Generally, the IRS must assess a deficiency against a taxpayer within three years after the filing of an income tax return or the return’s due date if filed early.1 However, Sec. 6501(e)(1)(A) extends the statute to six years when the taxpayer “omits from gross income an amount properly includible therein” that is “in excess of 25 percent of the amount of gross income stated in the return.”
Last April, the Supreme Court in Home Concrete & Supply, LLC,2 resolved a split among the circuit courts of appeal as to whether the six-year statute applies when the taxpayer overstates basis in property sold, thereby understating gain and gross income by more than 25%. While the Court’s ruling that the six-year statute does not apply clarifies the statute, of greater significance is its finding that prior court decisions will prevail under certain circumstances over the general judicial doctrine of deference to Treasury regulations. Thus, where a court, or at least the Supreme Court, has ruled on a specific controversy interpreting the Code, leaving no ambiguity in the meaning of the statute, that ruling may not be reversed by subsequent regulations, despite the general judicial principle that courts should defer to regulations when interpreting a statute.
This article reviews the Supreme Court opinions and IRS regulations that gave rise to Home Concrete and analyzes how a deeply divided Supreme Court resolved the issue. It concludes with a discussion of how taxpayers and their advisers should weigh conflicting court cases and IRS pronouncements in light of the Home Concrete decision.
Background of Home Concrete
The transaction from which Home Concrete arose was the infamous son-of-boss tax shelter in which the IRS alleged a partner had overstated his partnership basis in connection with the sale of his interest.3 The facts of Home Concrete are identical to those of cases in several other circuits, some of which held that an overstatement of basis triggered the six-year statute,4 while others, including the Fourth Circuit’s Home Concrete decision, sided with the taxpayer.5
The split among the circuits arose because of the conflict between the Supreme Court’s 1958 ruling in Colony,6 which held the six-year statute did not apply to understatements of income caused by overstatements of basis, and a 2010 regulation, which was finalized while the issue was being litigated, holding that an understatement of basis does trigger the six-year statute.7 In Colony, the Supreme Court interpreted a provision of the Internal Revenue Code of 1939, the operative language of which is identical to that of the current statute, finding the phrase “omits from gross income” did not include an overstatement of basis. Therefore, the extended six-year statute did not apply. Simply stated, Colony found that the extended statute applied only to cases where income is left off the return, not where something on the return is misstated. The Colony court also noted that, while the statute was not “unambiguous,” it could, after examining the law’s legislative history, conclude that Congress intended no exception to the three-year statute for an understatement of income caused by an overstatement of basis.
In response to several Tax Court and district court decisions holding that Colony prevented the IRS from applying the six-year statute to son-of-boss transactions, the IRS and Treasury Department finalized Regs. Sec. 301.6501(e)-1 in December 2010, declaring the regulation retroactive for all tax years that would still be open employing the rule.8 The regulation flatly contradicts the result in Colony, stating “an understated amount of gross income resulting from an overstatement of unrecovered cost or other basis constitutes an omission from gross income.”9 The government also asserted that Colony did not apply to Sec. 6501(e)(1)(A) because the statute involved in the case had been amended since the decision, thereby permitting the six-year statute to apply to son-of-boss transactions.
