Originally published on Passive Activities and Other Oxymorons on April 27th, 2011.
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HOME CONCRETE AND SUPPLY, LLC v. U.S. 107 AFTR 2d 2011-767
BEARD v. COMM. 107 AFTR 2d 2011-552
GRAPEVINE IMPORTS, LTD v. U.S., Cite as 107 AFTR 2d 2011-1288
Back in October I wrote about Fidelity International Currency, the epic story of EMC founder Richard Egan’s doomed tax shelters. One of the things that I highlighted in the case was attorney Stephanie Denby’s meticulous documentation of the thought process that went into the transactions:
Denby also rated and commented with respect to the manner in which the tax loss was generated, noting a plus if the transaction was “harder for IRS to find” and a minus if the transaction was “easier” for the IRS to find.
Denby also rated and commented with respect to their complexity, noting a plus if the complexity of the structure made it harder for the IRS to “unwind” or “pick-up” and a minus if the simplicity of the structure made it easier for the IRS to trace.
One of her comments concerned basis:
Secondly, some of the transactions focus on generating basis as opposed to capital loss. Basis is more discrete and less likely I believe to cross the IRS radar screen.
It reminded me of an apocryphal story about an accountant who advised his clients “Put in puchases. They never look there.”, whenever he encountered a disbursement of dubious deductibility.
One of the commnents on that post was:
Jeff said…
ignoring the effectiveness of the reg, this case certainly shows the need for reg §301.6501(e)-1T(a)(1)(iii).
What’s that about besides proving that Jeff is even more of a tax geek than I am ? Here’s the deal. The statute of limitations is three years on tax returns. That means that if you filed timely you can relax about 2007. Of course there are exceptions. There are always exceptions, except when there aren’t any, which would be an exception. The relevant one here is that if you omitted more than 25% of your gross income, the statute of limitations is 6 years. What the regualtion did for all returns that were still open in September of 2009 was “clarify” that an overstatement of basis was an ommission from gross income.
Home Concrete was a fairly typical “get some basis with a one sided entry” type of deal:
On May 13, 1999, each of the taxpayers initiated short sales 1 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.
They weren’t at all ashamed of what they did:
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.”
Eventually the IRS caught on:
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.
Absent the six year statute, they were too late. They tried to argue that since the case hadn’t been decided by September of 2009, the new regulation should apply, but the Court wasn’t buying it:
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.
The Beard decision was a similar deal. The Court gave a nice summary of the concept:
Short selling is often a way to hedge against the market, but a Son-of-BOSS transaction relies on the delayed tax recognition of a short sale for a gamble of a different kind. In Son-of-BOSS, the taxpayer contributes the proceeds of the short and the corresponding obligation to close out the short to another legal entity in which he has ownership rights (usually a partnership). The taxpayer (or, perhaps more accurately, the tax-avoider) then sells his rights in the partnership, claiming an inflated outside basis in the partnership corresponding to the amount of the transferred proceeds without an offsetting basis reduction for the transferred liability. This is advantageous for the taxpayer because the capital gains tax on such a transaction is calculated by subtracting the outside basis from the amount recognized in the sale of the ownership rights, so a higher outside basis means lower capital gains tax and more money in the pocket of the taxpayer. Therefore, the gamble in the Son-of-BOSS transactions was that the participant could legally increase his outside basis in a partnership by not reporting the offsetting transferred contingent liability of the short position on his tax return.
The timing in Beard was similar. It was a 1999 return that the IRS did not catch up with until 2006. The Court in Beard (Seventh Circuit as opposed to Fourth Circuit in Home Concrete) concluded that in a non-business transaction the six year statute applies:
Using these definitions and applying standard rules of statutory construction to give equal weight to each term and avoid rendering parts of the language superfluous, we find 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. See Regions Hospital v. Shalala, 522 U.S. 448, 467 (1997); Hawkins v. United States, 469 F.3d 993, 1000 (Fed. Cir. 2006). It seems to us that an improper inflation of basis is definitively a “leav out” from “any income from whatever source derived” of a quantitative “amount” properly includible. There is an amount—the difference between the inflated and actual basis—which has been left unmentioned on the face of the tax return as a candidate for inclusion in gross income.
They get there without even considering the IRS regulation. Had they needed it, though, they would have used it:
Much ink has been spilled in the briefs over whether temporary Treasury Regulation Section 301.6501(e)-1T(a)(1)(iii) would be entitled to Chevron deference if Colony were found to be controlling. This temporary regulation, which was issued without notice and comment at the same time as an identical proposed regulation, purports to offer taxpayers guidance by resolving an open question and stating definitively that in the case of a disposition of property, an overstatement of basis can lead to an omission from gross income. This temporary regulation has since been replaced by a nearly identical final regulation, issued after a notice and comment period. T.D. 9511 (eff. Dec. 14, 2010), 75 Fed. Reg. 78,897. Because we find that Colony is not controlling, we need not reach this issue. However, we would have been inclined to grant the temporary regulation Chevron deference, just as we would be inclined to grant such deference to T.D. 9511.
Grapevine Imports was close to an identical fact pattern to Home Concrete even to the extent of partiotically using contracts on US Treasuries to create phony basis. In Grapevine, the Federal Circuit reviewing a Court of Claims decisions says that the new regulations make all the difference:
The new Treasury regulations cannot, of course, change the Tax Code. But they may reflect the Treasury Department’s exercise of authority granted by Congress to interpret an ambiguity in that code. Where an executive department, entrusted with interpretive authority, promulgates statutory interpretations that are reasonable within the circumstances established by Congress, then the courts must defer to that interpretation. Chevron, U.S.A., Inc. v. Natural Res. Def. Council, Inc., 467 U.S. 837, 843–44 (1984).
When the Court of Federal Claims entered judgment for Grapevine, the Treasury Department had not yet exercised its interpretive authority over the limitations periods at issue in this case. It now has, and we, like the Court of Federal Claims, are obliged to defer to that interpretation. We therefore reverse the entry of judgment for Grapevine and remand for further proceedings.
Frankly this stuff is all a little too lawerly for me being a simple minded CPA, who loves debits to equal credits. I would like to extract a practical lesson from it. There are probably some people who did Son of Boss deals or similar offenses against the fundamentals of double entry in 2005 or maybe even 2004 who thought they were home free and now have to start sweating again, while they vigorously root for the Fouth Circuit. The lesson is this. If you are thinking about a transaction or return filing positions and find yourself getting into a discussion of whether a three year statute or a six year statute would apply, just don’t do it.
P.S.
I did a follow-up on this as the Tax Court just issued another ruling on this issue.