Jan. 26, 2011 – Federal circuits disagree on whether an overstatement of basis on a federal tax return constitutes an omission from gross income. Recently, a U.S. Court of Appeals for the Seventh Circuit panel ruled that overstating basis is indeed an omission, giving the Internal Revenue Service six years to come knocking on the overstating taxpayer’s door.
Internal Revenue Code section 6501(e) deals with substantial omissions from gross income and gives the IRS a six-year statute of limitations period to proceed against the taxpayer if an omission exceeds 25 percent of that which is actually reported.
Almost six years after Kenneth and Susan Beard filed their 1999 federal tax return, the IRS hit them with a notice of deficiency for overstating basis in corporate stock ownership interests they sold after transferring short sale proceeds to the corporation.
The IRS has deemed these types of transactions – variants on son-of-BOSS (Bond and Option Sales Strategy) transactions – abusive tax shelters.
However, the U.S. Tax Court granted summary judgment to the Beards, ruling that the IRS’s notice of deficiency was subject to the standard three-year limitations period, and the IRS missed it. On appeal, the Seventh Circuit Court of Appeals panel reversed.
In Beard v. Commissioner of Internal Revenue, No. 09-3741 (Jan. 26, 2011), a three-judge panel – in an opinion written by Judge Terence Evans – ruled that an inflation of basis, in this case, is considered an omission from gross income that triggers the six-year limitations period.
The transaction
Kenneth Beard engaged in a short sale of U.S. Treasury Notes for about $12.2 million. Short sellers borrow securities and sell them hoping value drops after the sale, because short sellers are operating with borrowed securities, the value of which must be repaid eventually.
Beard did not extinguish the liability after sale (close the short position), but used the proceeds to purchase more notes in two transactions, one for $5.7 million and the other for $6.46 million. Then Beard transferred the notes to two companies in which he was majority owner.
The same day, the companies sold the notes for $7.5 and $8.5 million, respectively, and closed out the short positions. Beard then sold his ownership interests in both companies.
On their 1999 tax return, the Beards reported capital gains of $413,588 and $992,748 from the stock sales. The Beards had subtracted basis of $6.16 million from the stock sale price of $6.57 million of one company and subtracted $6.64 million basis from the stock sale price of $7.63 million in the other. The Beards also reported a loss on the initial note sale for $12.2 million.
According to the panel, “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.” In addition, the Beards’ tax return did not indicate that the corporations assumed the liability to cover the short positions.
The argument
In a 1958 case interpreting the predecessor to section 6501(e) – Colony, Inc. v. Commissioner of Internal Revenue, 357 U.S. 28 (1958) – the U.S. Supreme Court found that an overstatement of basis was not an omission from gross income that triggers the six-year limitations period.
The rationale is that basis overstatements give the IRS a clue as to the existence of an omitted item, and thus an extended limitations period is unwarranted.
The Beards argued, and the U.S. Tax Court agreed, that even if the Beards overstated basis, Colony controlled to bar the IRS from challenging the Beards’ tax return under the standard three-year statute of limitations.
The Seventh Circuit Appeals panel noted that the Fourth and Fifth circuits have ruled that an overstatement of basis can be an omission from gross income despite Colony, but the Ninth Circuit has ruled that Colony controls so that a basis overstatement is not an omission.
“Although it is clearly a contentious issue and a close call,” Judge Evans wrote, “Colony does not control here and an overstatement of basis can be treated as an omission from gross income under the 1954 Code.”
The court noted that the Colony court interpreted the 1939 tax code, and tax code revisions in 1954 added subsections that are relevant in this case to distinguish Colony. Thus, the panel reversed the decision of the U.S. Tax Court.
The circuit split makes the case ripe for U.S. Supreme Court review.
