A Four-Letter Word Causes The IRS Trouble

By Buck Buchanan

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.

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3 Comments on “A Four-Letter Word Causes The IRS Trouble”

  1. Richard G. Jacobus Says:

    Mr. Buchanan:

    Let’s assume the Supreme Court’s Colony decision, under the later reasoning of the courts in Bakersfield, Salman Ranch, etc., forecloses the Service’s construction of section 6501(e)(1)(A).

    Assuming that reasoning is sound, as you appear to say, does it not follow that Culbertson continues to prescribe the test for the existence of a bona fide partnership for tax purposes, notwithstanding recent suggestions that section 704(e)(1) supplants Culbertson?

    What do you think?

  2. Buck Buchanan Says:

    First, thank you for taking time to read and comment on our tax blawg.

    Second, you raised an interesting question regarding 704(e)(1). The Revenue Act of 1951 is the birthplace of 704(e)(1). Congress enacted the Act to raise money to address the Korean conflict. I mention this because, nearly sixty years later, I thought it interesting that today’s headlines still concern the Korean conflict.

    Congress, directly addressing the uncertainty created by the Supreme Court in Culbertson, added to section 3797(a)(2) of the Internal Revenue Code of 1939 the following language: “A person shall be recognized as a partner for income tax purposes if he owns a capital interest in a partnership in which capital is a material income-producing factor, whether or not such interest was derived by purchase or gift from any other person.” Of course, today that sentence can be found (slightly altered) in section 704(e)(1): “A person shall be recognized as a partner for purposes of this subtitle if he owns a capital interest in a partnership in which capital is a material income-producing factor, whether or not such interest was derived by purchase or gift from any other person.” Congress made motive irrelevant: “If the ownership is real, it does not matter what motivated the transfer to him or whether the business benefited from the entrance of the new partner.” H.R. Rep. No. 82-586, at 32 (1951).

    My guess is that you agree with Senator Humbert Humphrey who protested Congress’ reaction to Culbertson by stating:

    “This is nothing more nor less than a shameful act of permitting tax avoidance. I submit that the record bears me out. What did the courts hold? The courts set up the test of good faith, and acting with a business purpose in the conduct of an enterprise, in order for a family partnership to be given tax recognition. What does the Senate provision set up, and what does the House provision set up? They replace the good faith and business purpose tests with the mere test that a gift of a capital share is a real gift, and that ownership by the recipient is actual ownership.” 97 Cong. Rec. 12,146 (1951).

    Congress has sole authority to enact legislation. The executive branch is responsible for implementing and enforcing the laws. The federal courts enjoy the sole power to interpret the law. In Colony et al., unlike Culbertson, we do not have a Congressional counter-reaction to a Supreme Court decision. Instead, it appears that the executive branch has stepped upon both the legislative branch’s and judicial branch’s toes.


  3. [...] that have addressed the issue (including the Fourth, Ninth, and Federal Circuits, as well as the Tax Court) by holding that an overstatement of basis does not trigger the extended statute.  At this point, [...]


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