Judicial Deference to Regulations
While the Colony case is seemingly on point, the Supreme Court has stated that the judiciary must generally defer to administrative regulations, including those of the IRS, whenever the statute interpreted by the regulations is not silent or ambiguous and the regulation is not arbitrary or capricious. Specifically, the Supreme Court in Chevron U.S.A. Inc. v. Natural Resources Defense Council10 declared the degree of deference courts must give to regulations as follows:
When a court reviews an agency’s construction of the statute which it administers, it is confronted with two questions. First, always, is the question whether Congress has directly spoken to the precise question at issue. If the intent of Congress is clear, that is the end of the matter; for the court, as well as the agency, must give effect to the unambiguously expressed intent of Congress. If, however, the court determines Congress has not directly addressed the precise question at issue, the court does not simply impose its own construction on the statute, as would be necessary in the absence of an administrative interpretation. Rather, if the statute is silent or ambiguous with respect to the specific issue, the question for the court is whether the agency’s answer is based on a permissible construction of the statute. . . . If Congress has explicitly left a gap for the agency to fill, there is an express delegation of authority to the agency to elucidate a specific provision of the statute by regulation. Such legislative regulations are given controlling weight unless they are arbitrary, capricious, or manifestly contrary to the statute. Sometimes the legislative delegation to an agency on a particular question is implicit, rather than explicit. In such a case, a court may not substitute its own construction of a statutory provision for a reasonable interpretation made by the administrator of any agency.11
Thus, the Supreme Court in Chevron sets out a two-step procedure for deciding when a court may substitute its judgment for that of an agency rule such as a Treasury regulation. First, if the court finds congressional intent regarding the words of a statute is “unambiguous,” the court will not defer to a contrary agency interpretation. However, if the statute is ambiguous, then the court will defer to “legislative” regulations unless they are “arbitrary, capricious, or manifestly contrary” to the statute and will defer to all other “interpretive” regulations when they are “reasonable.”12
Most importantly, the Chevron court also directed that a statute’s legislative history be consulted to determine a statute’s meaning, stating:
The judiciary is the final authority on issues of statutory construction, and must reject administrative constructions which are contrary to clear congressional intent. . . . If a court, employing traditional tools of statutory construction, ascertains that Congress had an intention on the precise question at issue, that intention is the law, and must be given effect.13 [Emphasis added.]
In applying the two-step approach to determine judicial deference to regulations, the Supreme Court in Mead Corp.14 found that there are a “great variety of ways in which the laws invest the Government’s administrative arms with discretion, and with procedures for exercising it, in giving meaning to Acts of Congress.”15 Specifically, courts should defer to government agency pronouncements that overturn prior court decisions according to the following standard:
We hold that administrative implementation of a particular statutory provision qualifies for Chevron deference when it appears that Congress delegated authority to the agency generally to make rules carrying the force of law, and that the agency interpretation claiming deference was promulgated in the exercise of that authority. Delegation of such authority may be shown in a variety of ways, as by an agency’s power to engage in adjudication or notice-and-comment rulemaking, or by some other indication of a comparable congressional intent.16
Therefore, where a court case and subsequent regulation conflict, courts must consider whether a government agency’s pronouncement carries the “force of law” and defer to those pronouncements that have undergone “notice-and-comment” review by the public.17
Chevron was further clarified by the Supreme Court in connection with judicial deference of regulations reversing prior court decisions in National Cable & Telecommunications Ass’n v. Brand X Internet Services,18 where the Court stated:
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. . . . Only a judicial precedent holding that the statute unambiguously forecloses the agency’s interpretation, and therefore contains no gap for the agency to fill, displaces a conflicting agency construction.19
Thus, a subsequent regulation cannot overturn a prior court’s interpretation of a statute where that court found the statute unambiguous. Because Colony was decided before Chevron, Mead, and Brand X, the Home Concrete court struggled with whether the Colony court held that the statute was unambiguous, thereby invalidating the regulation.
Stare Decisis Trumps Judicial Deference
In Home Concrete, the issue of whether Colony or the regulations controlled was resolved in favor of Colony, with the Supreme Court holding that an overstated basis does not constitute an omission of income under Sec. 6501(e)(1)(A). The majority opinion written by Justice Stephen Breyer, joined by Chief Justice John Roberts and Justices Clarence Thomas, Samuel Alito, and, in part, Antonin Scalia, held that Colony determined the outcome of the case, and its analysis of what constitutes an omission of gross income squarely applies because nothing affecting the taxpayer’s liability was left off the return.
Although the Colony court did not have the benefit of Chevron, Mead, or Brand X to provide guidance on how to declare its ruling to be irreversible by regulations, the Home Concrete majority, relying on Colony’s consideration of the statute’s legislative history, found that the following statement in Colony had effectively filled any potential regulatory gap:
Although we are inclined to think that the statute on its face lends itself more plausibly to the taxpayer’s interpretation, it cannot be said that the language is unambiguous. In these circumstances we turn to the legislative history . . . [and] find in that history persuasive evidence that Congress was addressing itself to the specific situation where a taxpayer actually omitted some income receipt or accrual in his computation of gross income, and not more generally to errors in that computation arising from other causes.20
Although the Colony court did not have the benefit of Brand X to appreciate the implication of its statement that the statute was not “unambiguous,” the majority in Home Concrete concluded that Colony’s holding, taking into account the statute’s legislative history, was the “only permissible reading” of the statute. In short, the majority in Home Concrete found that deference to the regulation was not required because Colony had filled any gap in the statute’s interpretation regarding whether an overstatement of basis could create an understatement of income under Sec. 6501(e)(1)(A).
