Civil Statutes of Limitation for Abusive Tax Shelters (5/10/10)

The statute of limitations rules for civil cases are:

a. In non-TEFRA cases, the general rule is 3 years with two key exceptions in the case of tax shelters: (i) 6 years if a 25% omission of gross income is involved and (ii) no statute if fraud is involved. See Section 6501(c)(1) & 2 and (e)(1)(A) (prior to amendment by the HIRE Act).

b. In TEFRA cases, the special statute of limitations (which may extend the limitations periods discussed in paragraph a.) a general 3 year rule with extended periods paralleling the general rules in paragraph a. in the case of: (i) false or fraudulent partnership returns (6 years except that partners "signing or participating in the preparation of" a false or fraudulent return) may be assessed at any time,” (ii) 6 years for 25% gross income omissions, (iii) unlimited if no return, and (iv) Service prepared returns. § 6229(a) &.(c).

Many abusive tax shelters attempted to make sure the general 3 year statute of limitations would apply by (i) offering a packaged (Government would call "cookie-cutter") legal opinion so as (the promoters and taxpayers hoped) to avoid fraud and (ii) creating the shelter through a mechanism other than omission of gross income. One of the so-called loss generator strategies was to create artificial basis. The Son-of-Boss transactions were typical of this type of abusive tax shelter. I won't get into the details of that genre of shelter, but I will illustrate in a highly simplified example. Suppose a taxpayer had $50,000,000 of capital gain and his or her only other income was $1,000,000 in compensation. If the taxpayer omitted the capital gain from his or her return, he or she would easily have a 25% omission of income and the six year statute would apply. If, however, the taxpayer can generate artificial basis to offset the capital gain (say making the gain net of the artificial basis $50,000 rather than $50,000,000), the taxpayer has set the stage for an argument that the three year statute applies. The argument is based on the Supreme Court's holding in Colony Inc. v. Commissioner, 357 U.S. 28 (1958), which interpreted the 1939 Code equivalent of the Section 6501(e) 25% omission 6 year statute. The IRS has argued that Colony did not require that holding, but the courts have generally disagreed. As a result, the IRS promulgated regulations that, if valid, would sustain the IRS position and overrule the cases holding otherwise.

The IRS hoped that the regulations would be the law, regardless of prior precedent, including even the Supreme Court precedent in Colony.  The IRS based its hope on the line of cases beginning with Chevron U.S.A. Inc. v. Natural Res. Def. Council, 467 U.S. 837 (1984) which gives the IRS broad authority to promulgate the law by regulation so long as the statute does not foreclose the interpretation adopted in the regulation -- i.e., the IRS may choose among reasonable interpretations of the statutory text. In National Cable & Telecommunications Association v. Brand X Internet Services, 545 U.S. 967 (2005) ("Brand X") held that the IRS could by regulation overturn prior judicial precedent.  Justice Thomas for the majority synthesized the holding of Chevron as follows:

In Chevron, this Court held that ambiguities in statutes within an agency's jurisdiction to administer are delegations of authority to the agency to fill the statutory gap in reasonable fashion. Filling these gaps, the Court explained, involves difficult policy choices that agencies are better equipped to make than courts. If a statute is ambiguous, and if the implementing agency's construction is reasonable, Chevron requires a federal court to accept the agency's construction of the statute, even if the agency's reading differs from what the court believes is the best statutory interpretation. (Citations omitted.)

Then moving to whether an agency interpretation can trump an earlier court decision, Justice Thomas said:

A contrary rule would produce anomalous results. It would mean that whether an agency's interpretation of an ambiguous statute is entitled to Chevron deference would turn on the order in which the interpretations issue: If the court's construction came first, its construction would prevail, whereas if the agency's came first, the agency's construction would command Chevron deference.

Justice Thomas then concluded: “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.” Further emphasizing the point, Justice Thomas states: “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.”

Brand X thus grants (or recognizes) the IRS’s (or any agency’s) authority to change the prior judicial interpretation so long as the agency interpretation is not foreclosed as a reasonable interpretation of an otherwise ambiguous statute. In other words, if in order to resolve the case at hand, the prior judicial opinion applies an interpretation that it thinks best resolves the case but is not necessarily commanded as the only reasonable interpretation of the statute, the prior judicial opinion does not foreclose an agency from adopting an interpretation otherwise that is a different reasonable interpretation and qualify that interpretation for Chevron deference.

Of course everything turns upon whether the prior judicial opinion effectively forecloses other reasonable interpretations of the statute. This then can become a tough call, and drawing this line will be where the play comes in the application of Brand X’s vision of Chevron deference. This was the setting as to the new IRS regulations interpreting the 25% omission rule which could be read as overturning Colony.

In Intermountain Insurance Service of Vail LLC v. Commissioner, 134 T.C. No. 11 (5/6/10), the Tax Court tackled that issue and held that Colony lived despite the regulation.  The Tax Court held that the Colony interpretation of the statutory text foreclosed there being reasonable alternatives that the IRS could choose among by regulation. The concurring opinion by Judge Halpern ably contests that notion.

Obviously, the particular phenomenon that has the IRS so exercised is the fact that it views the extended 6 year statute of limitations to be important to its collection of the taxes avoided by the abusive shelter because the parties involved well-hid their perfidy. Intermountain arose in the context of the TEFRA iteration of the 25% omission rule, but as noted above there is another TEFRA 6 year statute -- for returns that are false or fraudulent. The IRS has noised for years that Son-of-Boss transactions were false or fraudulent and have indicted and convicted some of the enablers in these transactions. Although no taxpayers have been indicted or convicted, the prosecutors in the cases certainly felt that the taxpayers were complicit. So, the IRS could get a 6 year TEFRA statute if it could prove by clear and convincing evidence that the partnership return was false or fraudulent. It is unclear why the IRS has not taken that approach. Morever, if indeed the prosecutors could prove that the taxpayer partners were complicit in the fraud, then an unlimited statute would apply (whether by virtue of the TEFRA rule or, perhaps even, by the regular § 6501(c)(1) and (2) rule). And, to trace this even further, the IRS might argue that the fraud which infects the individual return is sufficient to invoke the holding of Allen v. Commissioner, 128 T.C. 37 (2007), here.  (See my prior discussion of Allen here.)  I have not traced such a line of argument out to the end, but simply suggest that I see no clear reason why it might not be available.