Editors: Mindy Tyson Cozewith, CPA, M. Tax., and Sean Fox, MPA
Procedure & Administration
Can the IRS issue regulations with retroactive effect? That is the central administrative issue in a case pending before the U.S. Supreme Court.
In January, the Supreme Court heard oral arguments in Home Concrete & Supply, LLC, 599 F. Supp. 2d 678 (E.D.N.C. 2008), rev’d, 634 F.3d 249 (4th Cir. 2011), cert. granted, S. Ct. Dkt. 11-139 (9/27/11). The immediate issue in the case is whether the statute of limitation on assessments, a three-year period in most instances, is extended to six years due to a substantial omission of income caused by an overstatement of basis. A second, and potentially more important, issue is the amount of deference courts are required to give to Treasury regulations.
Home Concrete involved an overstatement in basis of a partnership interest, which in turn generated a tax loss upon disposition of assets. The transaction giving rise to the tax loss occurred in 1999 and was reported on the 1999 partnership return filed in 2000. In 2004, the IRS received information that the Home Concrete partnership had engaged in what the IRS considered a tax shelter. The IRS audited the partnership under the unified audit procedures applicable to partnerships under the Tax Equity and Fiscal Responsibility Act of 1982, P.L. 97-248, and issued a final partnership administrative adjustment disallowing the tax loss.
In most instances, the IRS has three years from the time a tax return is filed to assess an additional tax deficiency under Sec. 6501. Home Concrete filed its partnership tax return in April 2000, and, under normal circumstances, the IRS would have had until April 2003 to assess any additional tax through the tax matters partner under the unified audit procedures and, in turn, to the partners of Home Concrete. In this case, however, the IRS did not propose an assessment of tax until September 2006, more than three years after the normal statute of limitation on assessments had expired (but within six years of filing because the statute was tolled nearly a year for compliance with an IRS summons).
Under Sec. 6501(e), the IRS has six years to make a tax assessment if the taxpayer omits from gross income an amount in excess of 25% of the gross income stated on the return. The IRS took the position that, because the partnership had overstated basis in the partners’ interests, there was a greater than 25% omission of gross income from the partnership’s return. The IRS won in district court, but the Fourth Circuit reversed that decision in the taxpayers’ favor.
Several court cases interpreting Sec. 6501(e) support the taxpayers’ position—that a substantial omission from gross income does not include one caused by a basis overstatement. There has been extensive litigation on the issue of whether an understatement of income caused by an overstatement of basis constitutes a “substantial omission from gross income,” with most cases involving a listed transaction under Regs. Sec. 1.6011-4. After losing several cases in court, the IRS issued temporary and proposed regulations to bolster its litigating position. Issued in 2009, Temp. Regs. Sec. 301.6501(e)-1T(b) sought to clarify that the definition of “omits from gross income” includes an overstatement of basis. Treasury finalized the regulations in 2010 (T.D. 9511). The regulations were clearly designed to stem the IRS’s litigation losses and to tacitly overrule the Supreme Court’s decision in Colony Inc., 357 U.S. 28 (1958). The regulations also had a retroactive effect—the IRS would never have been able to litigate the Home Concrete case absent a change in the regulations.
One year ago, the Supreme Court decided Mayo Foundation for Medical Education and Research, 131 S. Ct. 704 (2011). In Mayo, the Supreme Court addressed how much weight federal courts should give to a federal tax regulation. The issue raises a complex constitutional and administrative law problem. Congress has the authority to write and enact federal tax legislation under Article I of the Constitution. Under Article II, the executive branch, through the Treasury Department, enforces the laws passed by Congress and is called upon to interpret those laws through regulations, revenue rulings, and other administrative announcements. The judiciary, under Article III, determines the validity of the law and whether the executive branch’s interpretation of a statute is in accord with the legislation passed by Congress.
Mayo involved a Federal Insurance Contributions Act (FICA) tax issue, but in its opinion, the Supreme Court also addressed the administrative law issue concerning the application of Treasury regulations. The Court ruled unanimously that, if Treasury properly issues regulations to clarify an ambiguous Code section and the regulations are a “reasonable interpretation” of the statute, the regulations are valid and not subject to challenge. Under the Mayo rationale, Treasury can issue a regulation that effectively overrules established case law, and the regulation will be valid so long as the regulation is a reasonable interpretation of the statute.
An agency issuing a regulation must meet the procedural requirements spelled out by Congress in the Administrative Procedures Act (APA), P.L. 79-404, for the regulation to be considered valid. Generally, regulations are issued in notice-and-comment format—the agency issues a proposed regulation and solicits comments. After considering comments, an agency may modify the proposed regulation and issue it as a final regulation. Courts will consider the regulation valid as long as it is within the agency’s power to issue, is a reasonable interpretation of the law, and does not conflict with a congressionally approved statute.
At issue in Home Concrete is whether Temp. Regs. Sec. 301.6501(e)-1T(b) was issued in accordance with the APA and is therefore valid. When promulgated, the regulation was issued as both a proposed and a temporary regulation. Comments on the proposed regulation were requested, but the commentators’ suggestions were not adopted, and the final regulation ended up identical to the proposed regulation. The IRS clearly promulgated the regulation to overturn established case law and to stem the tide of unfavorable court decisions. There is a question of fairness when the IRS can suddenly change the litigation playing field by issuing a regulation to bolster its position in court. Under the constitutional separation of powers, is a court required to defer to Treasury, or can the court reach its own conclusion?
Several interested parties, including the American College of Tax Counsel, have filed friend-of-the-court briefs. The College argues in its brief that retroactive, or “fighting,” regulations are not entitled to judicial deference, as they operate to revive a tax controversy that otherwise is barred under the statute of limitation in effect at the time the tax return was filed.
Resolution of the administrative issues in Home Concrete may have far-reaching effects. For example, a taxpayer may have relied on judicial or congressional authorities to take a return position due to a lack of guidance by Treasury. Can the taxpayer’s position suddenly be rendered uncertain when the IRS issues contrary and retroactive regulations?
A decision in Home Concrete is not expected until later this year. Whatever the Supreme Court decides will have a significant effect on how Treasury and the IRS issue regulations and guidance to taxpayers and whether such guidance is binding.
Mindy Tyson Cozewith is a director, Washington National Tax in Atlanta, and Sean Fox is a director, Washington National Tax in Washington, DC, for McGladrey & Pullen LLP.
For additional information about these items, contact Ms. Cozewith at (404) 751-9089 or email@example.com.
Unless otherwise noted, contributors are members of or associated with McGladrey & Pullen LLP.