Although the dissenting opinion by Justice Anthony Kennedy, joined by Justices Ruth Bader Ginsburg, Sonia Sotomayor, and Elena Kagan, adopted the government’s argument that amendments to the statute subsequent to Colony permitted a different result, the majority found that the operative language of Sec. 6501(e)(1)(A) was “identical” and “materially indistinguishable” from the 1939 Code provision interpreted by Colony. Stating that “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,” the court affirmed that the word “omits” in Sec. 6501(e)(1)(A) “limits the statute’s scope to situations in which specific receipts or accruals of income are left out of the computation of gross income.” As a result, the court found that there was nothing left for regulations to interpret differently, stating, “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.”
A plurality of the justices (i.e., Breyer, Roberts, Thomas, and Alito), went on to discuss the Brand X test for determining when a regulation can trump a prior judicial construction, stating, “The underlying interpretive problem [is] . . . deciding whether, or when, a particular statute in effect delegates to an agency the power to fill a gap, thereby implicitly taking away from a court the power to void a reasonable gap-filling interpretation.”21 Although Colony held that Sec. 6501(e)(1)(A) was not unambiguous, “[t]here is no reason to believe that the linguistic ambiguity noted by Colony reflects a post-Chevron conclusion that Congress had delegated gap-filling power to the agency.”22
In a concurring opinion, Scalia stated that he would be willing to deny precedential effect to Colony because “agency resolutions of ambiguities are to be accorded deference,” but he concluded that Colony should nevertheless control because of “justifiable taxpayer reliance.”23 Scalia would have simply held the regulation to be an unreasonable interpretation of the statute in light of Colony, abandoning the “magic word” test of whether a statute is “ambiguous” or “unambiguous.”24
Lessons Learned and Unresolved Issues
While the court resolved the specific issue at hand, the larger question of the degree of deference courts must give regulations remains unresolved. Taxpayers should find comfort in Home Concrete’s holding that the judiciary may invalidate IRS regulations if prior judicial decisions leave no gap for regulations to fill. Breyer’s opinion specifically states that “[i]f a court, employing traditional tools of statutory construction, ascertains that Congress had an intention on the precise question at issue, that intention is the law and must be given effect,”25 regardless of the regulations. In fact, the opinion suggests that judges today might use methods other than examining a statute’s legislative history to determine whether Congress left a gap to fill, thereby leaving open the question of how courts are to decide whether to defer to regulations that conflict with case law.
While agency expertise has traditionally justified judicial deference to regulations, Home Concrete specifically rejects the expert opinion of the commissioner when that opinion conflicts with a Supreme Court ruling. However, the government came within one vote of having a regulation overturn a decision of the Supreme Court.
While the plurality decision is based on stare decisis,26 the opinion at the same time notes that Colony held that the statute’s language was not “unambiguous,” so that under Chevron and Brand X, the Court could have permitted the regulation to overturn Colony. But because Colony was decided before Chevron and Brand X, the plurality concluded that the Colony court should not be held to a “magic word” test for whether a court decision is irreversible by regulations when the Colony court had otherwise indicated that the legislative history made the statute unambiguous. This implies that at least Supreme Court decisions prior to Chevron cannot be reversed by regulations. Whether regulations may overrule holdings in cases decided after Chevron where the “magic words” are not used remains unanswered, but the Home Concrete majority suggests that court cases can be found to have decided that a statute is unambiguous even when the word “unambiguous” is not used.
