501(e)(1)(A) of the Internal Revenue Code of 1954."³ 357 U.S. at 37. The Court thus concluded in 1958 that its decision in Colony applies equally to the identical language contained in the 1939 and 1954 Codes -- a determination that the Seventh Circuit simply ignored in its contrary determination in this case. See note 3, supra.

b. The Seventh Circuit reasoned that it was not required to follow Colony in the present case because the holding in Colony should be limited to situations "involving" a trade or business. (App., infra, 11a.) In reaching that conclusion, however, the Seventh Circuit failed to recognize that Colony was decided by this Court for the very purpose of resolving a conflict among the courts of appeals in all cases, some of which did not involve a trade or business. Colony, 357 U.S. at 31 n.2 and 37 (citing Slaff v. Commissioner, 220 F.2d 65 (9th Cir. 1955)). Indeed, the Sixth Circuit reached its holding in Colony by adhering to its prior decision in Reis v. Commissioner, 142 F.2d 900 (1944), which involved casual sales of property and did not involve sales in the course of a trade or business.

In determining that the holding of Colony was limited to situations involving a "trade or business," the Seventh Circuit sought to rely on a clause that was added to the predecessor statute when Section 6501(e)(1)(A)(i) was enacted in 1954. This new portion of this statute provides: "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 diminution by the cost of such sales or services." 26 U.S.C. § 6501(e)(1)(A)(i). In seeking to rely on this clause to distinguish the statute addressed in Colony, however, the Seventh Circuit failed to recognize that the "gross income" of a trade or business is routinely and properly calculated by subtracting the cost of goods sold from gross receipts. As the Fifth Circuit correctly held in the Burks case, Section 6501(e)(1)(A)(i) thus merely "provides an alternative to this customary definition in the context of sales of goods or services by a trade or business by defining 'gross income' as gross receipts rather than gross receipts less the cost of goods sold." 633 F.3d at 358.

2. On each of the issues addressed by the court of appeals, the decision of the Seventh Circuit directly conflicts with decisions of the Fourth, Fifth, Ninth, and Federal Circuits. The existence of this deeply embedded conflict is expressly acknowledged in the decision below. (App., infra, 12a-13a.)

a. In Bakersfield Energy Partners L.P. v. Commissioner, 568 F.3d 767 (2009), the Ninth Circuit held that Colony remains controlling precedent and that an overstated basis is not an omission from gross income for purposes of Section 6501(e)(1). The Ninth Circuit observed that "Congress did not change the language in the body of § 6501(e)(1)(A), which is identical to the language in § 275(c) that the Supreme Court construed in Colony. As a general rule, we construe words in a new statute that are identical to words in a prior statute as having the same meaning." 568 F.3d at 775. The Ninth Circuit expressly rejected the argument of the United States that Congress' addition of subparagraph (i) "casts the language in the body of § 6501(e)(1)(A) in a different light." 568 F.3d at 776. Instead, the court held that Congress "intended to clarify, rather than rewrite, the existing law" with that addition. Id.

b. In Salman Ranch Ltd. v. United States, 573 F.3d 1362 (2009), the Federal Circuit expressly agreed with the reasoning and conclusion of the Ninth Circuit in Bakersfield Energy. The Federal Circuit held in Salman Ranch that Colony applies to the current version of this statute of limitations because the key phrase "omits from gross income an amount properly includible therein" is identical to the same language used in Section 275(c) in the 1939 Code. The court of appeals further noted that, "in the years since Colony, Congress has not indicated that the Court's interpretation of the language of § 275(c) should not apply to § 6501(e)(1)(A). This is true despite the post-Colony debate over whether § 6501(e)(1)(A) is triggered only when an item of income is entirely omitted from a return." 573 F.3d at 1373-74 (citing Bob Jones Univ. v. United States, 461 U.S. 574, 600-02 (1983)). "Given that Colony was decided over fifty years ago, we believe that, if Congress had so desired, it would have expressed its intention to change the meaning of the relevant language." 573 F.3d at 1374.

c. Less than two weeks after the Seventh Circuit issued its decision in this case, the Fourth Circuit decided Home Concrete & Supply, LLC v. United States, 634 F.3d 249 (2011). The Fourth Circuit held that "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." Id. at 255. The court of appeals found that, "[b]ecause 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.'" 634 F.3d at 255 (quoting Colony, 357 U.S. at 33).

d. Three days after the decision of the Fourth Circuit in Home Concrete, the Fifth Circuit issued its decision in Burks v. United States, 633 F.3d 347 (2011). The Fifth Circuit began by explaining that is earlier decision in Phinney v. Chambers, 392 F.2d 680 (1968), was not on point and that the Seventh Circuit had erred in attempting to rely on that case. 633 F.3d at 353 n.5. The Fifth Circuit then found "that Colony's holding with respect to the definition of 'omits from gross income' remains applicable in light of the revisions to the Code." Id. at 355. The court expressly rejected the government's argument that the addition of subsection (i) to Section 6501(e)(1)(A) made Colony inapplicable to the current Code. "Under the Code, gross income of a trade or business is usually calculated by subtracting the cost of goods sold from the gross receipts of the sale. 26 U.S.C. § 61(a). Subsection (i) provides an alternative to this customary definition in the context of sales of goods or services by a trade or business by defining 'gross income' as gross receipts rather than gross receipts less the cost of goods sold. See § 6501(e)(1)(A)(i)." Id. at 358.

3. The Seventh Circuit created an additional circuit split in suggesting -- without any analysis -- that if the governing statute were ambiguous (which the court concluded it was not), the court would then hold that the temporary Treasury Regulation 301.6501(e)-1T(a)(1)(iii) should be respected because it is entitled to "Chevron" deference. (App., infra, 14a.) That conclusion directly conflicts with the decisions of the Fourth Circuit in Home Concrete & Supply, LLC v. United States, 634 F.3d 249 (2011), and the Fifth Circuit in Burks v. United States, 633 F.3d 347 (2011).

