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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.