Beard v. Comm'r of Internal Revenue

• Decision Date: 08 April 2011
• Docket Number: No. 09–3741.,09–3741.
• Parties: Kenneth H. BEARD and Susan W. Beard, Petitioners–Appellees,v.COMMISSIONER OF INTERNAL REVENUE, Respondent–Appellant.
• Court: U.S. Court of Appeals — Seventh Circuit

633 F.3d 616

107 A.F.T.R.2d 2011-552

2011-1 USTC P 50,176

Kenneth H. BEARD and Susan W. Beard, Petitioners–Appellees,

v.COMMISSIONER OF INTERNAL REVENUE, Respondent–Appellant.

No. 09–3741.

United States Court of Appeals, Seventh Circuit.

Argued Sept. 27, 2010.Decided Jan. 26, 2011.Rehearing and Rehearing En Banc Denied April 8, 2011.

Robert E. McKenzie (argued), Attorney, Arnstein & Lehr LLP, Chicago, IL, for Petitioners–Appellees.Michael J. Haungs, Attorney, Department of Justice, Civil Division, Immigration Litigation, Washington, DC, Joan I. Oppenheimer (argued), Attorney, Department of Justice, Tax Division, Appellate Section, Washington, DC, Gilbert S. Rothenberg, Deputy Assistant Attorney General, Department of Justice, Office of the Attorney General, Washington, DC, for Respondent–Appellant.Before ROVNER, EVANS, and WILLIAMS, Circuit Judges.EVANS, Circuit Judge.

This case presents the seemingly simple question of whether an overstatement of basis in ownership interests is an omission of income under the Internal Revenue Code Section 6501(e) ¹, thereby triggering a six-year, rather than the standard three-year, statute of limitations. But things are not always as they appear—the answer to the seemingly simple question requires a rather lengthy discussion of a case decided more than a half-century ago, in 1958, the year Elvis Presley was inducted into the army.

At issue here is a variant on a Son–of–BOSS (Bond and Option Sales Strategy) transaction, a type of abusive (so says the government) tax shelter that was popular a few years back. On the other side of this dispute, Kenneth and Susan Beard give the transaction a much more benign handle calling it simply “a tax advantaged transaction.” We think the government's characterization is closer to the mark.

In a Son–of–BOSS transaction, an individual uses a short sale mechanism to artificially increase his basis in a partnership interest prior to selling the interest, thereby limiting his capital gains tax on the sale. A short sale is a “sale in which an investor sells borrowed securities in anticipation of a price decline and is required to return an equal number of shares at some point in the future.” http:// www. investopedia. com/ terms/ s/ shortsale. asp (last visited Jan. 5, 2011). As such, a short sale produces proceeds from the sale of the shares as well as an outstanding liability in the amount of the number of borrowed shares multiplied by the current price per share. This liability disappears when the short is closed out, and the hope of the usual short seller is that between the time he borrows the shares and the time he closes out the short, the price per share will have dropped so that he makes more selling the borrowed shares up front than he spends later to replace them. The tax gain or loss recognition in a short sale is delayed until the seller closes the sale by replacing the borrowed property. Hendricks v. Commissioner of Internal Revenue, 51 T.C. 235, 241, 1968 WL 1424 (1968), aff'd 423 F.2d 485 (4th Cir.1970).

Short selling is often a way to hedge against the market, but a Son–of–BOSS transaction relies on the delayed tax recognition of a short sale for a gamble of a different kind. In Son–of–BOSS, the taxpayer contributes the proceeds of the short and the corresponding obligation to close out the short to another legal entity in which he has ownership rights (usually a partnership). The taxpayer (or, perhaps more accurately, the tax-avoider) then sells his rights in the partnership, claiming an inflated outside basis in the partnership corresponding to the amount of the transferred proceeds without an offsetting basis reduction for the transferred liability. This is advantageous for the taxpayer because the capital gains tax on such a transaction is calculated by subtracting the outside basis from the amount recognized in the sale of the ownership rights, so a higher outside basis means lower capital gains tax and more money in the pocket of the taxpayer. Therefore, the gamble in the Son–of–BOSS transactions was that the participant could legally increase his outside basis in a partnership by not reporting the offsetting transferred contingent liability of the short position on his tax return.

