Government Seeks Review of Fifth Circuit Decision on Basis Overstatement

1. Whether an understatement of gross income attributable to an overstatement of basis in sold property is an "omi[ssion] from gross income" that can trigger the extended six-year assessment period.

2. Whether a final regulation promulgated by the Department of the Treasury, which reflects the IRS's view that an understatement of gross income attributable to an overstatement of basis can trigger the extended six-year assessment period, is entitled to judicial deference.

Respondents are Daniel S. Burks; MITA, a general partnership; and John F. Lynch.

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a. When a taxpayer sells property, any "[g]ain[ ]" that he realizes from the sale contributes to his "gross income." 26 U.S.C. 61(a)(3). The taxpayer's gain, however, is not the sale price of his property. Rather, it is the sale price minus the taxpayer's capital stake in the sold asset, which is generally the amount paid to obtain the property, as adjusted by various other factors. 26 U.S.C. 1012. For tax purposes, that capital stake is commonly referred to as the taxpayer's "basis" in property. 26 U.S.C. 1011(a). Because the taxable income from a property sale is generally determined by subtracting the taxpayer's basis from the property's sale price, an overstatement of basis will typically decrease the amount of the taxpayer's gain (and thus the amount of federal income-tax liability) that is attributable to the sale.

That issue arises in these consolidated cases in the context of a particular kind of tax shelter, known as a Son-of-BOSS (Bond and Option Sales Strategy) transaction. In a Son-of-BOSS transaction, a taxpayer uses some mechanism, often a short sale, to artificially increase his basis in an asset before the asset is sold. A short sale is a sale of a security that the seller does not own or has not contracted for at the time of the sale. To close the short sale, the seller is obligated to purchase and deliver the security at some point in the future, often by using the proceeds from the short sale itself. Typically in a Son-of-BOSS transaction, a taxpayer enters into a short sale and transfers the proceeds as a capital contribution to a partnership. The partnership then closes the short sale by purchasing and delivering the relevant security on the open market. See Beard v. CIR, 633 F.3d 616, 617-618 (7th Cir. 2011), petition for cert. pending, No. 10-1553 (filed June 23, 2011).

When the taxpayer and partnership file their tax returns for the year in which a transaction of the kind described above occurs, they are required under 26 U.S.C. 722, 723, and 752 to report their taxable bases in the partnership. The taxpayer's basis in the partnership is called an "outside basis," while the partnership's basis in its own assets is called an "inside basis." See Kornman & Assocs., Inc. v. United States, 527 F.3d 443, 456 n.12 (5th Cir. 2008). In a Son-of-BOSS transaction, when computing both "outside" and "inside" basis, the taxpayer and the partnership include the short-sale proceeds contributed to the partnership, without decreasing that amount by the corresponding obligation (i.e., to close the short sale by purchasing and delivering the relevant security) that the partnership has assumed. As a result, the taxpayer either generates a large paper loss that can be used to offset capital gains on other unrelated investments, or turns what would otherwise have been a sizeable capital gain into a smaller taxable gain or even a capital loss.¹ See Beard, 633 F.3d at 618.

b. In this case, respondents Daniel S. Burks and John F. Lynch (along with their spouses and some of their trusts) owned stock that had appreciated in value. Respondents wanted to sell that stock while minimizing their taxable gains from the sales. Respondents therefore engaged in various short sales of United States Treasury Notes. In late 1999, respondents transferred the proceeds of the short sales as capital contributions to various pass-through partnerships that they had created (one of which was respondent MITA, a general partnership formed by respondent Lynch). Those partnerships then closed the short sales by purchasing and delivering the requisite Treasury Notes. App., infra, 2a-3a; see Gov't C.A. Br. 6-7 (No. 09-11061); Gov't C.A. Br. 4-5 (No. 09-60827).

In 2000, respondents filed their tax returns for the previous year. In computing their outside bases, respondents Burks and Lynch included the amount of the short-sale proceeds that they had contributed to the partnerships, without reducing those amounts to reflect the partnerships' offsetting obligations to close the short positions. As a result, respondent Burks turned what would have been a large capital gain into a much smaller one, and respondent Lynch turned what would have been a large capital gain into a capital loss. See Gov't C.A. Br. 8 (No. 09-11061); Gov't C.A. Br. 5-7 (No. 09-60827).

2. In 2006 and 2007, the IRS issued Final Partnership Administrative Adjustments (FPAAs), reducing respondents' outside bases in their partnerships and thereby substantially increasing their taxable income for 1999.² App., infra, 3a-4a. Respondents challenged the FPAAs, arguing that they were barred because they were issued after the expiration of the three-year assessment period provided by 26 U.S.C. 6501(a). The government contended that the FPAAs were governed instead by the extended six-year assessment period in 26 U.S.C. 6501(e)(1)(A), which applies when a taxpayer "omits from gross income an amount properly includible therein which is in excess of 25 percent of the amount of gross income stated in the return."

In the case of respondent Burks, the district court denied his motion for summary judgment, holding that an overstatement of basis in sold assets can give rise to an omission from gross income for purposes of Section 6501(e)(1)(A). App., infra, 34a-43a. The court of appeals then granted Burks leave to file an interlocutory appeal. Id. at 4a. In the case of respondents Lynch and MITA, the Tax Court held that, under this Court's decision in The Colony, Inc. v. CIR, 357 U.S. 28 (1958) (Colony), an overstatement of basis in sold assets does not give rise to an omission from gross income for purposes of Section 6501(e)(1)(A). App., infra, 46a-48a. The Tax Court therefore granted respondents' motion for summary judgment, and the government timely appealed. Id. at 5a.

3. The court of appeals consolidated the cases and held that an overstatement of basis in sold assets does not give rise to an omission from gross income. App., infra, 1a-28a. The court therefore concluded that the three-year period in Section 6501(a), not the six-year period in Section 6501(e)(1)(A), applied to the IRS's assessments. Id. at 14a. The court declined to apply a regulation promulgated in temporary form by the IRS in September 2009, which became final in December 2010 while the appeals were pending, and which construes the phrase "omits from gross income" to encompass situations in which a taxpayer understates his income by overstating his basis in property. Id. at 25a. The court of appeals read this Court's decision in Colony to hold that the relevant statutory language is unambiguous and therefore precludes any contrary agency interpretation. Ibid.

Beard is the earlier-filed petition, and the government is not aware of any reason why these cases would present a more suitable opportunity than Beard for resolving the circuit conflict. If the Court grants the petition in Beard and concludes that an overstatement of basis in sold property does trigger the extended six-year assessment period, then the assessments at issue in these cases were timely and the court of appeals erred in holding otherwise. Accordingly, the Court should hold this petition pending the disposition of Beard, including any subsequent proceedings on the merits, and then dispose of the petition as appropriate in light of those decisions.

AUGUST 2011

² Although the FPAA for respondent Lynch was issued in March 2007, more than six years after he had filed his return in October 2000, Lynch had consented to extending the assessment period until March 31, 2007. See Gov't C.A. Br. 8 (No. 09-60827).