In prior Client Alerts,1 the Latham & Watkins Tax Department detailed decisions by the Tax Court and the appellate courts regarding the IRS’s litigating position that an overstatement of basis is an “omission from gross income” that triggers the extended six-year limitations period under IRC Sections 6229(c)(2) and 6501(e)(1)(A) for assessing tax. In the first round of cases, the Tax Court and the Ninth and Federal Circuits Courts of Appeal rejected the IRS’s claim and held that the Supreme Court’s 1958 Colony2 opinion, which involved a predecessor statute, was controlling. In response to those losses, the IRS issued retroactive regulations seeking to overrule the Supreme Court’s interpretation of the same operative language and the decisions that followed it. Armed with these “fighting regulations,” the IRS had success in some appellate courts, leading to a circuit split on the issue. In September 2011, the Supreme Court granted certiorari in the Home Concrete case,3 which had been decided in the taxpayer’s favor by the Fourth Circuit.

Members of Latham & Watkins’ Tax Controversy and Supreme Court and Appellate practices represented the taxpayers before the Supreme Court in Home Concrete. In a sharply-divided 5-4 opinion written by Justice Breyer,4 the Court rejected the IRS’s position and held that its interpretation of the same operative language in Colony was controlling. It further held that, because its interpretation was controlling, the IRS’s contrary construction of IRC Section 6501(e)(1)(A) in its regulations was invalid. The Supreme Court’s holding is a significant victory for taxpayers; however, it left unanswered issues regarding the ability of the IRS and other agencies to use their regulatory powers to overrule case law.

Reaffirmation of Stare Decisis

The first issue in Home Concrete was whether the Supreme Court’s 1958 Colony opinion, which addressed the same operative language in former-IRC Section 275(c), governed for purposes of interpreting IRC Section 6501(e)(1)(A). The Court conclusively answered in the affirmative:

In our view, Colony determines the outcome of this case. The provision before us is a 1954 reenactment of the 1939 provision that Colony interpreted. The operative language is identical. It would be difficult, perhaps impossible, to give the same language here a different interpretation without effectively overruling Colony, a course of action that basic principles of stare decisis wisely counsel us not to take.5

The Court’s rationale continues its trend of reaffirming the strength of the doctrine of stare decisis in the post-Brand X era.6 In Brand X, the Supreme Court broadly stated that a “court’s prior judicial construction of a statute trumps an agency construction otherwise entitled to Chevron deference only if the prior court decision holds that its construction follows from the unambiguous terms of the statutes.”7 Some lower courts and legal commentators viewed Brand X as weakening the doctrine of stare decisis by allowing an agency to adopt a statutory interpretation contrary to an existing decision so long as that decision did not use the words “ambiguous” or “unambiguous.” This “magic words” requirement was rejected by Home Concrete, and if a court (especially the Supreme Court) has previously interpreted a statute, an agency’s contrary construction should face heightened scrutiny.

The Court rejected the government’s argument that Congress’s addition of IRC Section 6501(e)(1)(A)(i) (“Subparagraph (i)”) — which clarified the proper computation rules that apply in the context of sales or goods or services by certain businesses — in 1954 required a different interpretation of the operative language carried over nearly verbatim from former-IRC Section 275(c), finding “these points are too fragile to bear the significant argumentative weight the Government seeks to place upon them.”8 The Court further rejected the government’s argument that Subparagraph (i) would be rendered superfluous by applying Colony. It also observed that it had already rejected in Colony the same textual arguments advanced by the government in Home Concrete regarding any distinction between the use of “item” and “amount” in IRC Section 6501(e). The Court pointedly noted that “to rely in the case before us on this solitary word change in a different subsection is like hoping that a new batboy will change the outcome of the World Series.”9

Restrictions on Agency Interpretations Designed to Overturn Judicial Precedent

The government argued that Brand X allowed the IRS to disregard Colony because that opinion did not state that its holding followed from the unambiguous terms of the statute. The majority in Home Concrete was plainly troubled by the government’s position. As noted above, the Supreme Court rejected any “magic words” requirement in testing whether a prior judicial interpretation forecloses a contrary agency construction of a statute. In its view, “Colony has already interpreted the statute, and there is no longer any different construction that is consistent with Colony and available for adoption by the agency.”10

The Plurality — Brand X Limited?

In the last section of the Court’s opinion, four Justices (the plurality) faulted the government for relying blindly on Brand X while overlooking the reason why it had held that a prior judicial construction might not trump a subsequent agency construction. The plurality went to great lengths to ascertain Congress’ intent in enacting the predecessor statute and whether Congress had intended any change in enacting the current statute. Acknowledging that Colony found the same operative language “not unambiguous,” the plurality observed that the Colony Court had employed traditional tools of statutory construction and had determined that Congress did not intend for the longer limitations period to apply in the case of an overstatement of basis. The plurality concluded that Colony made clear that Congress did not leave a gap for the IRS to fill on this point and that the regulations therefore do not merit deference.

Justice Scalia’s Concurrence — Get Rid of Brand X

In a strongly-worded concurring opinion, Justice Scalia declined to join the last section of the opinion. He chided the plurality for “revising yet again the meaning of Chevron11 and thereby avoiding taking Brand X head-on. His continuing view, which was thoroughly detailed in his dissent in Brand X, is that “the Court should abandon … Brand X.”12 His view therefore remains that “‘[o]nce a court has decided upon it de novo construction of the statute, there no longer is a different construction that is consistent with the court’s holding and available for adoption by the agency.’”13

The Dissent — Colony is Obsolete

The dissent, written by Justice Kennedy,14 echoed the government’s argument that the differences between former IRC Section 275(c) and IRC Section 6501(e)(1)(A) were significant and that Colony reserved judgment on the interpretation of the latter because that version of the statute was not before it. The dissent would have upheld the regulations as a permissible interpretation of the statute that did not change the law and, therefore, were not impermissibly retroactive.

Future Impact of Home Concrete

Home Concrete conclusively answered the question of whether an overstatement of basis that results in an understatement of income is an “omission from gross income” for purposes of the six-year statute of limitations.15 Although the government presented the issue as one relating to “tax shelters” and “listed transactions,” the opinion’s reach is not so limited. Rather, it affects all taxpayers and all transactions in which basis is a factor, from an individual’s sale of a rental property to partnership transfers, redemptions or contributions involving an IRC Section 754 election that results in a step-up in basis under IRC Sections 734 or 743.

Home Concrete also shows that courts should not blindly follow guidance issued by the IRS (or any agency) that conflicts with prior judicial precedent and that the Court’s recent tax decision in Mayo16 did not grant unbridled regulatory power to the IRS. Further, as discussed above, the opinion underscores the continuing importance of stare decisis in interpreting statutes.

However, given the sharp divide among the Justices and the failure of a majority to provide further clarification on the application of Brand X or to address several arguments briefed by the parties, a number of issues remain. For example, the Court did not address the issues raised under the Administrative Procedures Act (APA) with respect to the manner in which the IRS promulgated the regulations. The APA is being implicated in more and more tax cases, as demonstrated by some of the lower court decisions in the basis overstatement saga,17 by Mayo and by recent opinions involving the telephone excise tax. Nor did the opinion address several other administrative issues, including the proper deference due to fighting regulations, the definition of retroactivity, when retroactivity is permissible, and whether Congress’ 1996 amendments to IRC Section 7805(b) were intended to preclude retroactivity for all regulations enacted after 1996 or just those that relate to new statutory provisions enacted after 1996. Given the lack of guidance on these issues, it remains to be seen whether Home Concrete will change the way agencies approach the rulemaking processes.