Son-of-BOSS Statute of Limitations Issue Inundates the Courts of Appeals

The government has successfully challenged understatements of income attributable to stepped-up basis in so-called Son-of-BOSS tax shelters.  See, e.g., American Boat Co., LLC v. United States, 583 F.3d 471, 473 (7th Cir. 2009).  But it has been stymied in some cases by the three-year statute of limitations for issuing notices of deficiency.  Code section 6501(e)(1)(A) provides for a six-year statute “[i]f the taxpayer omits from gross income an amount” that exceeds the stated gross income by 25 percent.  Section 6229(c)(2) provides a similar six-year statute for cases governed by the TEFRA partnership rules.  The IRS has argued, unsuccessfully so far, that this section applies when there is a substantial understatement of income that is attributable not to a direct omission of income but rather to an overstatement of basis of sold assets.

The major obstacle to the government’s argument is that the Supreme Court long ago rejected essentially the same argument with respect to the predecessor of section 6501(e)(1)(A) (§ 275(c) of the 1939 Code).  The Colony, Inc. v. Commissioner, 357 U.S. 28, 32-33 (1958).  The IRS argued there that the six-year statute applies “where a cost item is overstated” and thus causes an understatement of gross income.  Id. at 32.  The Court agreed with the taxpayer, however, that the six-year statute “is limited to situations in which specific receipts or accruals of income items are left out of the computation of gross income.”  Id. at 33.  The Court added that, although this was the best reading, it did not find the statutory language “unambiguous.”  Id.  Accordingly, the Court noted that its interpretation derived additional support from the legislative history and that it was “in harmony with the unambiguous language of [the newly enacted] section 6501(e)(1)(A).”  Id. at 37.  Based largely on the precedent of Colony, the Tax Court and two courts of appeals have already rejected the government’s attempts to invoke the six-year statute of limitations in Son-of-BOSS cases.  See Salman Ranch Ltd. v. Commissioner, 573 F.3d 1362 (Fed. Cir. 2009); Bakersfield Energy Partners, LP v. Commissioner, 568 F.3d 767 (9th Cir. 2009), aff’g, 128 T.C. 207 (2007).

Seeking to rescue numerous other cases that were still pending in the courts or administratively, the government responded by issuing temporary regulations on September 24, 2009, that purported to provide a regulatory interpretation of the statutory language to which the courts would afford Chevron deference.  The temporary regulations provide that “an understated amount of gross income resulting from an overstatement of unrecovered cost or other basis constitutes an omission from gross income for purposes of [sections 6229(c)(2) and 6501(e)(1)(A)].”  Temp Regs. §§ 301.6229(c)(2) – 1T, 301.6501(e)-1T. 

The Tax Court was the first tribunal to consider the efficacy of this aggressive (one might say, desperate) effort to use the regulatory process to trump settled precedent, as the IRS moved the Tax Court to reconsider its adverse decision in Intermountain Ins. Service v. Commissioner, T.C. Memo. 2009-195, in the wake of the temporary regulations.  The reception was underwhelming.  The Tax Court denied the motion for reconsideration by a 13-0 vote, generating three different opinions.  The majority opinion, joined by seven judges, was the only one to base its ruling on rejecting the substance of the government’s argument that courts should defer to the regulations notwithstanding the Supreme Court’s Colony decision.  (Four judges stated simply that the new contention about the temporary regulations should not be entertained on a motion for reconsideration; two judges stated that the temporary regulations are procedurally invalid for failure to submit them for notice and comment.)

The government’s deference argument rests on Nat’l Cable and Telecommunications Ass’n v. Brand X Internet Servs., 545 U.S. 967, 982 (2005), which ruled 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 statute and thus leaves no room for agency discretion.”  (In a concurring opinion, Justice Stevens stated his view that this rule would not apply to a Supreme Court decision, since that would automatically render the statute unambiguous, but that remains an open question.).  The Tax Court majority ruled that the Supreme Court’s statement in Colony that the statute was ambiguous “was only a preliminary conclusion,” but “[a]fter thoroughly reviewing the legislative history, the Supreme Court concluded that Congress’ intent was clear and that the statutory provision was unambiguous.”  Accordingly, the majority concluded that Brand X did not apply, and “the temporary regulations are invalid and are not entitled to deferential treatment.”  (The two judges who found the regulations procedurally invalid questioned the majority’s reasoning and suggested that the Court should not have reached the substantive issue).