Home Concrete also leaves unanswered the extent to which regulations may be applied retroactively. Although the regulations were not finalized until 2010, the government sought to have Regs. Sec. 301.6501(e)-1 apply to tax years as far back as 2000 if the year would be open using the new regulation’s extended six-year statute.27 Finding the regulation invalid because of Colony, the majority opinion never reached the issue of the regulation’s effective date. However, Kennedy in his dissent apparently would permit such retroactivity. He stated, “[h]aving worked no change in the law, and instead having interpreted a statutory provision without an established meaning, the Department’s regulation does not have an impermissible retroactive effect.”28 Clearly, retroactivity will be an issue in future cases where a regulation is found to trump prior judicial decisions; however, courts should not defer to regulations issued simply to bootstrap the government’s litigating position currently under consideration by courts.
Home Concrete demonstrates the difficulty of the “two-step” Chevron approach in trying to ascertain whether a court’s ruling is sufficiently ambiguous to permit regulations to overturn its decision. In fact, Scalia in his concurrence indicates that the “step one” ambiguity test blurs into the “step two” arbitrary and capricious test in determining if a regulation may trump a court decision.29 In any event, Home Concrete wisely confirms that a statute’s legislative history may be referred to in determining whether a statute is ambiguous and whether a regulation can therefore reverse a court’s interpretation of that statute.
Home Concrete also confirms that subsequent amendment to a statute previously interpreted by a court does not necessarily permit regulations to overrule that court’s opinion. However, the four justices dissenting in Home Concrete argued that the minor amendments to Sec. 6501 that were made after Colony—a new Sec. 6501(e)(1)(B)(i) requiring gross income to be determined without taking into account cost of goods sold and a new Sec. 6501(e)(2) to extend the statute for understatements of estate or gift taxes—called for judicial deference to a regulation in conflict with Colony’s interpretation of the unamended word “omits” in Sec. 6501(e)(1)(A). The majority, on the other hand, found such amendments irrelevant to Colony’s ruling on the meaning of “omits.” In fact, Breyer found the minority’s reliance on such unrelated amendments akin to hoping that a new bat boy would change the outcome of the World Series.30
The majority and dissenting opinions also reflect great differences in what the court’s role should be in interpreting statutes such as Sec. 6501(e)(1)(A). The dissent advanced the view that “[o]ur legal system presumes there will be continuing dialogue among the three branches of Government on questions of statutory interpretation and application.”31 Scalia in his concurrence made a special point to reject such a “romantic, judge-empowering image” finding that “Congress prescribes; and where Congress’s prescription is ambiguous the Executive can (within the scope of the ambiguity) clarify that prescription; and if the product is constitutional the courts obey.”32 These two vastly different views on the interaction of the judiciary with the legislature’s creation and the executive’s administration of the Code could have a profound effect on whether Congress will enact detailed, targeted statutes that provide specific, clear guidance or instead simply provide general directions of intent that the IRS implements to prevent tax avoidance and encourage compliance.
While Home Concrete has resolved the specific issue whether Sec. 6501(e)(1)(A) extends the statute of limitation for basis understatements, it does not fully resolve the degree of deference courts must give to regulations that reverse their prior decisions. Clearly, Scalia believes that regulations should not generally trump prior case law, particularly decisions of the Supreme Court. Breyer and those joining his plurality opinion continue to refine the Chevron two-step test, finding that a court need not declare the statute to be unambiguous for it to be, in fact, unambiguous. Finally, four justices apparently would have been content to have their decisions reversed by regulations based on the slimmest of statutory distinctions between the 1939 and 1954 versions of the Code and then have those regulations apply retroactively to tax years open due to litigation over the precise issue that the regulation decides in favor of the government.
Ultimately, which branch of government (judicial or administrative) should prevail regarding statutory interpretation is an issue that transcends the Code. As Scalia predicted in Brand X, this issue creates a world “full of promise for administrative-law professors in need of tenure articles and, of course, for litigators.”33 While we await further litigation, this article serves as an effort to assist taxpayers and their advisers in deciding whether a regulation in conflict with a prior court case must be followed.
1 Secs. 6501(a) and (b).
2 Home Concrete & Supply, LLC, S. Ct. Dkt. 11-139 (U.S. 4/25/12), aff’g 634 F.3d 249 (4th Cir. 2011).
3 See Notice 2000-44, 2000-2 C.B. 255, finding the son-of-boss transaction to be a “listed transaction” for penalty purposes.