In 2000, the IRS issued Notice 2000–444, effectively invalidating future Son–of–BOSS transactions, and courts began to invalidate these transactions as lacking economic substance. Bernard J. Audet, Jr., One Case to Rule Them All: The Ninth Circuit in Bakersfield Applies Colony to Deny the IRS An Extended Statute of Limitations in Overstatement of Basis Cases, 55 Villanova Law Review 409, 411–12 (2010). In 2004, the IRS offered a settlement initiative to approximately 1,200 identified taxpayers, but that left a large number of taxpayers who did not qualify or who had not yet been identified as taking part in a Son–of–BOSS transaction. Id. at 412.

With this in mind, we turn to the facts of this case. In 1999, Kenneth Beard participated in a short sale of U.S. Treasury Notes, recognizing cash proceeds of $12,160,000. Beard used these proceeds to buy more Treasury Notes in two transactions of $5,700,000 and $6,460,000. He then transferred these Treasury Notes to two companies in which he was majority owner, MMCD, Inc. and MMSD, Inc., respectively, along with the obligation to close out the short positions. On that same day, MMCD and MMSD sold these Treasury Notes and closed out the short positions for $7,500,000 and $8,500,000, respectively. Beard then sold his ownership interests in the two companies.

On their 1999 tax return, the Beards reported long-term capital gains of $413,588 and $992,748 from the sale of the MMCD and MMSD stock, respectively. They arrived at these numbers by subtracting bases of $6,161,351 and $6,645,463 from the sale prices of $6,574,939 and $7,638,211. The Beards 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. The high bases in MMCD's and MMSD's stock resulted from the asymmetric treatment of the short sale transactions—Beard had increased his outside bases in the companies by the amount of the short sale proceeds contributed to each company, but had not reduced the bases by the offsetting obligation to close the short positions. The 1999 tax returns of MMCD and MMSD did not indicate that these S-corporations had assumed the liability to cover the short positions.

In 2006, almost six years after the Beards filed their 1999 tax return, the IRS issued a notice of deficiency, reducing the Beards' bases in the MMCD and MMSD stock by the amount of the transferred Treasury Notes, and thereby increasing the Beards' taxable capital gains on the sales of the companies by $12,160,000. The Beards contested this deficiency in tax court, and, rather than disputing the facts, moved for summary judgment on the grounds that overstatement of basis is not an omission from gross income for the purpose of the extended six-year statute of limitations under Section 6501(e) of the Code, and so the IRS was out of luck as the notice of deficiency came too late. The tax court agreed and granted summary judgment, finding that the principles of Colony, Inc. v. Commissioner of Internal Revenue, 357 U.S. 28, 78 S.Ct. 1033, 2 L.Ed.2d 1119 (1958), applied in this case. The Commissioner of the Internal Revenue Service appeals. We review the tax court's decision de novo. See Bell Federal Savings & Loan Ass'n v. Commissioner of Internal Revenue, 40 F.3d 224, 226 (7th Cir.1994).

Although decided after the 1954 revisions, Colony (which was decided in 1958) interprets Section 275(c) of the 1939 Code, the predecessor to current Section 6501(e)(1)(A). Section 275(c) allowed for a five-year statute of limitations for tax assessment, rather than the normal three-year limit, in cases where “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.” Essentially the same language is found in current Section 6501(e)(1)(A), although the extended statute of limitations is now six years, rather than five.

The taxpayer in Colony was a real estate company which understated its business income from selling residential lots by erroneously including unallowable items of development expense in the calculation of the lots' bases. Colony, 357 U.S. at 30, 78 S.Ct. 1033. In finding that the overstatement of basis was not an omission from gross income that triggered the longer statute of limitations, the Court noted that although “it cannot be said that the [statutory] language is unambiguous,” the legislative history of Section 275(c) provides “persuasive evidence that Congress was addressing itself to the specific situation where a taxpayer actually omitted some income receipt or accrual in his computation of gross income, and not more generally to errors in that computation arising from other causes.” Id. at 33, 78 S.Ct. 1033.

After reviewing the legislative history, the Court believed that Congress' purpose was to provide extra time 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.” Id. at 36, 78 S.Ct. 1033. Finally, the Court concluded that “the conclusion we reach is in harmony with the unambiguous language of § 6501(e)(1)(A) of the Internal Revenue Code of 1954.” Id. at 37, 78 S.Ct. 1033. The question facing us then is: Was the tax court correct to apply the principles of Colony to this dispute involving the 1954 Code?

The question has been addressed by multiple federal courts, with differing results. Some have found that Colony does not apply and an overstatement of basis can be an omission from gross income. See, e.g., Phinney v....