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Three Years or Six to Audit? Substance and Procedure in
Intermountain
Tax code 6501(a) says that in general the IRS cannot audit a
taxpayer more than three years of when the tax is due but the limit is
six 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.”
In Intermountain, the IRS waited more than three years but less
than six to tell Intermountain it had reported too low an asset basis in
computing capital gains. After losing in a 13-judge review Tax Court
decision unanimous in the result, the IRS issued new regulations
making six years the limit and successfully pleaded for Chevron in its
appeal to the D.C. Circuit. Lots of other appeals turn on the same issue
and the circuits are split, so the Supreme Court will likely hear the case.
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ISSUES
ISSUE ONE: Is “to state too low a basis” included in “to omit from
gross income”?
ISSUE TWO. Did the D.C. Circuit correctly give Chevron deference to
the new rules, as opposed to using its best judgement as to how the
statute should be interpreted?
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MY ANGLE: In looking at both issues, it is crucial to think about the
costs and benefits of changing to the six-year rule.
Doing so helps show that “to omit from gross income” means “to
leave out” and not “to include but falsely report” because there are
sound reasons to have a shorter audit time for tax return items that
require taxpayer recordkeeping than for those that do not.
The DC Circuit wrongly gave Chevron deference because it is clear the
executive branch made no attempt to evaluate cost and benefits, so its
rulemaking procedure was invalid and fails. In addition, the sloppy
executive decisionmaking provides an argument against Chevron
deference itself as opposed to mere prudent consideration by the
courts of executive-branch arguments.
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WHAT I NEED TO DO TO WRITE THE PAPER
The trickiest part of writing the paper is to do or talk about doing
the cost-benefit analysis. It is easy to show that the IRS didn’t do it,
which is all that the law part of the paper really requires. But it seems
nobody in law-and-economics or law has seriously thought about how
long statutes of limitations should be, so I’d like to do that in this
paper. Thus, I want to list the costs and benefits, generally and for tax
laws, and I want to do at least a back-of-the-envelope calculation.
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QUESTIONS FOR THE AUDIENCE
1. How should I estimate the increased cost of recordkeeping from
increasing the statute of limitations to 6 years for capital gains?
2. What are the costs and benefits of a longer statute of limitations for
tax, civil, and criminal law?
3. Has anyone ever written on the optimal statute of limitations (a) in
any area of law, and (b) in tax?
4. What are the recordkeeping requirements for capital gains basis?
5. Can an administrative law APA challenge be made to IRS rules that
do not go through notice and comment?
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II. The 6-Year Limit Is a Hasty and Ill-Considered Rule.
Tax Advisors and Even the IRS Website Thinks the Statute of Limitations Is
Three Years for Capital Gains Basis, Not Six.
The most compelling example is from the IRS itself, on the main taxpayer
information webpage dealing with record-keeping:
“How long should the records related to a business or other long-term asset
be kept?
In the case of an asset, records related to the asset should generally be kept for as
long as you have the asset plus three years.”
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WHAT IS THE COMMON LAW?
If we thought of using the logic of the common law, which is to look at the
customs of the nation, the market, or the industry, a judge who is “discovering the
law” would fail to find any support for the 6-Year Limit. It is an unfilled gap in the
law only insofar as the issue has never been formally written down in a court
reporter; many many people have looked at the specific issue of how long the
statute of limitations is for underestimating capital gains and failed to see any gap
at all.
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Millions of Taxpayers Will Have Trouble Justifying the Incomes They
Have Truthfully Reported.
142 million personal income tax returns filed.
8 million had a net gain reported on Schedule D, 12 million a net loss.
5 million with net gains and 8 million with net losses had incomes of less than
$100,000.
This does not include corporations and trusts.
So we have 20 million total returns. Assume 30 million people over 3 years, lots of
overlap. 10 million people will have positive costs of keeping extra stuff.
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Even Once Taxpayers Have Adjusted, the 6-Year Limit Will Impose Heavy
Costs
MENTAL COSTS
(a) some records need to be kept for six years, some for three
(b) in particular, capital gains records need to be kept for six years, and everything
else for three.
This is more than a doubling of the complexity of the recordkeeping time rules. I
should find out how many steps the two regimes cost, using the methodology
Turing developed for computer science to measure the size of a computer program
(the necessary preliminary to his proof that particular tasks are “computable” or
not).
