A Discussion of the Procedural Challenges to the Irs's Compliance With the Apa and Its Impact on Tax Litigation

• Publication year: 2023

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Jeffrey S. Luechtefeld ^*

Abstract: The Administrative Procedure Act (APA) places specific requirements on agencies of the federal government when engaged in a "rule making" that has the force and effect of law. Recently, the APA has become a focal point in tax litigation, due in large part to the IRS's history of refusing to comply with the process mandated by the APA. This article focuses on procedural challenges to the IRS's compliance with the APA based on the IRS's history of non-compliance with the APA's notice-and-comment requirement. It highlights recent trends in tax litigation and considers the future of APA challenges in this area.

The Administrative Procedure Act (APA) has been the law of the land since the end of World War II and has generally followed its current form since the mid-1960s. ¹ The APA places specific requirements on agencies of the federal government when engaged in a "rule making" that has the force and effect of law. ² Recently, the APA has had an increased presence in tax litigation, due primarily to the Internal Revenue Service's (IRS) history of refusing to comply with the process the agency has mandated. This article addresses procedural challenges to the IRS's compliance with the APA based on the IRS's history of non-compliance with the APA's notice-and-comment requirement, as raised in both refund, injunction, and Tax Court litigation. ³

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The APA: Generally, Government Agencies Must Follow Proscribed Procedures to Comply with the APA

As a general matter, when an agency of the federal government engages in rule making, it must (1) publish a general notice of proposed rule making in the Federal Register, (2) allow interested parties an opportunity to participate in the rule making, (3) consider relevant matters presented by interested parties, and (4) incorporate into any final rule a concise statement of basis and purpose. ⁴

Notice-and-comment rule making requires federal agencies "to include a 'concise' statement of why [the rule] was adopted and what it [was] intended to accomplish." ⁵ The basis and purpose statement must allow a reviewing court to "see the objections and why the agency reacted to them as it did." ⁶ At a minimum, the APA requires an agency to "respond to comments that can be thought to challenge a fundamental premise underlying" the rule. ⁷ To comply with notice-and-comment rule making, an agency must "consider the relevant materials presented" and "incorporate in the rules adopted a concise general statement of their basis and purpose." ⁸ In the face of significant comments, an agency must "give adequate reasons for its decisions." ⁹

The APA provides a remedy for a procedurally invalid rule making, in that a reviewing court must "hold unlawful and set aside agency action, findings, and conclusions of law found to be arbitrary, capricious, an abuse of discretion, or otherwise not in accordance with the law; . . . [or] without observance of the procedure required by law." ¹⁰ The Supreme Court has made the impact of this failure clear—"[agency action] subject to the APA cannot be afforded the 'force and effect of law' if not promulgated pursuant to the statutory procedural minimum found in [the APA]." ¹¹ When a court vacates an agency's rules under the APA, the vacatur restores the status quo before the invalid rule took effect. ¹² The vacatur applies to all, not just the named plaintiffs. ¹³

The APA and the IRS

For many years, the IRS believed that it was exempt from some of the requirements of the APA. ¹⁴ This belief was rooted in a

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distinction between interpretative and legislative agency actions. ¹⁵ This belief caused the agency to take positions that certain Treasury Regulations or notices were interpretive and exempt from complying with the APA. ¹⁶ In 2011, the Supreme Court put the IRS on notice that the IRS's general view of the APA was incorrect. ¹⁷ However, the IRS has not officially changed its views. ¹⁸ In fact, it continues to litigate the validity of certain notices issued without notice-and-comment. ¹⁹ It also recently argued, to no avail, that temporary, legislative regulations were not subject to the APA's notice-and-comment requirement. ²⁰ Even if the IRS changes its views, decades of rules and regulations remain that were imposed by the IRS without notice-and-comment, ripe for an APA challenge. ²¹

IRS "Listing" Notices Subject to Notice-and-Comment

Section 6011 provides the IRS with the authority to prescribe regulations requiring any person labile for tax to "make a return or statement according to the forms and regulations prescribed by the Secretary." ²² Based on this authority, the IRS promulgated Treasury Regulation § 1.6011-4, requiring taxpayers that participated in certain identified transactions to file a statement with the IRS. One category of transaction requiring disclosure are so-called "listed transactions." Listed transactions include transactions that are "the same or substantially similar to one of the types of transactions that the Internal Revenue Service (IRS) has determined to be a tax avoidance transaction and identified by notice, regulation, or other form of published guidance as a listed transaction." ²³ Another relevant category of transactions are "transactions of interest," which too are identified by the IRS by "notice, regulation, or other form of published guidance." ²⁴