The Fourth Circuit held in Home Concrete that this temporary regulation is entitled to no deference because, in Colony, this Court had concluded that the phrase "omits from gross income" was unambiguous. The court of appeals further held that the regulation was not a valid interpretive rule because it did not merely clarify existing law but instead "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 preregulation law." 634 F.3d at 257. In a concurring opinion, Judge Wilkinson recognized the benefits of deferring to agency expertise but explained that "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. . . . 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." Id. at 259.

The Fifth Circuit similarly held in Burks that the regulation is invalid because it was "an unreasonable interpretation of settled law." 633 F.3d at 360-61. The Fifth Circuit explained "that § 6501(e)(1)(A) is unambiguous and its meaning is controlled by the Supreme Court's decision in Colony, [so] we need not determine the level of deference owed to the Regulations." 633 F.3d at 360. The government was unable to cite any authority "refuting prior case law that has held § 6501(e)(1)(A) to be unambiguous with respect to the definition of 'omits.'" Id. at 360 (citing Colony, 357 U.S. at 37, where this Court held that "the conclusion we reach is in harmony with the unambiguous language of § 6501(e)(1)(A)". The Fifth Circuit expressly held these regulations to be invalid because they improperly "attempt to 'trump' what is established precedent on what constitutes an 'omission from gross income' for purposes of § 6501(e)(1)(A)." 633 F.3d at 360. See also note 3, supra.

The Fifth Circuit in Burks went on to note that, even if Section 6501(e)(1)(A) were ambiguous and even if Colony did not control, it is doubtful that these regulations would be entitled to Chevron deference under Mayo Foundation for Medical Education and Research v. United States, 131 S. Ct. 704, 711 (2011). The court explained that, "in Mayo the Supreme Court was not faced with a situation where, during the pendency of the suit, the treasury promulgated determinative, retroactive regulations following prior adverse judicial decisions on the identical legal issue. 'Deference to what appears to be nothing more than an agency's convenient litigating position' is 'entirely inappropriate."' 633 F.3d at 360 n.9 (quoting Bowen v. Georgetown Univ. Hosp., 488 U.S. 204, 213 (1988)). The Fifth Circuit further explained that "Mayo emphasized that the regulations at issue had been promulgated following notice and comment procedures," while these regulations were made immediately effective without subjecting them to notice and comment procedures. Id.

In Grapevine Imports, Ltd. v. United States, 636 F.3d. 1368 (2011), however, the Federal Circuit widened the circuit split on the issues presented in this case by holding that this Treasury Regulation is valid and entitled to Chevron deference. In contrast to the holdings of the Fourth and Fifth Circuits, the Federal Circuit found that Section 6501(e)(1)(A) was ambiguous and that the legislative history did not make Congress' "intent so clear that no reasonable interpretation could differ." 636 F.3d at 1379. But see note 3, supra. Finding no constraint on the agency in the decision of this Court in Colony or the Federal Circuit's own prior decision in Salman Ranch, the Federal Circuit determined that the regulation was a reasonable construction of the statute that could be retroactively applied. Id. at 1382.

Finally, and most recently, the Tenth Circuit agreed "with much" of the Seventh Circuit decision to hold that Section 6501(e)(1)(A) is ambiguous, notwithstanding this Court's decision in Colony, and that the regulation was entitled to Chevron deference. Salman Ranch, 2011 WL 2120044, at *7. The Tenth Circuit expressly noted that it was "not swayed by [the] contrary conclusions" of the Fourth and Fifth Circuits. Id. at *6 n.12.⁴

4. In the absence of a decision from this Court resolving the conflict among these several courts of appeals, the treatment of identically-situated taxpayers will differ based solely on geographic happenstance. Both of the issues addressed in the decision below have substantial recurring administrative importance. As the numerous cases raising this same issue reflect, the decision of the Seventh Circuit to treat an overstatement of basis as though it were an "omission" of income will incorrectly subject many routine sale transactions to the expanded statute of limitations. Moreover, the holding of the court of appeals that the Treasury is empowered to reject and overrule longstanding precedent of this Court and other courts that it disfavors, simply through the issuance of temporary regulations without notice and public comment threatens obvious, far-reaching consequences. Resolution of these recurring issues is needed to avoid continuing uncertainty and uneven application of the revenue laws.

² At the time, the extended limitations period provided by this statute was five years, rather than six. See page 2, supra.

³ Section 275 of the 1939 Code was renumbered as Section 6501 in the 1954 Code. Although Congress has amended Section 6501 thirty-nine times since it was first enacted in 1954, Congress has never changed the phrase "omits from gross income" which, as this Court concluded in Colony, governs the correct disposition of these cases. 357 U.S. at 36-37. Because Congress has revised this statute numerous times without altering this governing language, there is no ambiguity as to its proper meaning: "Congress is presumed to be aware of [a] judicial interpretation of a statute and to adopt that interpretation when it re-enacts a statute without change." Lorillard v. Pons, 434 U.S. 575, 580 (1978) (emphasis added).

⁴ The Commissioner issued notices of final partnership administrative adjustment ("FPAAs") to Salman Ranch making adjustments to the partnership tax returns that Salman Ranch filed for 1999, 2001, and 2002. Salman Ranch challenged the 1999 FPAA in the Court of Federal Claims and the 2001 and 2002 FPAAs in the Tax Court, leading to appellate review by both the Federal and Tenth Circuits. Those circuit courts issued conflicting decisions, as explained in the text.