The Tax Court’s decision in Intermountain is just the first skirmish in what will be an extended battle over the temporary regulations.  The Justice Department has asserted that there are currently 35-50 cases pending in the federal courts that raise the same issue, with approximately $1 billion at stake.  Accordingly, the government is pursuing an appeal to the D.C. Circuit in Intermountain, and it is arguing for deference to the temporary regulations in other cases pending on appeal in other circuits, even where those regulations were not considered by the trial court.  The government seems determined to litigate the issue in every possible court of appeals, presumably hoping that it can win somewhere and then persuade the Supreme Court to grant certiorari and reconsider Colony.  The current map looks like this:

D.C. Circuit:  Briefing schedules have been issued in Intermountain, No. 10-1204, and in an appeal from another Tax Court case, UTAM Ltd. v. Commissioner, No. 10-1262.  The government’s opening brief is due in Intermountain on December 6, 2010, and in UTAM on January 6, 2011.  The panel assigned to both cases is Judges Sentelle, Tatel, and Randolph.

Federal Circuit:  Grapevine Imports, Ltd. v. United States, No. 2008-5090, is fully briefed and scheduled for oral argument on January 12, 2011.  The Federal Circuit has already rejected the government’s invocation of the six-year statute in Salman Ranch, but the government is arguing in Grapevine that the Federal Circuit should reverse its position in light of the temporary regulations, which were not previously before the court.

Fourth Circuit:  Home Concrete & Supply, LLC v. United States, No. 09-2353, is fully briefed and was argued on October 27, 2010, before Judges Wilkinson, Gregory, and Wynn.  In that case, the district court had ruled for the government, distinguishing Colony as limited to situations in which the taxpayer is in a trade or business engaged in the sale of goods or services.  That was the rationale of the Court of Federal Claims in the Salman Ranch case, but that decision was reversed by the Federal Circuit.

Fifth Circuit:  Burks v. United States, No. 09-11061 (consolidated with Commissioner v. MITA, No. 09-60827) is fully briefed and was argued on November 1, 2010, before Judges DeMoss, Benavides, and Elrod.  In its briefs on this issue in various courts, the government has often invoked the Fifth Circuit’s decision in Phinney v. Chambers, 392 F.2d 680 (1968), the only court of appeals decision that has applied the six-year statute in the absence of a complete omission of gross income.  In Phinney, the taxpayer on her return had mislabeled proceeds from payment of an installment note as proceeds from a sale of stock with basis equivalent to the proceeds, reporting no income from that sale.  The Fifth Circuit accepted the government’s contention that the six-year statute applied, finding that it applies not only in the Colony situation where there is “a complete omission of an item of income of the requisite amount,” but also where there is a “misstating of the nature of an item of income which places the Commissioner . . . at a special disadvantage in detecting errors.”  392 F.2d at 685.  The government has argued that Phinney essentially involved an overstatement of basis, and therefore strongly supports its position in the Son-of-BOSS cases.  Indeed, the district court in Burks ruled for the government based on Phinney.  The government therefore likely viewed the Fifth Circuit as the most favorable appellate forum for the current dispute. 

At oral argument, however, the panel appeared sympathetic to the taxpayer’s position that Phinney involved a situation where the taxpayer had taken steps akin to a direct omission that would make it difficult for the IRS to discover the potential tax liability.  Therefore, the taxpayer maintains, Phinney is fully consistent with the position that the six-year statute does not generally apply to overstatements of basis. 

