United States Court of Appeals
For the First Circuit
No. 01-1169
CC&F WESTERN OPERATIONS LIMITED PARTNERSHIP,
CC&F INVESTORS, INC., TAX MATTERS PARTNER,
Petitioner, Appellant,
v.
COMMISSIONER OF INTERNAL REVENUE,
Respondent, Appellee.
ON APPEAL FROM A DECISION OF THE UNITED STATES TAX COURT
[Hon. Mary Ann Cohen, U.S. Tax Court Judge]
Before
Boudin, Chief Judge,
Stahl, Senior Circuit Judge,
and Lynch, Circuit Judge.
William F. Nelson, with whom J. Bradford Anwyll, Christopher
P. La Puma, Nathan E. Clukey, McKee Nelson, Ernst & Young LLP,
Peter J. Genz and King & Spalding were on brief for petitioner.
Charles Bricken, Tax Division, Department of Justice, with
whom Claire Fallon, Acting Assistant Attorney General, and Bruce
R. Ellisen, Tax Division, Department of Justice, were on brief
for respondent.
December 10, 2001
BOUDIN, Chief Judge. We are asked to resolve whether
a tax assessment against CC&F Western Operations Limited
Partnership ("Western") was timely filed under a provision of
the Internal Revenue Code that gives the IRS three additional
years to impose such an assessment on a partnership that omits
a substantial amount of gross income from its return. 26 U.S.C.
§ 6229(c)(2) (1994). The facts, which are fully stipulated,
involve the sale of real estate interests in a complicated two-
step transaction.
CC&F Investment Company Limited Partnership ("CC&F
Investment") and CC&F Investors, Inc. ("CC&F Investors") formed
Western in 1990 for the sole purpose of selling certain
partnership interests owned by CC&F Investment to Trammell Crow
Equity Partners II, Ltd. ("Trammell Crow"). CC&F Investment
owned, directly or through its lower-tier partnership CC&F West,
two relevant sets of assets: 84 percent general partner
interests in seven real estate partnerships ("the real estate
partnerships") and 100 percent ownership interests in five
vacant land parcels.1
1
CC&F Investment also owned--and sold to Trammell Crow--
stock in CC&F Stadium Properties, Inc., a corporation involved
in real estate leasing. The IRS determined that the gross
income on this sale was also under-reported, but neither party
contends that this transaction affects the timeliness of the
IRS's assessment.
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In a tax-free transaction prior to the Trammell Crow
sale, CC&F Investment and CC&F West sold Western their 84
percent interest in the real estate partnerships and conveyed
the five land parcels to five new partnerships in which Western
was a 99 percent partner ("the vacant land partnerships"). The
remaining 16 percent interest in the real estate partnerships
was held by other partnerships whose partners were primarily
employees of CC&F Investment's general partner ("the employee
partnerships"); CC&F Investors retained the residual 1 percent
interest in the vacant land partnerships.
In two separate transactions in March and April 1990,
Western joined with the employee partnerships and CC&F Investors
to sell a 100 percent interest in each of the twelve
partnerships (collectively, "the subsidiary partnerships") to
Trammell Crow for $74,122,212 in cash. Because Trammell Crow
was promised the assets free and clear of debt, $52,928,095 of
the sale proceeds went directly from the escrow agent to repay
all of the third-party bank debt.
As a result of the sale, each of the twelve
partnerships underwent a tax termination under 26 U.S.C. §
708(b)(1)(B) and submitted a final tax return for the
abbreviated tax year. All but one return included a statement
that the partnership had been sold to an unrelated third party
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by Western and the employee partnerships. (One of the seven
real estate partnerships--CC&F Bellvue--erroneously stated that
all of its interests had been liquidated and transferred to
Western.)
Western timely filed its 1990 partnership information
return (Form 1065) on October 15, 1991. The return stated that
Western had sold "various partnership interests" on March 29,
1990 at a "gross sales price" of $27,965,551 and at a "cost or
other basis" of $31,161,890, for a net loss of $3,196,339. No
explanation of the derivation of these figures was given.
Western also attached the Schedule K-1s from the twelve
subsidiary partnership returns, which taken together stated that
Western's allocable share of those partnerships' liabilities
just prior to the sale totaled $69,959,490.