We have replaced the rule “all records need to be kept for three years” with the
rule “all but one kind of tax record need to be kept for three years, and that one
has to be kept for six.” 140 million personal income tax returns , so if $1`/extra
mental effort is $1/return, $140million/year.
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The other part of the record-keeping cost is the cost of keeping records for
an additional 3 more years. Part of this cost is the cost of the physical space or the
computer disk space, but most of it is the mental cost of having to look over extra
records to find particular information needed for any objective and the mental cost
of remembering which records to retain and which can be thrown away.
Using our estimate of 30 million taxpayer-years of extra record-keeping, if the
cost per taxpayer-year, if these two costs amount to $3/taxpayer-year, the total cost
is $90 million/year, which when capitalized at 5% amounts to $1.8 billion dollars.
The total cost of the 6-year rule is $4.6 billion, at a very rough estimate.
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D. The Optimal Statute of Limitations Trades Off Detecting More Cheating
against Incurring More Record-Keeping Costs.
Does anyone know of articles on the optimal length of statutes of limitations?
The optimal statute of limitations will trade off the cost of record-keeping
against the injustice of unpaid taxes and the loss of legitimate government revenue.
E. The Tradeoff between Compliance and Costs Is Good Reason For a
Three-Year Limit for Tax Items that Require Taxpayer Recordkeeping and
Six-Year for Items that Don’t.
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Colony said:
“We think that, in enacting § 275(c), Congress manifested no broader purpose
than to give the Commissioner an additional two years 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.”
Courts that have reached to the issue (instead of using Chevron deference) have
reasoned that “to omit” does not mean “to understate”.
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F. The Rulemaking Process Followed Here Has Been So Flimsy that
Nobody Has Even Noticed These Arguments, Much Less Addressed Them.
The IRS didn’t do the cost-benefit analysis that “significant regulatory actions”
require, even though millions of people are affected by this regulation.
“It has been determined that this notice of proposed rulemaking is not a
significant regulatory action as defined in Executive Order 12866. Therefore, a
regulatory assessment is not required. It also has been determined that section
553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5) does not apply to
these regulations and because these regulations do not impose a collection of
information on small entities, the Regulatory Flexibility Act (5 U. S.C. chapter 6)
does not apply. Pursuant to section 7805(f) of the Internal Revenue Code, these
regulations have been submitted to the Chief Counsel for Advocacy of the Small
Business Administration for comment on their impact on small business.” i
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Justice Scalia, unlike the other Justices in Brand-X, confronts the big question
directly: Must the Supreme Court itself defer to the executive agency?
“Imagine the following sequence of events: FCC action is challenged as ultra vires
under the governing statute; the litigation reaches all the way to the Supreme Court of the
United States. The Solicitor General sets forth the FCC's official position (approved by the
Commission) regarding interpretation of the statute. Applying Mead, however, the Court
denies the agency position Chevron deference, finds that the best interpretation of the statute
contradicts the agency's position, and holds the challenged agency action unlawful. The
agency promptly conducts a rulemaking, and adopts a rule that comports with its earlier
position--in effect disagreeing with the Supreme Court concerning the best interpretation
of the statute. According to today's opinion, the agency is thereupon free to take the action
that the Supreme Court found unlawful. ” (Scalia dissent, Brand-X)
Could Congress to write as part of a statute that it is to be interpreted by a panel
of nine members chosen by the President? The Courts would be left only with the
authority to declare the panel’s rulings arbitrary and capricious.
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Intermountain and the 2011 Stern v. Marshall bankruptcy case make for an
interesting comparison. In Stern v. Marshall, a federal Bankruptcy Judge decided a
claim of state tort law that was peripherally relevant to a bankruptcy case.
Afterwards, the state court decided the claim differently. The question is which
decision the federal District Court should take as the final judgement. That
decision was appealed up to the U.S. Supreme Court. The majority decided the
case narrowly, saying that the Bankruptcy Court could not enter final judgement in
a state law counterclaim:
Thus, Stern v. Marshall says that a Bankruptcy Court’s findings on state law
counterclaims, at least (it was a narrow holding),cannot constitutionally be final
judgements.
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Combining Stern v. Marshall with Brand-X gives us this view of current
Supreme Court thinking: We can trust those guys in ATF and the FBI to be
prudent and intelligent, and we can trust those guys in the IRS to be restrained in
their claims for executive authority, but when it comes to the court-appointed
bankruptcy judges --- reckless, emotionally involved, power-mad, and pea-brained-- watch out!
