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The Seventh Circuit handed the government a victory yesterday, deciding in Beard v. Comm’r that a taxpayer’s overstatement of basis can result in an omission of income under Code section 6501(e), thereby extending to six years the statute of limitations for the IRS to make an assessment, rather than the usual three.
Beard involved an individual taxpayer who had engaged in a variant of the so-called “Son-of-BOSS” transaction in which the taxpayer sold short a position in a financial asset and contributed to a partnership both the proceeds of and the debt created by the short sale. The intended result of the transaction is that the contribution of these interests gives the taxpayer a high – the government would say “inflated” – tax basis in his partnership interest.
The tax play arises because the contributed obligation reduces the value of the taxpayer’s partnership interest, but does not reduce his basis in the partnership. As a result, when the partnership interest is sold, the taxpayer can either (i) minimize his gain on the transaction or (ii) realize a loss, which is then used to offset pre-existing or anticipated gains from other dispositions.
In the Tax Court, the Beards filed for summary judgment arguing that the IRS’s notice of deficiency was issued after the expiration of the three-year statute of limitations that ordinarily applies to tax returns. According to the Beards (with whom the Tax Court agreed), the putative overstatement of basis that results from the Son-of-Boss transaction is not an omission from income within the scope of section 6501(e)(1)(A), which would give the IRS a six-year statute of limitations within which its notice of deficiency would have been timely.
The Seventh Circuit’s Opinion
In a decision that deepens a split among the circuits regarding the proper interpretation of the issue, the Seventh Circuit reversed the Tax Court and held that “a plain reading of Section 6501(e)(1)(A) would include an inflation of basis as an omission of gross income in non-trade or business situations.” (In this case, the “non-trade or business situation” was the taxpayer’s participation in a listed transaction, unrelated to any business activity.)
The Seventh Circuit declined to follow the Supreme Court’s 50-plus year-old decision in Colony, Inc. v. Comm’r, 357 U.S. 28 (1958), reasoning that, because Colony interpreted the Internal Revenue Code of 1939, subsequent changes to section 6501 meant that Colony was not controlling authority. Having thus distinguished Colony and given itself the freedom to interpret section 6501 for its own purposes, the court turned to the text of the statute itself.
After the Colony decision, Congress amended section 6501(e)(1)(A), adding two new subsections. The first subsection provides that, in the case of a trade or business, “gross income” essentially means gross receipts before deducting any costs. The second subsection provides that the amount “omitted” from gross income does not include “any amount which is omitted from gross income stated in the return if such amount is disclosed in the return….”
Focusing its attention on subsection (ii) (because the transaction at issue did not involve a trade or business), the court concluded that “a plain reading of section 6501(e)(1)(A) would include an inflation of basis as an omission of gross income in non-trade or business situations.” The court reasoned that the subsection’s use of the phrase “gross income” required consideration of the Code’s general definition of “gross income.” Seen in that context, according to the court, “an improper inflation of basis is definitively a ‘leav[ing] out’ from ‘any income from whatever source derived’ of a quantitative ‘amount’ properly includible.”
The court’s reasoning, if not dubious doctrinally (given its complete disregard for the Supreme Court’s decision in Colony), certainly seems inconsistent with the logic of section 6501(e)(1)(A)(ii). As the Beard court stated, Congress’ intention in enacting the extended statute of limitations “was to give the IRS a fighting chance in situations where the taxpayer’s return doesn’t provide a clue to the omission.” Thus, the opinion quoted approvingly Phinney v. Chambers, 392 F.2d 680 (5th Cir. 1968), where the Fifth Circuit said that subsection (ii) is “intended to apply where there is either a complete omission of an item of income of the requisite amount or misstating of the nature of an item of income….” (emphasis in original).
Notwithstanding its acknowledgement of the intent underlying section 6501(e)(1)(A)(ii), the court’s subsequent analysis entirely at odds with that intent. An overstatement of basis may lead to an understatement of gross income because the taxpayer reports less gross income than he otherwise would have; however, that overstatement does not lead to “either a complete omission of an item of income… or misstating the nature of an item of income.”
To the contrary, even where the taxpayer’s basis is “inflated,” once the taxpayer reports that item on his return, he has neither omitted the item nor misstated its nature. As a result, it could not be said that the IRS does not have a “fighting chance” to discover the transaction. Thus, the court’s analysis seems contrary to the purpose of the statute.
Now it might be argued that, because the court relied on the “plain meaning” of the statute, resort to Congress’s intent is unnecessary. Nevertheless, if the language of 6501(e)(1)(A)(ii) were really as “plain” as the Seventh Circuit suggests, there must be some explanation for how Congress drafted a statute that was so wildly inconsistent with what multiple court’s have acknowledged to be its intent. Perhaps Congress simply did a poor job drafting the statute, which allowed the Seventh Circuit to reach a decision that applies more broadly than what was intended.
The alternative, and perhaps more persuasive, explanation is that the court was not prepared to let the taxpayers get away with what the court clearly considered to be an “abusive… tax shelter.” (Indeed, a number of commentators in today’s Tax Notes coverage of the case also suggested as much.) Thus, the court sought to read the language in a manner that would not allow the transaction to escape the reach of the IRS, even though it had to do some interpretive gyrations to get there.
The issues presented by Beard, together with the Supreme Court’s recent Mayo Foundation decision (giving Chevron deference to IRS regulations) and the temporary regulations issued under section 6501, raise a variety of other issues that are too involved to be addressed in a blawg post. Given the split among the circuits, it is unlikely that we have heard the last word on this issue.