On October 14, 1997--a day less than six years after
Western's return was filed--the IRS sent CC&F Investors,
Western's tax matters partner, an adjustment with a proposed
increase of nearly $83 million in Western's taxable income from
the sale of the twelve partnership interests. This adjustment
was later acknowledged to be miscalculated, and the parties now
agree that Western's $3,196,339 net loss on the sale should have
been reported as a net gain of $9,182,216--an upward adjustment
of $12,378,555.
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The correct gain was calculated based on gross sale
proceeds to Western of $20,904,872 (the $74,122,212 purchase
price paid by Trammell Crow minus the employee partnerships'
$289,245 share and the $52,928,095 that went to pay off the
third-party bank debt). The aggregate tax basis of Western's
interest in the twelve partnerships was calculated to be
$9,276,412, disregarding the third-party bank debt (which had
also been disregarded in calculating Western's proceeds).
Certain other costs were also attributed to the sale. The exact
calculations appear in an appendix to this opinion.
Western concedes that this adjustment is accurate but
contends that the adjustment was not timely filed. It argues
that the statutory three-year extension for substantial
omissions of gross income does not apply because its gross
income was adequately disclosed on its return and attached
schedules. On cross-motions for summary judgment, the Tax Court
sustained the IRS, 80 T.C.M. (CCH) 345 (2000), and this appeal
ensued. We have jurisdiction, and our review is de novo. 26
U.S.C. § 7482; State Police Ass'n of Mass. v. Comm'r, 125 F.3d
1, 5 (1st Cir. 1997).
The limitations provisions that directly govern are
contained in sections 6229(a) and (c) of the 1954 Code, enacted
as part of the Tax Equity and Fiscal Responsibility Act of 1982
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("TEFRA"), Pub. L. No. 97-248, § 402, 96 Stat. 324, 648. Under
TEFRA, tax treatment of partnership items is determined in a
unified partnership level proceeding, although assessments occur
at the individual partner level.
Section 6229(a) says that the limitations period for
assessing tax on a taxpayer, where the tax is attributable to a
partnership item, does not expire before three years after the
partnership return was filed. Section 6229(c) then creates
certain extensions, including one in subsection (c)(2) for
"[s]ubstantial omission of income":
If any partnership omits from gross
income an amount properly includible therein
which is in excess of 25 percent of gross
income stated in its return, subsection (a)
shall be applied by substituting "6 years"
for "3 years".
In this case, notice of an adjustment tolling the
statute was sent to Western's tax matters partner one day before
the six-year period expired. If the six-year period governs,
the parties have stipulated that additional tax from Western on
the under-reported income is now due. The parties also
stipulate that the 25 percent threshold has been met. Whether
one compares actual gross proceeds with reported gross proceeds,
or real net gain with reported net loss, the actual amounts
involved exceed the reported figures by far more than 25
percent. See Appendix.
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Based on the bare language of section 6229, it might
appear that this alone is enough to entitle the IRS to the six-
year statute of limitations. However, Western has two counter-
arguments to the IRS, both of which depend on reading section
6229 in light of case law developed in connection with two other
provisions--section 275 of the 1939 Code and section 6501 of the
1954 Code. The arguments can scarcely be understood, let alone
assessed, without an excursion into pre-TEFRA law and precedent.
Language embodying section 6229's substantial omission
test was originally contained in section 275 of the 1939 Code to
qualify the ordinary three-year limitations period for all
income tax returns and not just partnerships; the only
difference was that the extension provided was from three years
to five years rather than six. In 1954, Congress superseded
section 275 with section 6501. Subsection 6501(a) adopts the
normal three-year period; subsection (e)(1) adopts the
substantial omission test extending the period to six years but
also adds two further subsections not contained in section 275
providing special rules for implementing the test. 26 U.S.C. §
6501(e)(1)(A)(i), (ii).
Not long after the 1954 Code was enacted, the Supreme
Court in Colony, Inc. v. Commissioner, 357 U.S. 28 (1958),
construed section 275 as applied to a pre-1954 Code return. In
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Colony, the case around which Western's main arguments revolve,
the taxpayer reported the sale of several lots of land, giving
the full amount of the gross receipts from the sales but
overstating its basis in the property, resulting in an
understatement of gross income. Relying upon legislative
history of section 275, Justice Harlan held that its longer
limitations period did not apply where gross receipts had been
fully reported, even though gross income was substantially
under-reported. Id. at 33.
