T.C. Memo. 2009-184
UNITED STATES TAX COURT
KENNETH H. AND SUSAN W. BEARD, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 13372-06. Filed August 11, 2009.
Robert E. McKenzie and Adam S. Fayne, for petitioners.
Thomas D. Yang, for respondent.
MEMORANDUM OPINION
HAINES, Judge: In a notice of deficiency sent April 13,
2006, respondent determined that petitioner Kenneth Beard (Mr.
Beard) had overstated his basis in two S corporations sold during
the taxable year 1999, thus causing an understatement of gross
income by more than 25 percent of the amount stated in
- 2 -
petitioners’ return.1 The issue for decision is whether, under
those circumstances, petitioners omitted income, giving rise to
an extended 6-year period of limitations. This issue has been
presented by petitioners’ motion for summary judgment under Rule
121 and respondent’s notice of objection, and supplemental briefs
from both parties.
Background
For purposes of the pending motion, the following facts have
been assumed. At the time they filed their petition, petitioners
resided in Illinois. Mr. Beard was a majority shareholder in two
S corporations, MMCD, Inc. (MMCD), and MMSD, Inc. (MMSD). Mr.
Beard had a 76-percent stock ownership interest in each entity.
On August 24, 1999, petitioners entered into short sales
whereby they borrowed U.S. Treasury notes from a third party and
sold them for cash to another third party. These sales generated
$12,160,000 in cash.
On August 25, 1999, petitioners used this cash to buy more
Treasury notes in two transactions of $5,700,000 and $6,460,000.
On the same day petitioners transferred to MMCD and MMSD the
purchased Treasury notes of $5,700,000 and $6,460,000,
respectively, together with the short positions (the obligation
1
Unless otherwise indicated, all section references are to
the Internal Revenue Code, as amended, and all Rule references
are to the Tax Court Rules of Practice and Procedure. Amounts
are rounded to the nearest dollar.
- 3 -
following the short sale to replace the borrowed securities). On
the same day MMCD and MMSD sold their Treasury notes and closed
the short positions on the Treasury notes for $7,500,000 and
$8,500,000, respectively.
On August 29, 1999, Mr. Beard sold his entire interest in
MMCD and in MMSD to Unicom, an unrelated third-party purchaser,
for $6,574,939 and $7,638,211, respectively.
On April 11, 2000, petitioners jointly filed their 1999
Federal income tax return. On their Schedule D, Capital Gains
and Losses, petitioners claimed a cost basis of $6,161,351 in
MMCD and $7,638,463 in MMSD and net gains from the sales of the
shares of $413,588 and $992,748, respectively. Petitioners also
reported gross proceeds from the sale of Treasury notes of
$12,125,340, a cost basis of $12,160,000, and a resulting net
loss of $34,660. There is no indication on Schedule M-2,
Analysis of Accumulated Adjustments Account, Other Adjustments
Account, and Shareholders’ Undistributed Taxable Income
Previously Taxed, of the 1999 income tax return of either MMCD or
MMSD that the S corporations had assumed the liability to cover
the short position in Treasury notes.
On April 13, 2006, respondent issued a notice of deficiency
reducing petitioners’ bases in the MMCD and MMSC stock by
- 4 -
$5,700,000 and $6,460,000, respectively.2 The result was a
$12,160,000 increase in the capital gain from the sale.
Respondent contends that the bases in the MMCD and MMSC stock
were inflated because they were not reduced by the liability to
close the short position.
On July 11, 2006, petitioners filed a timely petition with
this Court. On September 11, 2007, petitioners filed a motion
for summary judgment on the ground that the notice of deficiency
was issued after the period of limitations had expired.
Petitioners contend that overstatement of basis is not an
omission from gross income for purposes of the extended period of
limitations under section 6501(e)(1)(A).
On February 19, 2008, respondent filed his notice of
objection to petitioners’ motion, agreeing that the material
facts necessary to determine whether petitioners actions
constitute an omission from gross income are not in dispute.
Respondent contends, however, that there is a genuine issue of
fact as to whether the notice of deficiency was timely issued
under section 6501(e).
2
Respondent also disallowed $155,858 of petitioners’
itemized deductions.
- 5 -
Discussion
Summary judgment is intended to expedite litigation and
avoid unnecessary and expensive trials. Fla. Peach Corp. v.
Commissioner, 90 T.C. 678, 681 (1988). The Court may grant
summary judgment when there is no genuine issue of material fact
and a decision may be rendered as a matter of law. Rule 121(b);
Sundstrand Corp. v. Commissioner, 98 T.C. 518, 520 (1992), affd.
17 F.3d 965 (7th Cir. 1994); Zaentz v. Commissioner, 90 T.C. 753,
754 (1988). The moving party bears the burden of proving that
there is no genuine issue of material fact. Dahlstrom v.
