CC & F Western Operations Ltd. Partnership v. Commissioner

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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