In addition, the discussion of the temporary regulation at oral argument specifically addressed the debate over whether deference to Treasury regulations is governed by Chevron principles or by ­­the less deferential National Muffler Dealers standard.  As we have discussed elsewhere, the Supreme Court may resolve that question in the next few months in the Mayo Foundation case.

Seventh Circuit:  Beard v. Commissioner, No. 09-3741 is fully briefed and was argued on September 27, 2010, before Judges Rovner, Evans, and Williams.  Although the panel, particularly Judge Rovner, expressed skepticism about some of the IRS’s legal arguments, Judges Williams and Evans appeared troubled by the prospect of allowing the taxpayer to escape scrutiny on statute of limitations grounds.  Judge Williams suggested that the taxpayer still ought to have the relevant records and that there was no apparent reason why a misstatement should be treated different from an omission.  Judge Evans emphasized that the taxpayer’s position with respect to tax liability was very weak and suggested that Colony might be distinguishable because it involved a return that was much easier for the IRS to decipher than the complex return involved in Beard.  Thus, to some extent, the government seemed to have found a sympathetic ear in the Seventh Circuit, though that will not necessarily translate into a reversal of the Tax Court.

Ninth Circuit:  Reynolds Properties, L.P. v. Commissioner, No. 10-72406.  The court of appeals vacated the briefing schedule to allow the parties to participate in the court’s appellate mediation program.  The government, however, has indicated that the case is not suitable for mediation, and therefore a new briefing schedule is likely to be issued soon.  The Ninth Circuit has already ruled in Bakersfield that the six-year statute does not apply to overstatements of basis.  Presumably, the government will ask the court to reverse itself in light of the temporary regulations, which were not previously before the court.

Tenth Circuit:  Salman Ranch Ltd. v. United States, No. 09-9015, is fully briefed and was argued on September 22, 2010, before Judges Tacha, Seymour, and Lucero.  This case comes from the Tax Court, but involves the same partnership that prevailed in front of the Federal Circuit. 

Attached below as a sampling are the briefs filed in the Fourth and Seventh Circuit cases.

Home Concrete – Taxpayer’s opening brief

Home Concrete – United States response brief

Home Concrete – Taxpayer’s reply brief

Beard – United States opening brief

Beard – Taxpayer’s response brief

Beard – United States reply brief

Briefing Completed in Container

The government has filed its reply brief in Container, and the parties will now await an order assigning a date for oral argument.  The parties’ respective arguments were well delineated in the opening briefs, and the reply brief does not shed much additional light on the issue.  The government emphasizes that it has never argued that guarantee fees are interest; instead it argues that they are more analogous to interest than to a payment for services.  And, disputing the taxpayer’s argument, the government reiterates that this analogy is supported by the two most relevant cases, Bank of America and Centel.

The reply brief notes that Congress addressed this issue for future years in the Small Business Jobs Act of 2010.  (This legislation is briefly discussed in our first post on the Container case.)  Quoting the Blue Book, the reply brief asserts that the new legislation “‘effect[s] a legislative override’ of the Tax Court’s opinion in this case,” providing that a guarantee fee paid by a domestic corporation “is now expressly considered to be income from a United States source.”

We note that the practical implications of the new statute and the Container decision can differ from country to country depending on treaty provisions.  The November 8 edition of Tax Analysts’ Tax Notes Today reported on a speech given by Robert Driscoll, a technical adviser at the IRS Large Business and International Division.  It quoted Mr. Driscoll as saying that withholding and taxation of guarantee fees could depend on treaty provisions if the guarantor is a qualified resident of a treaty country.  Specifically, if the guarantee fee can be categorized as “other income” under the treaty, Mr. Driscoll is quoted as saying, the payment “from a U.S. [subsidiary] to its foreign parent guarantor would not be U.S.-source income and thus would not be subject to withholding.”  That statement is imprecise since “other income” provisions of treaties typically do not directly address sourcing.  What Mr. Driscoll appears to be indicating is the IRS’s view that the “other income” provisions of treaties could preclude the U.S. from taxing guarantee fee income, even if that income is technically characterized as U.S.-source income under the new law (or, presumably, under prior law if the government prevails in Container).  That would lead to the same tax result as a practical matter as a determination that the fees are not U.S.-source income. 