The result may seem surprising because section 275 did
not speak of gross receipts at all but of gross income, and
taxpayer Colony had under-reported gross income by more than 25
percent by overstating the basis. Gross income on land sales is
normally computed as net gain after subtracting the basis. 26
U.S.C. §§ 61(a)(3), 1001(a); 26 C.F.R § 1.61-6 (2001). However,
Justice Harlan read section 275 in light of legislative reports
and debates giving examples of cases where an income receipt was
entirely omitted from the return. Colony, 357 U.S. at 33-35.
Although these could have been deemed merely examples, Colony
read them as reflecting the limits of section 275.2
2
Whether Colony's main holding carries over to section
6501(e)(1) is at least doubtful. That section's first "special
rule" adopts Justice Harlan's gross receipts test but only for
sales of goods and services. 26 U.S.C. § 6501(e)(1)(A)(i). The
arguable implication is that it does not apply under section
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Justice Harlan's decision concluded with the following:
We think that in enacting § 275(c)
Congress manifested no broader purpose than
to give the Commissioner an additional two
years [now increased to three] to
investigate tax returns in cases where,
because of a taxpayer's omission to report
some taxable item, the Commissioner is at a
special disadvantage in detecting errors.
In such instances the return on its face
provides no clue to the existence of the
omitted item. On the other hand, when, as
here, the understatement of a tax arises
from an error in reporting an item disclosed
on the face of the return the Commissioner
is at no such disadvantage.
357 U.S. at 36.
Western's first argument based upon Colony is
straightforward. It says that Colony is on all fours with this
case and that, as section 6229(c) tracks section 275, it follows
that the substantial omission test not met in Colony was also
not met in this case. The equation is mistaken. Colony did not
involve the failure to include attributed income; rather, all
receipts were disclosed and the taxpayer's only fault was an
overstatement of basis.
In the present case, by contrast, the huge payment by
Trammell Crow discharging Western's indebtedness to banks is
properly treated as a gross receipt and gross income
6501 to other types of income. See Lawson v. Comm'r, 67 T.C.M.
(CCH) 3121 (1994). But we need not resolve this issue.
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attributable to Western. 26 U.S.C. §§ 752(d), 1001(b); 26
C.F.R. §§ 1.752-1(h), 1.1001-2(a) (2001). All or most of this
amount, stipulated as $52,928,095, was simply omitted as an
income item on Western's return. In Colony there was no such
omission and that was decisive; here, there was. So much for
any argument that Colony is directly in point and that its
outcome compels the same one here.
However, Western has a second argument based not on
Colony's main holding (that a gross receipt must be omitted
before the extension applies) but rather on Justice Harlan's
reference, quoted above, to the lack of any clue alerting the
IRS to an omission from the return. Western's position is that,
following Colony, the six year statute is triggered only if the
return, in addition to omitting over 25 percent of gross income,
also gives the IRS no clue that this omission has occurred.
And, it says, the aggregate of Western's indebtedness, reflected
in the twelve subsidiary partnerships' Schedule K-1s that were
attached to Western's own partnership return, provided that
clue.
Read literally, Justice Harlan's reference to the lack
of a clue was not at all a description of a condition for
implementing section 275. The only test adopted in Colony was
that there be an omission of gross receipts exceeding 25 percent
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and not just an overstatement of basis that effectively reduced
reportable gross income by that amount. The clue language was
used merely to explain why Congress might have been more
concerned about an omitted receipt than an overstated basis--
specifically, because the omitted receipt will (ordinarily)
provide no clue as to the error; by implicit contrast, an
overstated basis provides something the IRS can check. Colony,
357 U.S. at 36.
Nevertheless, several Tax Court decisions have
described the clue reference as if it were an independent test
so that there must be both an omission of over 25 percent and
also no clue to the existence of the omission. E.g., Rhone-
Poulenc Surfactants & Specialities, L.P. v. Comm'r, 114 T.C.
533, 557-58 (2000), appeal dismissed and remanded, 249 F.3d 175
(3d Cir. 2001); Univ. Country Club, Inc. v. Comm'r, 64 T.C. 460,
469 (1975). However, these statements generally appear not as
a gloss on section 275 or on section 6229; instead, they are
addressed to the second "special rule" in section 6501, which
contains this added language:
In determining the amount omitted from
gross income, there shall not be taken into
account any amount which is omitted from
gross income stated in the return if such
amount is disclosed in the return, or in a
statement attached to the return, in a
manner adequate to apprise the Secretary of
the nature and amount of such item.
