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Last summer, the Ninth Circuit Court of Appeals handed the IRS a defeat that the IRS did not take lightly. The Ninth Circuit ruled that an overstated basis, no matter how large, is simply not omitted income. See Bakersfield Energy Partners, LP v. Commissioner , 568 F.3d 767 (2009). The key to the decision is the definition of a four letter word, omit, which means “left out,” whereas an overstated basis by definition is stated on the return, i.e., not left out. Without an omission of income, the three year statute of limitations applies, not the extended six year period. The Ninth Circuit relied heavily upon a Supreme Court decision that came to the same conclusion. Colony, Inc. v. Commissioner, 357 U.S. 28 (1958).
After Bakersfield, the IRS suffered a series of losses. Not one to stand idly by, the IRS took matters into its own hands and seized upon a small opening left in the Ninth Circuit's decision: "The IRS may have the authority to promulgate a reasonable reinterpretation of an ambiguous provision of the tax code, even if its interpretation runs contrary to the Supreme Court's 'opinion as to the best reading' of the provision. . . . We do not." Bakersfield, 568 F.3d at 778 (citations omitted). With that, the Treasury Department issued Temp. Reg. §§ 301.6229(c)(2)-1T and 301.6501(e)-1T, which provided "an understated amount of gross income resulting from an overstatement of unrecovered cost or other basis constitutes an omission from gross income." With the new regulation in hand, the IRS went about attempting to overturn a series of unfavorable decisions.
One of those cases was Intermountain Insurance Service of Vail, LLC, Thomas A. Davies, Tax Matters Partner v. Commissioner, 134 T.C. No. 11 (2010). The IRS moved to vacate the September 1, 2009 decision in Intermountain relying upon its new regulation. The problem that faced the IRS was that the effective date of the regulations is September 24, 2009. For the regulation to be applicable, the statute would need to be open on September 24, 2009 when the regulations became effective. However, if the statute was open on September 24, 2009, the IRS would not need to rely on the new regulation. The IRS attempted to explain away this conundrum through creative reasoning that appears to involve time travel. The Tax Court found the IRS's explanation "irreparably marred by circular, result driven logic and the wishful notion that the temporary regulations should apply . . . ."
Further, the Tax Court analyzed whether they were bound to the IRS construction of the statute or by the Supreme Court's construction in Colony. The Supreme Court's construction trumps the IRS' construction if the Supreme Court "holds that its construction follows from the unambiguous terms of the statute." National Cable & Telecommunications Ass'n v. Brand X Internet Services 545 U.S. 967, 982(2005). The Tax Court in Intermountain determined that the Supreme Court in Colony unambiguously forecloses the IRS' construction.
With the Tax Court ruling that the temporary regulations are invalid and not entitled to deferential treatment in Intermountain, a series of other cases pending before the Tax Court should follow Intermountain's lead. Also, keep on eye on the 10th Circuit, which should issue a decision in the near future regarding the validity of these same temporary regulations.