Container – Government’s reply brief

Petition for Certiorari Filed in Kawashima

As we expected, a petition for certiorari has been filed in Kawashima v. Holder, 615 F.3d 1043 (9th Cir. 2010).  To review, that case involves the question of whether pleas by Mr. and Mrs. Kawashima to section 7206 offenses of subscribing to false statements (and assisting same) as to their corporation’s 1991 tax return could be “aggravated felonies” under the immigration laws.  As noted in our initial blog post, the relevant section of 8 U.S.C. §1101(a)(43)(M), if read holistically, would seem to preclude that conclusion but a divided panel of the Ninth Circuit (after changing its mind a few times in the interim) ultimately held that section 7206 offenses do provide a basis for deportation.

In addition to pointing out the circuit split (the Third Circuit – in another divided panel – previously adopted the Kawashimas’ position), the petition cites myriad statutory construction cases for the premise that (M)(i), involving “fraud or deceit,” cannot encompass section 7206 when M(ii) specifically references only section 7201 (the crime of tax evasion).  We were disappointed to see that our favorite case on this subject (United Savings Association of Texas v. Timbers of Inwood Forest Associates, 484 U.S. 365 (1988)) wasn’t cited:

Statutory construction . . . is a holistic endeavor.  A provision that may seem ambiguous in isolation is often clarified by the remainder of the statutory scheme – because the same terminology is used elsewhere in a context that makes its meaning clear . . . or because only one of the permissible meanings produces a substantive effect that is compatible with the rest of the law.

Id. at 371.  Perhaps that gem will make it into a merits brief if certiorari is granted.

The petition also takes on the question of whether a section 7206 crime necessarily involves fraud, citing Considine v. United States, 683 F.2d 1285 (9th Cir. 1982) for the proposition that it doesn’t.  The petition also makes arguments based on rule of lenity as frequently applied in the immigration context.  See generally INS v. St. Cyr, 533 U.S. 289 (2001).

Finally, the petition presents a second question – an interesting procedural question of whether the Ninth Circuit acted outside of its authority under Federal Rule of Appellate Procedure 41 by amending its second opinion as to Mrs. Kawashima (which found she had not committed an aggravated felony on grounds that the loss amount has not been proven) after the date the mandate allegedly was required to issue as to her, because the petition for rehearing was filed only as to Mr. Kawashima.  This is a potential home-run argument for one of the petitioners, but the question lacks the broad applicability that would ordinarily interest the Supreme Court.  The Court is free under its rules to grant certiorari limited to one of the questions presented in the petition if it so chooses.  It will be interesting to see if it does so in this instance.

The government’s response is currently due on December 2, but the government routinely requests extensions of 30 days or more to respond to petitions for certiorari.  The Court can be expected to rule on the petition early in 2011.

Mayo Foundation Oral Argument Tilts Towards the Government and Raises Doubts About the Continuing Vitality of National Muffler Dealers

At oral argument on November 8, several Supreme Court Justices expressed skepticism regarding the claim that medical residents fall within the “student exemption” from FICA taxation.  Although it is always hazardous to predict the outcome of a case from the questions asked at oral argument, it is difficult to envision the taxpayer getting the five votes needed to overturn the court of appeals’ rejection of the exemption.

The Justices’ objections to the taxpayer’s position came from a variety of angles.  Justice Sotomayor focused on the essence of what a medical resident does, suggesting that a person working unsupervised for more than 40 hours per week, and for significant remuneration, is “really not a student.”  Justice Ginsburg focused more on Congress’s intent, suggesting that the exemption seemed directed at “the typical work/study program in a college.”  Chief Justice Roberts observed that the line between student and worker is a difficult one to draw and suggested that it was therefore appropriate to let the IRS draw the line in a categorical way and then defer to the IRS’s interpretation.  Justice Breyer took a different tack, arguing that the IRS’s position was a valid interpretation of a requirement that had been in the regulations for a long time – namely, that the employment has to be “incident” to the study.  Full-time employment, he suggested, would not be “incident” to the study because it is “so big in comparison to the study.”

