U.S. Supreme Court Decision May Pave Way for Future IRS Lawsuits

The U.S. Supreme Court recently rendered a unanimous opinion holding that the Anti-Injunction Act (AIA) did not block a lawsuit brought by CIC Services against the Internal Revenue Service (IRS), delivering an important victory to CIC and similarly situated taxpayers everywhere. While an important question must still be decided by the lower court – whether the IRS violated the Administrative Procedure Act (APA) – the Supreme Court's May 2021 decision has significant implications.

Facts of the Case

In 2004, Congress enacted Section 6707A of the Internal Revenue Code authorizing the imposition of penalties for failure to provide the IRS information with respect to "reportable transactions."¹ The penalties apply not only to taxpayers, but also material advisors (i.e., those that assist taxpayers such as attorneys, accountants, etc.). Penalty amounts for noncompliance can be severe – up to $200,000 as well as criminal prosecution.

In late 2016, the IRS published Notice 2016-66 (Notice), which identified certain micro-captive transactions as "transactions of interest," a type of reportable transactions. Stated simply, micro-captive transactions are a form of self-insurance through a related (or "captive") party. In the Notice, the IRS explained that such transactions have a potential for tax avoidance or evasion. Characterizing micro-captive transactions as transactions of interest triggered the reporting requirement for taxpayers and their material advisors under Section 6707A.

CIC – a material advisor to taxpayers engaging in micro-captive transactions – alleged that the Notice violated the APA. The IRS countered that the AIA – a longstanding law that generally requires taxpayers to receive an assessment, pay a tax or penalty, or be in collection status before bringing suit – prohibited CIC's lawsuit. In this case, CIC had not violated the Notice and therefore there were no penalties to pay first; rather, CIC argued that it, given the consequences, it would never be willing to violate the Notice. The U.S. District Court for the Eastern District of Tennessee and the U.S. Court of Appeals for the Sixth Circuit agreed with the IRS by holding that CIC's pre-enforcement challenge of the Notice was blocked by the AIA.

Decision by the U.S. Supreme Court

U.S. Supreme Court Associate Justice Elena Kagan authored the unanimous reversal of the Sixth Circuit, holding that a suit challenging the Notice is not barred by the AIA. The justices reasoned that CIC sought to set aside the Notice, not the tax penalty that could result from a failure to report the micro-captive transactions as required by the Notice. The Supreme Court rejected the IRS' argument that there was no real difference between the suit to invalidate the Notice and an action to restrain the tax penalty.

The justices identified three key aspects to support their repudiation of the IRS' claim: 1) the Notice imposes affirmative reporting requirements that are separate from the tax penalty for noncompliance, 2) the relationship between the lawsuit to invalidate the Notice and the restraint on tax assessment was too attenuated for application of the AIA and 3) the existence of criminal prosecution for failure to comply with the Notice forced CIC to bring a pre-enforcement suit because otherwise a party seeking to challenge the Notice would first have to defy the reporting rules and risk criminal punishment.

Next Steps

As the AIA is not a bar to CIC's lawsuit, the lawsuit will now proceed on the merits, i.e., whether the IRS violated the APA by issuing the Notice. CIC asserts that the IRS violated the APA because it did not follow public notice-and-comment procedures and was arbitrary and capricious because it imposed new reporting requirements without a proven need. A preliminary issue, however, is whether the APA even applies to notices like the one at issue.

Coincidentally, a few days before the Supreme Court's decision in CIC, the U.S. District Court for the Eastern District of Michigan in Mann Constr., Inc. et al. v. United States, 2021 US Dist Lexis 91344 (E.D. Mich. May 13, 2021) answered the preliminary question in favor of the IRS. In Mann, the notice at issue was similar to the Notice in that it designated a reportable transaction, thereby triggering Section 6707A reporting. The government argued that the APA's public notice-and-comment rule did not apply because Section 6707A's intent was clear that notice and comment was not required.

Section 6707A states that the term "reportable transaction" means "any transaction with respect to which information is required to be included with a return or statement because, as determined under regulations … [and is] of a type which the Secretary determines as having a potential for tax avoidance or evasion." In Mann, the government pointed out that IRS had in fact promulgated a regulation subject to APA, and in that regulation gave itself the authority to identify reportable transactions by a notice, not subject to the APA. See Treas. Reg. §1.6011-4(b)(2).