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26 U.S.C. § 6501(e)(1)(A)(ii).
On its face, the "adequate to apprise the Secretary of
the nature and amount" language establishes a much stiffer test
than a mere clue, and quite properly the cases tend to interpret
it as requiring far more than a mere clue that might intrigue
Sherlock Holmes. George Edward Quick Trust v. Comm'r, 54 T.C.
1336, 1347 (1970), aff'd per curiam, 444 F.2d 90 (8th Cir.
1971). And even if Colony were (wrongly) read as establishing
a clue test, it would be difficult to read the adequate
disclosure language as adopting that test since the language was
enacted four years before Colony was even decided and does not
appear in the statute there at issue (section 275). The use of
the clue language in decisions construing section 6501's
adequate disclosure provision likely reflects an impulse to
create a sense of continuity (unfortunately false) between
Colony and section 6501's adequate disclosure test.
On top of all this, it is debatable whether this
adequate disclosure safe harbor should even be read into section
6229, which is applicable here and contains no such language.
And it is also debatable whether this provision should be read
literally, as the IRS argues, to require disclosure of the exact
amount omitted or merely requires that there be a clear
indication that a large amount of gross income was omitted, as
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some cases have held, see Univ. Country Club, 64 T.C. at 471;
Quick Trust, 54 T.C. at 1347. We need not decide these
questions because even if both assumptions are indulged in favor
of Western, we think that it still loses in the present case.
Western's argument as to adequate disclosure is that
the Schedule K-1s of the twelve partnerships specified figures
representing Western's indebtedness immediately before the sale
in amounts that, if aggregated, approached $70 million. This,
says Western, should have alerted the IRS to a large amount of
missing gross income because Western had reported only $27
million as the "gross sales price" on its own return. If the
$70 million were treated as attributed income, the reported
figure should have been much higher.
But even if the IRS knew that this large amount of pre-
sale debt existed, Western does not explain why the IRS should
have assumed that the debt was paid off by Trammel Crow incident
to its purchase. Nothing in Western's return indicated the
allocation of debt or any other sale terms. Possibly, some
inference supporting such an assumption could be based on the
low amount of basis reported on Western's return; the theory
might be that if Western remained liable, it would be part of
that basis. But that is not crystal clear to us and Western
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offers no argument to show the IRS should have made that
assumption.
Further, even if the IRS had inferred that the buyer
had paid off Western's debts, it is unclear why this should have
created concern and prompted further inquiry. Formally, a
buyer's payment discharging the seller's bank debt should be
treated as income to the seller, but the parties indicate that
it is apparently fairly common in tax reporting for the seller
in these circumstances to omit the imputed income on the return
but also to omit the same amount from the basis. See also
Manolakas, Partnerships and LLCs: Tax Practice and Analysis ¶
1103.03, at 334 (2000). Because the liabilities are omitted
from both income and basis, the omission is normally a "wash"
and has no effect on the tax due. Thus, the failure of the IRS
to investigate further based solely on these bare facts is
understandable.
In the end, the safe harbor provision of section 6501
has to be read in light of its purpose, namely, to give the
taxpayer the shorter limitations period where the taxpayer
omitted a particular income item from its calculations but
disclosed it in substance. The chain of inferences relied upon
by Western is simply too thin and doubtful to meet this
requirement even on the debatable assumption that the safe
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harbor test should be read into section 6229 despite the absence
of any language to this effect. That is enough to resolve this
case.
Affirmed.
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APPENDIX
Western Western
Operations Operations
(Reported) (Adjusted)
Gross Sales Price $27,965,551 $74,122,212
Proceeds to Third-Party Debt $52,928,095
Proceeds to Employee $ 289,245
Partnerships
GROSS SALE PROCEEDS TO WESTERN $20,904,872
Tax Basis $ 9,276,412
Selling Expenses $ 1,791,016
Closing Costs $ 380,733
Other Costs $ 274,495
AGGREGATE COST & OTHER BASIS $31,161,890 $11,722,656
NET GAIN (LOSS) ($3,196,339) $ 9,182,216
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