Justice Alito seemed the most sympathetic to the taxpayer.  He rose to the taxpayer’s defense by offering an alternative reading of word “incident.”  Later, he challenged the government’s counsel to explain why medical residents should not be eligible for the exemption when law students who write briefs are eligible, arguing that the medical residents should be treated as students if their primary motivation is to complete a course of study rather than to earn money.  Justice Ginsburg and the Chief Justice also questioned government counsel, though not as sharply as they had questioned the taxpayer’s counsel.  Justices Scalia and Kennedy were uncharacteristically silent during the argument.  In accordance with his usual practice, Justice Thomas did not speak.  Justice Kagan is recused in the case because of her prior involvement when she was Solicitor General.

In our prior posts on this case (see here, here, and here), we discussed the possibility that this case could be a vehicle for the Supreme Court to address the correct standard for deference to Treasury regulations – that is, whether the more generic Chevron analysis has superseded the more specific, and in some respects less deferential, approach set forth in National Muffler Dealers Ass’n v. United States, 440 U.S. 472 (1979).  The Justices did not exhibit any independent interest in this issue, as their questions focused on the meaning of the statute, not on deference to the regulation.  At one point in his opening argument, taxpayer’s counsel noted that the new regulation was issued only after the government had repeatedly lost in court (a fact that would argue for less deference under the National Muffler Dealers approach), but that point did not elicit any reaction from the Justices.

Thus, the oral argument did not touch on the Chevron/National Muffler Dealers issue until the very end when taxpayer’s counsel affirmatively raised it during his few minutes of rebuttal time.  Counsel sought again to persuade the Court that the government’s position is suspect because it is a recent invention that seeks to overturn a series of adverse court decisions, and this time phrased the argument explicitly in terms of the standard for deferring to a regulation.  Taxpayer’s counsel argued that deference to the new Treasury Regulation is inappropriate under “[t]he National Muffler standards, which we understand still to be appropriate to evaluate deference given to an IRS regulation,” because the regulation “is not a contemporaneous regulation.”  Justice Sotomayor quickly objected, asserting that the Court has “said that agencies can clarify situations that have been litigated and positions that they have lost on.”  (She was referring here not to tax cases, but to decisions that apply the Chevron analysis.).  Shortly thereafter, Chief Justice Roberts zeroed in on the issue, asking:

Why are we talking about National Muffler?  I thought the whole point of Chevron was to get away from that kind of multifactor ad hoc balancing?

Taxpayer’s counsel tried to respond by arguing that the National Muffler Dealers factors were “sensible factors” that the Court should continue to apply in the case of a “regulation that pops up 65 years of the enactment of the statute, after the government has lost five cases.”  But the Chief Justice was dismissive, stating simply:  “If Chevron applies, those considerations are irrelevant, right?”

The outlook for the case therefore is that the Court will likely affirm the Eighth Circuit’s ruling that medical residents do not come within the student exemption from FICA.  Such a decision would not necessarily require a discussion of deference to Treasury regulations, but if there is such a discussion, the Court may well be ready to conduct the analysis explicitly in the Chevron framework and consign National Muffler Dealers to the dustbin of history.  As noted in our previous post, that would in some respects be an unfortunate outcome – giving too much deference to regulations that may well be unduly influenced by the IRS’s narrow interest in maximizing tax revenues rather than a neutral effort to implement the will of Congress.

Attached below are links to the taxpayer’s reply brief and to the transcript of the oral argument.  A decision is expected in the next few months.

Taxpayer Reply Brief in Mayo Foundation

Transcript of Oral Argument in Mayo Foundation

Oral Argument Scheduled in Sunoco

The Third Circuit has scheduled the oral argument in Sunoco for January 24, 2011.  The briefing was completed back in March, and the briefs can be found at the bottom of our previous post.