Commissioner, 85 T.C. 812, 821 (1985); Naftel v. Commissioner, 85
T.C. 527, 529 (1985). The Court will view any factual material
and inferences in the light most favorable to the nonmoving
party. Dahlstrom v. Commissioner, supra at 821; Naftel v.
Commissioner, supra at 529.
Under the general rule set forth in section 6501(a), the
Internal Revenue Service is required to assess the tax (or send a
notice of deficiency) within 3 years after a Federal income tax
return is filed. Section 6501(e)(1)(A) extends the limitations
period to 6 years “If the 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”.
Section 6501(e)(1)(A) was first enacted as section 275(c) of
the Revenue Act of 1934 (1934 Revenue Act), Ch. 277, 48 Stat.
- 6 -
745. See Badaracco v. Commissioner, 464 U.S. 386, 392 (1984).
In 1954 Congress made several changes to this provision. See H.
Rept. 1337, 83d Cong., 2d Sess. A414 (1954); S. Rept. 1622, 83d
Cong., 2d Sess. 584-585 (1954). Section 6501(e)(1)(A)(i)
provides an exception to the general definition of gross income,
stating that
In the case of a trade or business, the term ‘gross
income’ means the total of the amounts received or
accrued from the sale of goods or services * * * prior
to the diminution by the cost of such sales or
services.
Also, section 6501(e)(1)(A)(ii) provides a “safe harbor” for a
taxpayer who otherwise has made a substantial omission, stating
that
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.
Respondent argues that the overstatement of basis in a
context outside of the sale of goods or services should constitute
an omission from gross income and thus trigger the 6-year
limitations period under section 6501(e)(1)(A).3
3
Respondent also argues, alternatively, that petitioners’
transfer of Treasury notes to the S corporations should be recast
as bona fide and that petitioners’ two S corporations omitted
income from their returns by failing to report the close of their
short positions. See sec. 1.1233-1(a)(1), Income Tax Regs. In a
short sale, the timing of gain or loss recognition remains open
(continued...)
- 7 -
In Colony, Inc. v. Commissioner, 357 U.S. 28, 33, 37 (1958),
the Supreme Court, interpreting section 275(c) of the 1934 Revenue
Act, the predecessor of section 6501(e), held that the extended
period of limitations applies to situations where specific income
receipts have been “left out” in the computation of gross income
and not when an understatement of gross income resulted from an
overstatement of basis. The facts of Colony dealt with a taxpayer
who developed and sold lots in a subdivision. Id. at 30-31.
In Bakersfield Energy Partners, LP v. Commissioner, 128 T.C.
207 (2007), affd. 568 F.3d 767 (9th Cir. 2009), a partnership
(Bakersfield) which owned oil and gas property used the Internal
Revenue Code’s partnership termination and transfer provisions to
increase its basis in that property before selling it to a third
party in 1998.4 The Commissioner issued a notice of final
3
(...continued)
until the seller closes the sale by replacing the borrowed
property. Hendricks v. Commissioner, 51 T.C. 235, 241 (1968),
affd. 423 F.2d 485 (4th Cir. 1970). Respondent contends that, if
petitioners’ bases in the S corporations were increased by their
transfer of Treasury notes to MMCD and MMSD, the S corporations
should have recognized gain of $12,160,000 when they closed the
short sale obligation. Respondent’s reasoning is flawed,
however, as his analysis does not take into account the transfer
of petitioners’ short sale obligation to MMCD and MMSD, which
lowered petitioners’ bases in both S corporations by the same
amount their bases were raised through the transfer of the
Treasury notes. See Rev. Rul. 95-45, 1995-1 C.B. 53.
Ultimately, respondent’s alternative argument results in the same
overstatement of basis issue present in the notice of deficiency.
4
Specifically, four of the seven partners in Bakersfield
took the following steps to increase Bakersfield’s zero basis in
(continued...)
- 8 -
partnership administrative adjustment (FPAA) almost 6 years after
Bakersfield filed its return for 1998, and Bakersfield contended
that the FPAA was untimely under Colony. Because Bakersfield did
not omit any income receipt or accrual in its computation of gross
income, we held that the Supreme Court’s decision in Colony
applied and Bakersfield’s overstatement of basis did not trigger
the extended limitations period. Bakersfield Energy Partners, LP
v. Commissioner, supra at 215-216. As part of our holding, we
stated that neither “the language or the rationale of Colony, Inc.
can be limited to the sale of goods or services by a trade or
business.” Id. at 215.