The Supreme Court thinks it can decide policy questions such as whether
homosexuality and abortion should be legal, and operational questions, such as the
fine details of police search procedure, but it is neither qualified nor empowered
to interpret the words of statutes. If a court is objective and wise enough to decide
when human life begins, surely it can figure out what “omits from gross income”
means.
What are appellate judges good at, if not at figuring out the meaning of
words?
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I suspect that the reason the Supreme Court was willing to adopt Chevron was
at least partly that the Justices do think their personal opinions on abortion and
homosexuality are more reliable than their personal opinions on tax law and
telecommunications.
Tax law, like mathematics and accounting, is an unmerciful subject. It is easy to
show that someone is objectively wrong and make them look stupid.
Or, putting it differently, it is easy to demonstrate one’s own stupidity, to oneself
and to others.
There is no royal road to geometry, but nobody ever said that about political
opinions.
Lots of people say they are no good at math, but nobody says they just can’t make
good political judgements.
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Yet it is perhaps in tax cases—particularly business tax cases--- that even those
judges have the most advantage over the median voter.
A judge may find tax cases boring and difficult, but he has a better chance of
understanding them than most people, which is not so clear when it comes to the
more glamorous areas of the law where justice matters more and close reading
matters less.
It is, moreover, in the boring areas of the law that we can expect judges to face
the least temptation to impose their own preferences instead of trying to follow the
law. “The more boring the case, the better the law.”
Politicians, in contrast, while also having neutral ideological preferences, can use
the opacity of tax law to transfer large sums of money to sophisticated supporters
or to conceal extravagance with public funds.
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Cases
Crowell v. Benson, 285 U.S. 22 (1932)
Dobson v. Commissioner, 320 U.S. 489 (1943)
Skidmore v. Swift & Co., 323 U.S. 134 (1944)
Colony Inc. v. Commissioner, 357 U.S. 28 (1958)
Simon v. E. Ky. Welfare Rights Org., 426 U.S. 26 (1975)
Northern Pipeline Constr. Co. v. Marathon Pipe Line Co., 458 U.S. 50 (1982)
Chevron UNIVERSITY OF S.A. Inc. v. Natural Resources Defense Council, 467 U.S. 837
(1984)
Finlay v. Canada (Minister of Finance), [1986] 2 S.C.R. 607
Salman Ranch Ltd. v. United States, 573 F.3d 1362 (Fed. Cir. 2009)
Salman Ranch v. United States, ___ F.3d ___, 2011 WL 2120044 (10th Cir. May 31, 2011)
Bakersfield Energy Partners v. Commissioner, 128 T.C. 207
(2007), aff’d, 568 F.3d 767 (9th Cir. 2009)
Intermountain Insurance Service of Vail v. Commissioner of Internal Revenue Service, 134
T.C. No 11 (2010) reversed, No. 10-1204 (June 21, 2011) (DC Circuit, 2011)
Mayo Foundation v. U S., 131 S.Ct. 704 (2011)
Grapevine Imports, Ltd. v. United States, 636 F.3d 1368 (Fed. Cir. 2011)
Home Concrete & Supply, LLC v. United States, 634 F.3d 249 (4th Cir. 2011)
Burks v. United States, 633 F.3d 347 (5th Cir. 2011)
Stern v. Marshall, (U.S., No. 10–179, June 23, 2011)
Hemmings v. Barian, 822 F.2d 688 (7th Cir.1987, Posner, J.)
Smiley v. Citibank, 517 U.S. 735 (1996)
First Chicago NBD Corp. v. Commissioner, 135 F.3d 457 (7th Cir., Posner. J., 1998) aff’g 96
T.C. 421 (1991)
Estate of McLendon v. Commissioner, T.C. Memo 1996-307 (quoting Stubbs, Overbeck &
Assocs. v. United States, 445 F.2d 1142, 1146-47 (5th Cir. 1971))
Patrick D. Hoctor v. United States Department of Agriculture, 82 F.3d 165 (7th Cir. 1996,
Posner, J.)
Christiansen v. Harris County, 529 U.S. 576 (2000)
United States v. Mead Corp., 533 U.S. 218 (2001)
Nat’l Cable & Telecomms. Ass’n v. Brand X Internet Servs., 545 U.S. 967 (2005)
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