The government concluded its argument by claiming that Congress had given the IRS authority to identify reportable transactions by notice and such authority overrides the APA. The government noted that promulgation of more than 30 similar notices – without legislative protest – was further proof that Congress intended for the APA not to apply.

The court agreed with the IRS. Notably, however, neither the parties nor the court made reference to Mayo Foundation for Medical Educ. and Research v. U.S., 562 U.S. 44 (2011), which stands for the proposition that the APA applies to tax guidance. See also National Cable & Telecommunications Ass'n v. Brand X Internet Services et al., 545 U.S. 967 (2005). Just as important, at the time Mann was decided, the court did not have the benefit of the Supreme Court decision in CIC Services. Mann has been appealed to the Sixth Circuit and the result there may be different in light of these facts.

Implications

Will the Treasury and the IRS Change Their Tune?

Over time, there has been an evolution of case law concerning the application of the APA to tax guidance. As noted above, the Supreme Court has confirmed that the APA applies to tax guidance. Reinforced by cases like the U.S. Court of Appeals for the Fifth Circuit's Chamber of Commerce v. U.S. Department of Labor (validity of temporary Section 7874/inversion regulations) and the U.S. Court of Appeals for the District of Columbia Circuit's Florida Bankers Association v. U.S. Department of the Treasury (validity of bank reporting regulations), Treasury and the IRS need to pay more attention to the APA and other procedural regulatory requirements during the guidance process.

During the Trump Administration, Treasury and the IRS seemed to take heed, for example by fortifying the preambles to tax regulations and including lengthy reasoning of their decisions. A change was also made to require further review of tax regulations by the Office of Management and Budget (OMB). The decision in CIC Services will continue to force the Treasury and the IRS to devote more time to complying with the APA during the guidance process, which is good for the agency and taxpayers. As a result, taxpayers will better understand the choices made and the decision-making process used by the government.

Perhaps the biggest potential change will come after resolution on the merits of CIC Services. If the court rules that the APA applies to informal guidance like notices, revenue rulings and frequently asked questions (FAQs), the IRS will need to carefully consider when to issue informal guidance verses formal rulemaking. Reluctance to issue informal guidance without the required APA public notice-and-comment is not without cost – informal guidance is a quick way for the IRS to clarify issues on which taxpayers can rely. For example, taxpayers frequently look to FAQs for newly enacted legislation and for issues that arise during filing season, such as how to notify the IRS of an address change or handle a Form W-2 with errors.

As we consider the removal of the AIA as a hurdle for some (or all) APA challenges, will Treasury and the IRS be unwilling to issue informal guidance given concern that a taxpayer could march into court? At this point, it is too early to tell whether Treasury and the IRS will change their tune.

Will We See a Tsunami of Lawsuits?

The IRS argued in CIC Services that a holding in favor of the taxpayer on the AIA would open the floodgates for taxpayers to bring lawsuits. Perhaps the Supreme Court's attempt to narrow its holding, along with the narrow reading of the holding by Justices Sonia Sotomayor and Brett Kavanaugh in their concurring opinions, will limit the number of potential cases.

More importantly, the Supreme Court did not completely eviscerate the AIA and remove other hurdles to litigate pre-enforcement or collection. A taxpayer, for example, still cannot seek injunctive relief for the purpose of preventing the assessment or collection of tax as the AIA continues to apply in such situations. Further, a taxpayer must have standing (i.e., it must be impacted by the Treasury and IRS guidance), and the challenge must be about the validity of the impacting guidance. In addition, the taxpayer will retain the burden of proof to demonstrate that the guidance violated the APA or the guidance conflicts with a statute.

The vast majority of Treasury and IRS' guidance is not controversial. However, for controversial guidance, CIC Services may pave the way for other taxpayers wishing to bring a pre-enforcement. Likely candidates include the Section 385 regulations and various Tax Cuts and Jobs Act guidance in which the Treasury and the IRS attempted to address the gap between Dec. 31, 2017, and the first fiscal year beginning in 2018. Also, some taxpayers may challenge the validity of Section 965 and some of the policies in the Section 965 final regulations. More pre-enforcement challenges are coming, but it is unclear if it will be the tsunami the IRS fears.

Conclusion

CIC Services was a significant win for taxpayers, and it is important to taxpayers that the Treasury and IRS follow the protections guaranteed by the APA. However, it is too early to tell what actions the Treasury and IRS make take in response and whether, as the government fears, the floodgates to additional cases are open.

Notes

¹ A reportable transaction is one that the IRS has identified as having potential for tax avoidance or evasion.

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