Bakersfield Energy Partners, Lp v. C.I.R.

• Decision Date: 17 June 2009
• Docket Number: No. 07-74275.,07-74275.
• Citation: 568 F.3d 767
• Parties: BAKERSFIELD ENERGY PARTNERS, LP, Robert Shore, Steven Fisher, Gregory Miles, Scott McMillan, Partners other than the Tax Matters Partners, Petitioners-Appellees, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellant.
• Court: U.S. Court of Appeals — Ninth Circuit

568 F.3d 767

BAKERSFIELD ENERGY PARTNERS, LP, Robert Shore, Steven Fisher, Gregory Miles, Scott McMillan, Partners other than the Tax Matters Partners, Petitioners-Appellees, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellant.

No. 07-74275.

United States Court of Appeals, Ninth Circuit.

Argued and Submitted February 9, 2009.

Filed June 17, 2009.

Steven R. Mather, Beverly Hills, CA, for the petitioners-appellees.

Joan I. Oppenheimer, Washington, D.C., for the respondent-appellant.

Appeal from a Decision of the United States Tax Court. Tax Ct. No. 4204-06.

Before: ANDREW J. KLEINFELD, CARLOS T. BEA, and SANDRA S. IKUTA, Circuit Judges.

IKUTA, Circuit Judge:

The IRS generally has three years after a return is filed to assess a tax deficiency, but it has six years to do so when the return "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." 26 U.S.C. § 6501(a), (e)(1)(A). This case requires us to decide whether the IRS can use this extended six-year limitations period to assess a deficiency where a taxpayer has overstated its basis in an asset and thereby lowered the amount of gross income reported in its return. In other words, does a taxpayer "omit[] from gross income an amount properly includible therein" for purposes of § 6501(e)(1)(A) by overstating its basis? We conclude, like the Tax Court below, that we are bound by Colony, Inc. v. Comm'r, 357 U.S. 28, 33, 78 S.Ct. 1033, 2 L.Ed.2d 1119 (1958), which held that a taxpayer's overstatement of basis does not "omit[] from gross income an amount properly includible therein" for purposes of § 6501(e)(1)(A). Accordingly, the IRS had only three years to assess the tax deficiency at issue in this case, and it failed to do so. We therefore affirm the Tax Court's judgment in favor of the taxpayer.

I

Bakersfield Energy Partners, LP (Bakersfield), the taxpayer in this case, is a limited partnership that owned an interest in oil and gas property.¹ A third party Seneca, offered to purchase the property for $23,898,611.

According to the IRS, before the sale was consummated, four of the seven partners in Bakersfield took a series of steps that led Bakersfield to increase its basis in its oil and gas property and thereby decrease its gross (and potentially taxable) income from the sale.² Before taking these steps, Bakersfield's basis in the oil and gas property was zero.

The steps were as follows: First, the four partners formed a new partnership, Bakersfield Resources, LLC (Resources). Second, the four partners sold their partnership interests in Bakersfield to Resources for $19,924,870. The four partners collectively owned 76.3% of Bakersfield; by selling more than half of the total partnership interests in Bakersfield, they caused a technical termination of the Bakersfield partnership and the formation of a new Bakersfield partnership in which Resources held a 76.3% interest. See 26 U.S.C. § 708(b)(1)(B). Third, the new Bakersfield partnership made use of certain tax provisions that allow a partnership to elect to increase its basis in partnership assets following a transfer of a partnership interest. See 26 U.S.C. §§ 754, 743. In this case, Bakersfield made an election under § 754 to adjust its basis in all of its assets by the $19,924,870 sales price of the partnership interests sold to Resources. Bakersfield allocated $16,515,194 of its new $19,924,870 basis to the oil and gas property and the remainder to its other assets. Fourth, after completing these steps to adjust its basis in its oil and gas property, Bakersfield consummated the sale of its oil and gas property to Seneca for $23,898,611 in May 1998.

On October 15, 1999, Bakersfield filed a partnership return for the tax year ending December 1998. The return reported that Bakersfield's gain from the sale of the oil and gas property was $7,383,417: the sales price of the oil and gas property ($23,898,611) minus its new adjusted basis ($16,515,194). Bakersfield's return also stated that its gain was reduced by mining exploration costs of $1,993,034. Accordingly, Bakersfield's return recognized a net taxable gain of $5,390,383 from the sale of the oil and gas property (the $7,383,417 gain minus the $1,993,034 in mining and exploration costs).

Bakersfield's partnership return included a short statement explaining its claimed basis:

Pursuant to IRC Sec. 708(b)(1)(B) and the regulations thereunder, Bakersfield Energy Partners, LP terminated on April 1, 1998. On that date, certain partners sold over a 50% ownership interest in the partnership's capital and profits to Bakersfield Resources, LLC (TEIN 77-0479718). On April 7, 1998, Bakersfield Resources, LLC acquired additional partnership interests through purchases. These transactions resulted in a new partnership for federal income tax purposes (the "new" partnership retains the same federal employer identification number).