4 Beard, 633 F.3d 616 (7th Cir. 2011); Grapevine Imps. Ltd., 636 F.3d 1368 (Fed. Cir. 2011); Salman Ranch Ltd., 647 F.3d 929 (10th Cir. 2011); and Intermountain Ins. Serv. of Vail LLC, 650 F.3d 691 (D.C. Cir. 2011).
5 Home Concrete & Supply, LLC, 634 F.3d 249 (4th Cir. 2011). See also Burks, 633 F.3d 347 (5th Cir. 2011); and Bakersfield Energy Partners LP, 568 F.3d 767 (9th Cir. 2009).
6 Colony, Inc., 357 U.S. 28 (1958).
7 Regs. Sec. 301.6501(e)-1(a)(1)(iii). These regulations were initially issued in temporary form in 2009 (T.D. 9466) and made final in 2010 prior to their review by the appellate courts (T.D. 9511).
8 Regs. Sec. 301.6501(e)-1(e); preamble to T.D. 9511.
9 Regs. Sec. 301.6501(e)-1(a)(1)(iii).
10 Chevron U.S.A. Inc. v. Natural Res. Def. Council, Inc., 467 U.S. 837 (1984). The Chevron standard of judicial deference to agency interpretations of statutes was made specifically applicable to IRS regulations in Mayo Found. for Med. Educ. and Research, S. Ct. Dkt. 09-837 (U.S. 1/11/11).
11 Chevron, 467 U.S. at 842–44 (footnotes omitted).
12 The body of scholarly literature on Chevron is legion. For Chevron’s application to tax regulations, see, e.g., Coverdale, “Court Review of Tax Regulations and Revenue Rulings in the Chevron Era,” 64 Geo. Wash L. Rev. 35 (1995); and Aprill, “Muffled Chevron: Judicial Review of Tax Regulations,” 3 Fla. Tax Rev. 51 (1996).
13 Chevron, 467 U.S. at 843, n. 9 (citations omitted).
14 Mead Corp., 533 U.S. 218 (2000).
15 Id. at 236.
16 Id. at 226–27.
17 Generally, the Administrative Procedure Act (5 U.S.C. §553) calls for a notice-and-comment period before a regulation is made final. The regulations in Home Concrete were issued under Sec. 7805(e) in temporary and proposed form in September 2009, without prior notice and comment, and, following a comment period, were made final in December 2010.
18 National Cable & Telecomm. Ass’n v. Brand X Internet Servs., 545 U.S. 967 (2005).
19 Id. at 982–83.
20 Colony, 357 U.S. at 33.
21 Home Concrete, slip op. at 9.
22 Id. at 10.
23 Home Concrete, slip op. at 1 (Scalia, J., concurring).
24 Id. at 3 (Scalia, J., concurring).
25 Home Concrete, slip op. at 10, quoting Chevron, 467 U.S. at 843, n. 9.
26 The doctrine under which courts follow precedent and do not lightly overturn settled principles of law. See Black’s Law Dictionary (West 1979).
27 Sec. 6501(e)(1)(A) was enacted before 1996 and, therefore, the rule of Sec. 7805(b)(1) denying retroactivity to any regulation interpreting statutory provisions enacted after July 30, 1996, did not apply. See Taxpayer Bill of Rights II, P.L. 104-168, §1101(a).
28 Home Concrete, slip op. at 8 (Kennedy, J., dissenting).
29 This view is extensively discussed in Stephenson and Vermeule, “Chevron Has Only One Step,” 95 Va. L. Rev. 597 (2009).
30 Home Concrete, slip op. at 7.
31 Home Concrete, slip op. at 7 (Kennedy, J., dissenting).
32 Home Concrete, slip op. at 6 (Scalia, J., concurring).
33 Brand X, 545 U.S. at 1019 (Scalia, J., dissenting).
Donald Williamson is a professor of taxation, Howard S. Dvorkin Faculty Fellow, and executive director of the Kogod Tax Center at the Kogod School of Business at American University in Washington, D.C. Blair Staley is a professor of accounting and Master of Accountancy program coordinator at Bloomsburg University in Bloomsburg, Pa. For more information about this article, please contact Prof. Williamson at email@example.com.