Sixth Circuit Deals Major Blow to IRS for Failing to Follow Administrative Procedures Act Notice & Comment Requirements Before Issuing Listed Transaction Notice by ROBERT S. HORWITZ
As part of the 2004 Jobs Act, Congress added several provisions as part of the interminable effort to clear the tax system of abusive tax shelters:
- Sec. 6111, which requires “material advisors” to file returns disclosing information about reportable (including listed transactions);
- Sec. 6700, which imposes a penalty for failure to file a return, or filing an incomplete or false return, required under sec. 6111 of $50,000 or, in the case of a listed transaction, the greater of (a) $200,000 or (b) 50% of the gross income (75% for an intentional failure) derived prior to the filing of the return with respect to the transaction; and
- Sec. 6707A, which imposes a penalty on any person who fails to provide information on a reportable transaction required under sec. 6011.
Sec. 6707A(c) defined “reportable transaction” and “listed transaction” as
- Reportable transaction – 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 prescribed under section 6011, such transaction is of a type which the Secretary determines as having a potential for tax avoidance or evasion.
- Listed transaction – The term “listed transaction” means a reportable transaction which is the same as, or substantially similar to, a transaction specifically identified by the Secretary as a tax avoidance transaction for purposes of section 6011.
Besides civil penalties under secs. 6707 and 6707A, a person who willfully failed to file a return or filed a false return regarding a reportable or listed transaction could be subject to criminal penalties.
When it enacted these provisions, Congress did not address whether the IRS would have to comply with the Administrative Procedure Act when
identifying and defining reportable and listed transactions.
Since the 1990s, the IRS has been identifying what it determined were abusive tax avoidance transactions through various means. Sometimes the IRS would issue a regulation that identified a particular type of transaction as abusive, such as Treas. Reg. sec. 1.643(a)-8 (identifying abusive use of charitable remainder unitrusts). Other times the IRS would issue a revenue ruling identifying a transaction as abusive, such as Rev. Rul. 2000-12 (identifying certain debt straddles as abusive). Mostly, the IRS issued notices. See, IRS’s webpage Recognized Abusive and Listed Transactions, available online at https://www.irs.gov/businesses/corporations/listed-transactions#4.
Unlike regulations, notices are usually issued without offering interested persons notice and an opportunity to comment. One of the Notices was Notice 2007-83, which identified as listed transactions certain transactions involving the purchase of cash value life insurance policies connected to employer benefit plans.
In Mann Construction, Inc. v. United States, Dkt. No. 21-1500 (6th Cir. March 3, 2022), https://www.opn.ca6.uscourts.gov/opinions.pdf/22a0041p-06.pdf, the plaintiff corporation had an employee benefit plan in effect from 2013-2017 that paid premiums of cash value life insurance policies benefiting its principals. In 2019, the IRS determined that the transaction was that identified in Notice 2007-83. It assessed penalties against both the corporation and its principals, all of whom paid the penalties and filed refund claims. After the administrative route got them nowhere, they filed suit in district court, challenging the validity of the Notice because it (a) was issued without providing for notice and comment in violation of the Administrative Procedures Act (APA); (b) constituted unauthorized agency action; (c) was arbitrary and capricious; and (d) did not apply to the transaction engaged in by the taxpayers. The district court ruled for the Government on all issues and the taxpayers appealed to the Sixth Circuit, which reversed the district court, holding that Notice 2007-83 was invalid because it was issued in violation of the notice and comment requirements of the APA.
The Government argued that Notice 2007-83 was an “interpretive rule,” not a “legislative rule,” and, thus, was exempt from the APA’s notice and comment provisions. Addressing this argument, the Sixth Circuit focused on the difference between legislative and interpretive rules and found that the notice fell on the legislative side of the border:
Legislative rules have the “force and effect of law”; interpretive rules do not. Perez, 575 U.S. at 96–97 (quoting Shalala v. Guernsey Mem’l Hosp., 514 U.S. 87, 99 (1995)). Legislative rules impose new rights or duties and change the legal status of regulated parties; interpretive rules articulate what an agency thinks a statute means or remind parties of pre-existing duties. Tenn. Hosp. Ass’n, 908 F.3d at 1042. When rulemaking carries out an express delegation of authority from Congress to an agency, it usually leads to legislative rules; interpretive rules merely clarify the requirements that Congress has already put in place. Id. at 1043.
