The Seventh Circuit has just overruled the Tax Court on whether an erroneous overstatement of basis constituted an "omission of gross income" for purposes of §6501(e)(1)(A) thereby resulting in a six year statute of limitations instead of the general or standard three year statute where the resulting omission reaches the 25% threshold.
The case involved the taxpayer’s investment in a Son-of-BOSS (bond and option sales strategy) type transaction which the government labeled as abusive. In a Son-of-BOSS transaction, an individual uses a short sale to artificially increase his basis in a partnership interest or stock in an S corporation prior to selling the interest, thereby materially reducing his capital gains tax on the sale. A short sale is a "sale in which an investor sells borrowed securities in anticipation of a price decline and is required to return an equal number of shares at some point in the future." The short sale produces proceeds from the sale of the shares as well as an outstanding liability in the amount of the number of borrowed shares multiplied by the current price per share. This liability disappears when the short is closed out, and the hope of the usual short seller is that between the time he borrows the shares and the time he closes out the short, the price per share will have dropped so that he makes more selling the borrowed shares up front than he spends later to replace them. The tax gain or loss recognition in a short sale is delayed until the seller closes the sale by replacing the borrowed property. A Son-of-BOSS transaction strategy is designed to produce a substantial capital loss which can be used to reduce the taxpayer’s long term capital gains from other sources, such as gain from the sale of a business.
In Notice 2000-444, the Service announced it would challenge Son-of-Boss type transactions. This later resulted in favorable court decisions for the Service on the finding that Son-of-Boss basis plays lacked economic substance. In 2004, the IRS offered a settlement initiative to approximately 1,200 identified taxpayers, but that left a large number of taxpayers who did not qualify or who had not yet been identified as taking part in a Son-of-BOSS transaction.
Here, in 1999, the taxpayer participated in a short sale of U.S. Treasury Notes, recognizing cash proceeds of $12,160,000. Beard then purchased more Treasury Notes in two transactions for $5,700,000 and $6,460,000. He then transferred these Treasury Notes to two Subchapter S companies in which he was majority owner, MMCD, Inc. and MMSD, Inc., respectively, along with the obligation to close out the short positions. On that same day, MMCD and MMSD sold these Treasury Notes and closed out the short positions for $7,500,000 and $8,500,000, respectively. Beard then sold his ownership interests in the two companies.
On their 1999 tax return, the Beards reported long-term capital gains of $413,588 and $992,748 from the sale of the MMCD and MMSD stock, respectively. They arrived at these numbers by subtracting bases of $6,161,351 and $6,645,463 from the sale prices of $6,574,939 and $7,638,211. The Beards also reported gross proceeds from the sale of Treasury Notes of $12,125,340, a cost basis of $12,160,000, and a resulting net loss of $34,660. The high bases in MMCD's and MMSD's stock resulted from the asymmetric treatment of the short sale transactions—Beard had increased his outside bases in the companies by the amount of the short sale proceeds contributed to each company, but had not reduced the bases by the offsetting obligation to close the short positions taken into account by the corporations. The 1999 tax returns of MMCD and MMSD did not indicate that these S corporations had assumed the liability to cover the short positions.
In 2006, the Service issued a notice of deficiency, reducing the Beards' bases in the MMCD and MMSD stock by the amount of the transferred Treasury Notes, and increased the Beards' taxable capital gains by $12,160,000.
The Beards contested this deficiency in the Tax Court, and, rather than disputing the facts, moved for summary judgment on the legal ground defense that the statute of limitations had run, and in particular, that an overstatement of basis is not an omission from gross income for the purpose of the extended six-year statute limitations per §6501(e). See Colony Inc. v. Comm’r, 357 U.S. 28 (1958). The Tax Court granted summary judgment in favor of the taxpayers and the Service appealed.
In reviewing the applicable precedent and legislative history, and the lower court’s reliance on the Colony Inc., supra, decision, the Seventh Circuit noted that the question has been addressed by multiple federal courts, with differing results. Some have found that Colony does not apply and an overstatement of basis can be an omission from gross income. See, e.g., Phinney v. Chambers, 392 F.2d 680 (5th Cir. 1968); Home Concrete & Supply, LLC v. United States, 599 F. Supp. 2d 678 (E.D. N.C. 2008), appeal docketed, No. 09-2353 (4th Cir. Dec. 9, 2009); Burks v. U.S., 2009 WL 2600358 (N.D. Tex. June 13, 2008), appeal docketed, No. 09-11061 (5th Cir. Oct. 26, 2009); Brandon Ridge Partners v. U.S., 100 A.F.T.R. 2d 2007-5347, 2007 (M.D. Fla. Jul. 30, 2007). Others have found that Colony, supra, does apply and an overstatement of basis is not an omission of gross income. See, e.g., Salman Ranch Ltd. v. U.S., 573 F.3d 1362 (Fed. Cir. 2009);Bakersfield Energy Partners LP v. Comm’r, 568 F.3d 767 (9th Cir. 2009);Grapevine Imports, Ltd. v. U.S.,77 Fed. Cl. 505 (2007), appeal docketed, No. 2008-5090 (Fed. Cir. June 27, 2008).
The Seventh Circuit reversed and despite acknowledging that the issue is a "close call" it held that the plain meaning of the Code and a close reading of Colony case supports the conclusion that Colony does not control the proper interpretation of (revised) §6501(e)(1)(A) and that an overstatement of basis can be treated as an omission from gross income under the 1954 Code. In support it cited Regions Hospital v. Shalala, 522 U.S. 448, 467 (1997); Hawkins v. U.S., 469 F.3d 993, 1000 (Fed. Cir. 2006).
The Court further alluded to Temp.Reg. §301.6501(e)-1T(a)(1)(iii) which takes the position that an overstatement in basis can lead to an omission from gross income. This regulation has now been finalized. While the Seventh Circuit decided the case without taking the regulation into account, i.e., it found that Colony, supra, was not applicable, it strongly hinted that it would have been inclined to grant the temporary regulation Chevron deference had it needed to resolve the case on this alternative theory.