Respondent contends that Bakersfield was wrongly decided and
that Colony should be limited to cases where the taxpayer is
4
(...continued)
its oil and gas property: (1) The four partners formed a new
partnership, Bakersfield Resources, L.L.C. (Resources); (2) the
four partners sold their partnership interests in Bakersfield to
Resources for $19,924,870. The four partners held a collective
majority stake in Bakersfield and thus caused a technical
termination of the Bakersfield partnership and the formation of a
new partnership in which Resources held a majority interest under
sec. 708(b)(1)(B); (3) the new Bakersfield partnership elected to
increase its basis in partnership assets by the $19,924,870 sale
price of the partnership interests sold to Resources following
the transfer of partnership interest pursuant to secs. 754 and
743. Bakersfield allocated $16,515,194 of its new $19,924,870
basis to its oil and gas property and the rest to its other
assets; (4) Bakersfield sold its oil and gas property to a third
party for $23,898,611.
- 9 -
involved in the sale of goods and services.5 First, respondent
argues that Colony’s interpretation of section 275(c) of the 1934
Revenue Act is not binding because its successor statute, section
6501(e)(1)(A), is materially different (the materiality argument).
Second, respondent argues that Colony interpreted section 275(c)
of the 1934 Revenue Act as having the same meaning as section
6501(e)(1)(A)(i) and thus Colony should apply only to taxpayers
who realize gross receipts from sales or services in the course of
a trade or business (the interpretation argument).
The Commissioner raised these same arguments with regard to
Bakersfield in the Court of Appeals for the Ninth Circuit.
Bakersfield Energy Partners, LP v. Commissioner, 568 F.3d at 775.
Addressing the materiality argument, the Court of Appeals for the
Ninth Circuit noted that Congress did not change the language in
the body of section 6501(e)(1)(A), which is identical to the
5
Several cases have questioned the continuing viability of
Colony, Inc. v. Commissioner, 357 U.S. 28 (1958) in the light of
the 1954 amendments to sec. 6501(e)(1)(A). For example, in CC &
F W. Operations Ltd. Pship. v. Commissioner, 273 F.3d 402, 406
n.2 (1st Cir. 2001), affg. T.C. Memo. 2000-286, the Court of
Appeals for the First Circuit stated that “Whether Colony’s main
holding carries over to section 6501(e)(1) is at least doubtful”,
suggesting that the Supreme Court’s gross income test applies
only to sales of goods and services covered by sec.
6501(e)(1)(A), but not to other types of income. That position,
however, was not adopted by other Courts of Appeals. Most
recently, the Court of Appeals for the Federal Circuit determined
that there was no “basis for limiting Colony’s holding concerning
the ‘omits from gross income’ language of I.R.C. § 275(c) to
sales of goods or services by a trade or business.” Salman Ranch
Ltd v. United States, __ F.3d __ (Fed. Cir., July 30, 2009) (slip
op. at 20).
- 10 -
language in section 275(c) of the 1934 Revenue Act that the
Supreme Court construed in Colony.6 Id. at 775-776. Addressing
the interpretation argument, the Court of Appeals noted that the
Supreme Court expressly avoided construing the 1954 Code and “did
not even hint” that its interpretation of section 275(c) of the
1934 Revenue Act was limited to cases in which the taxpayer was
engaged in a trade or business. Id. at 778.
We believe that it would be inappropriate to “distinguish and
diminish the Supreme Court’s holding in Colony”. Bakersfield
Energy Partners, LP v. Commissioner, 128 T.C. at 215. The
principles of Colony apply where a taxpayer overstates his basis.
In both Colony and Bakersfield the taxpayers artificially inflated
their bases in assets that were subsequently sold. Although
Colony dealt with the sale of land and Bakersfield with the sale
6
The Court of Appeals for the Ninth Circuit also dismissed
the Commissioner’s sub-argument that applying Colony to the 1954
Code would render sec. 6501(e)(1)(A)(i) superfluous:
Section 6501(e)(1)(A) requires a comparison of two
numbers: (1) the “gross income” omitted with (2) the
“gross income” stated in the return. If the first
number divided by the second number is greater than
25%, then the 6-year limitations period applies.
Because § 6501(e)(1)(A)(i) changes the definition of
“gross income” for taxpayers in a trade or business, it
potentially affects both the numerator (the omission
from gross income) and the denominator (the total gross
income stated in the return). Colony’s holding,
however, affects only the numerator, by defining what
constitutes an omission from gross income.
Bakersfield Energy Partners, LP v. Commissioner, 568 F.3d 767,
776 (9th Cir. 2009), affg. 128 T.C. 207 (2007).
- 11 -
of oil and gas property, in neither case did the taxpayer fail to
report gross income on a return for purposes of the extended
limitations period.
We assume that petitioners overstated the bases of their S
corporations on their 1999 return. Under Colony and Bakersfield,
petitioners did not omit income from their return such as would
subject them to the extended period of limitations. Accordingly,
petitioners’ motion for summary judgment will be granted.
In reaching these holdings, the Court has considered all
arguments made and, to the extent not mentioned, concludes that
they are moot, irrelevant, or without merit.
To reflect the foregoing,
An appropriate order and
decision will be entered.