Measured by these metes and bounds, Notice 2007-83 amounts to a legislative rule. The Notice has the force and effect of law. It defines a set of transactions that taxpayers must report, and that duty did not arise from a statute or a notice-and-comment rule. It springs from the IRS’s own Notice. Taxpayers like Mann Construction had no obligation to provide information regarding listed transactions like this one to the IRS before the Notice. They have such a duty after the Notice. Obeying these new duties can “involve significant time and expense,” and failure to comply comes with the risk of penalties and criminal sanctions, all characteristics of legislative rules. CIC Servs., LLC v. IRS, 141 S. Ct. 1582, 1591 (2021); see also id. at 1592; Kristin E. Hickman, Unpacking the Force of Law, 66 Vand. L. Rev. 465, 524 (2013) (characterizing penalties as a leading indicator that a regulation is legislative rather than interpretive).
Slip op. at p. 5.
The Court dismissed the Government’s argument that the notice merely “interpreted” what was a “tax avoidance transaction” and, therefore, was an interpretive rule. Not so, responded the Court since under the notice a transaction that fell within its penumbra must be reported or the taxpayer faced a penalty. This made it a legislative rule.
The Sixth Circuit also rejected the Government’s argument that reportable/listed transaction notices were exempted by Congress from the APA’s notice and comment provisions. There is a baseline assumption that every agency action that will have the force and effect of law must comply with the notice and comment provisions before it becomes final. While Congress may carve out exceptions from the notice and comment requirement, the Government is required to show that Congress expressly did so. That was not the case with respect to sec. 6707A. Neither expressly nor by implication did the statute make the notice and comment provisions inapplicable nor did it create new procedures for determining what are listed or reportable transactions. “The statutes merely establish a disclosure and penalty regime for the IRS to administer. As to the statutory text, Congress did not change the background procedural requirements of the APA or otherwise indicate an exemption from those requirements in a ‘clear’ or ‘plain’ way that would make the APA’s procedures inapplicable to the IRS.” Slip op. at p. 9.
The Government also argued that, since a regulation in effect when sec. 6707A was enacted, which stated the IRS could identify listed and reportable transactions by “notice, regulation, or other form of published guidance,” Congress meant to exempt the identification of listed and reportable transactions from the APA’s notice and comment provisions. To the Court, this did not show what the Government claimed. All the regulation did was list the types of written documents in which it would identify listed and reportable transactions, not the procedure it would follow in issuing the guidance. Since Notice 2007-83 did not comply with the APA’s notice and comment provisions it was invalid. Thus, the district court was reversed.
This is not the first time that the IRS has run afoul of the APA over its failure to give notice and provide an opportunity for comment prior to issuing a listed transaction notice. In CIC Services, LLC v. Internal Revenue Service, 141 S.Ct. 1582 (2021), a unanimous Supreme Court held that the Anti-Injunction Act did not bar a material advisor on micro-captive insurance transactions from challenging Notice 2016-66, which identified certain micro-captive transactions as reportable transactions. On remand, the district court granted a preliminary injunction against the IRS enforcing the notice because it was a “legislative rule” that was invalid since it was issued without a notice and comment period, in violation of the APA. CIC Services, LLC v. Internal Revenue Service, 2021 WL 4481008 (E.D. TN, Sept. 21, 2021). CIC Services is appealable to the Sixth Circuit, so it is highly likely that the the micro-captive notice in that case will be held to be invalid. If courts in other circuits follow the Sixth Circuit, all listed/reportable transaction notices could be invalidated for failing to abide by the APA’s notice and comment requirement.
It has been more than ten years since the Supreme Court in Mayo Foundation for Medical Education & Research v. United States, 562 U.S. 44 (2011) stated that “[W]e are not inclined to carve out an approach to administrative review good for tax law only.” While no one could doubt the importance of the listing rules to curb abusive tax avoidance transactions, the notice and comment requirements of the APA are equally important and if Congress believes the IRS should be relieved of the requirement, it must clearly say so.