As reflected within the capital accounts, the partnership books were restated to reflect the value of the assets as required in the regulations under IRC 704. As reflected within this return, in the event of a sale of these assets proper adjustments have been made to reflect the tax basis and the proper taxable gain.

Bakersfield also attached a statement indicating its election under 26 U.S.C. § 754 to adjust the basis in its assets in accordance with § 743(b)(1).

On October 4, 2005, almost six years after the return was filed on October 15, 1999, the IRS mailed Bakersfield a notice of final partnership administrative adjustment (FPAA). An FPAA tolls the limitations period in which the IRS can assess a tax deficiency. See 26 U.S.C. §§ 6503(a)(1), 6229(d). The IRS conceded before the Tax Court that, if the FPAA was untimely, there was no other basis for tolling the limitations period for any assessment and that summary judgment should therefore be entered in favor of Bakersfield. See Bakersfield Energy Partners v. Comm'r, 128 T.C. 207, 212, 2007 WL 1712543 (2007).

The FPAA claimed that Bakersfield's adjustment of its basis in the oil and gas property from zero to $16,515,194 was invalid because it "was the result of a sham transaction, a transaction lacking economic substance that had no business purpose and no economic effect and/or was availed for tax avoidance purpose and should not be respected for tax purposes." Because the IRS determined that Bakersfield's basis in the oil and gas property was zero, not $16,515,194, the IRS calculated that Bakersfield's gain from the sale of the oil and gas property to Seneca was $21,905,577, not $5,390,383. Based on this calculation, the IRS determined that Bakersfield had underpaid its taxes and was also liable for a 40% penalty on the underpayment.

Bakersfield petitioned the Tax Court for readjustment. Before the Tax Court, the parties filed cross-motions for summary judgment. Bakersfield claimed, among other things, that the FPAA was untimely under the three-year limitations period in 26 U.S.C. § 6501(a).³ The IRS argued that the FPAA was timely under the six-year limitations period in 26 U.S.C. §§ 6501(e)(1)(A)⁴ and 6229(c)(2).⁵ These provisions give the IRS six years in which to assess a tax when "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." 26 U.S.C. § 6501(e)(1)(A). The IRS claimed that, because this provision applied to Bakersfield's 1998 return, the FPAA was timely.

Applying the Supreme Court's decision in Colony to § 6501(e)(1)(A), the Tax Court determined that the three-year limitations period applied. See Bakersfield, 128 T.C. at 215-16. Accordingly, the Tax Court held that the IRS's FPAA was untimely and granted Bakersfield's motion for summary judgment. The IRS timely appeals. We have jurisdiction under 26 U.S.C. § 7482.

This case turns on whether the general three-year limitations period in § 6501(a), or the extended six-year limitations period in § 6501(e)(1)(A), applies to Bakersfield's 1998 partnership return, which was filed almost six years before the IRS mailed its FPAA to Bakersfield. The Supreme Court addressed this precise question over sixty years ago in Colony, when it interpreted the same language in an earlier version of the tax code. Thus the primary legal dispute in this case is whether Colony is controlling or whether it is distinguishable.⁶

II

Understanding the parties' arguments requires an overview of the extended limitations period in § 6501(e)(1)(A) and its precursor, § 275(c), which was the provision construed by the Supreme Court in Colony.

Section 275(c) of the 1939 tax code provided:

If the taxpayer omits from gross income an amount properly includible therein which is in excess of 25 per centum of the amount of gross income stated in the return, the tax may be assessed, or a proceeding in court for the collection of such tax may be begun without assessment, at any time within 5 years after the return was filed.

26 U.S.C. § 275(c) (1934 & Supp. V), 53 Stat. 86-87 (emphasis added). Other than replacing the five-year period with a six-year period, and "per centum" with "percent," this language in the 1939 Code is identical to the language in the body of the current provision, 26 U.S.C. § 6501(e)(1)(A).⁷

The 1939 Internal Revenue Code, like the current code, generally defined "gross income" as including gains from "dealings in property" and provided that "gain from the sale or other disposition of property shall be the excess of the amount realized therefrom over the adjusted basis." 26 U.S.C. § 22(a) (1934 & Supp. V), 53 Stat. 9; 26 U.S.C. § 22(f) (1934 & Supp. V), 53 Stat. 12; 26 U.S.C. § 111(a) (1934 & Supp. V), 53 Stat. 37. In other words, "gross income" under the 1939 Code had the same general meaning that it does under the current code: the total amount of money received (i.e., "gross receipts") minus basis. See 26...