Whether a transaction meets the definition of a listed transaction or transaction of interest takes on outsized importance, due in large part to a reporting requirement supported by a penalty regime for failure to disclose such transactions, or failure to file the precise instructions of the IRS in disclosing participation. For example, Section 6707A imposes an ostensibly strict-liability penalty of up to $200,000 for failure to disclose participation in a listed transaction. ²⁵ In fact, this penalty applies even if the taxpayer

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files the required disclosure form with their tax return, but failed to mail a duplicate copy to the IRS Office of Tax Shelter Analysis. ²⁶ Additionally, Section 6662A imposes an accuracy-related penalty attributable to a "reportable transaction understatement." The penalty under Section 6662A applies at a rate of 20% to 30% of the underpayment, depending on the level of disclosure; further, taxpayers facing this penalty have limited defenses to its application. ²⁷ The specter of these two penalties and limited ability to dispute those penalties makes the "listing" of a particular transaction by the IRS significant, as the reporting requirements to avoid the penalties come with significant compliance costs.

Recent APA Trends in Tax Litigation

The Supreme Court Paves the Way for Limited Pre-Enforcement Challenges to Listing Notices in CIC Services, LLC v. I.R.S.

In 2021, a unanimous Supreme Court issued an opinion in CIC Services, LLC v. I.R.S., allowing a taxpayer's APA challenge to an IRS listing notice to proceed. ²⁸ The Supreme Court's decision did not address the APA challenge on the merits; however, it is important to APA challenges in the tax context, as it clears a path for "pre-enforcement" review of certain agency actions. After the Supreme Court reversed and remanded, the district court struck down the IRS listing notice as invalid. ²⁹ Here context matters, so we start with a little background.

CIC Services was a manager of captive insurance companies. On March 27, 2017, CIC Services, along with a co-plaintiff, Ryan, LLC, sued the IRS to enjoin it from enforcing the material advisor disclosure requirements of Notice 2016-66. The IRS issued Notice 2016-66 less than six months earlier, in November of 2016, without following the APA's notice-and-comment procedure. ³⁰ Notice 2016-66 designated certain "micro" captive insurance transactions as transactions of interest, thus invoking the reporting and penalty regime discussed above. ³¹

The government argued that CIC's suit violated the tax code's "anti-injunction act," prohibiting suits brought for the purpose of

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restraining the assessment or collection of tax. ³² The District Court for the Eastern District of Tennessee granted the government's motion to dismiss based on the anti-injunction act. CIC appealed to the Sixth Circuit, which affirmed. ³³ CIC then petitioned the Supreme Court for certiorari, which was granted. ³⁴ The Supreme Court reversed, finding the anti-injunction act inapplicable when an IRS listing notice requires significant reporting obligations whose failure to meet carries significant civil and/or criminal liability. ³⁵

The Court analyzed the combination of the required act (i.e., the information reporting) and the penalty regime under Section 6707A in concluding that suits challenging a reporting requirement on APA grounds, even if that reporting requirement was subject to a "sanction for flouting the Notice" are not barred by the anti-injunction act because the action "does not run against a tax at all." ³⁶ The case was ultimately remanded back to the Eastern District of Tennessee for further proceedings. ³⁷ The district court then granted a preliminary injunction against the enforcement of the Notice, finding CIC likely to prevail on the merits. ³⁸

Nearly five years to the day after CIC brought its suit, the district court addressed the merits of its APA challenge. ³⁹ The district court held that Notice 2016-66 was a legislative rule, the IRS issuing the Notice without notice-and-comment was arbitrary and capricious, and the Notice must be set aside. ⁴⁰ Substantively, the district court's opinion followed the Sixth Circuit's precedential opinion in Mann Construction (discussed below), which originated significantly after CIC brought its action. ⁴¹ The district court determined that the IRS's failure to engage in notice-and-comment rule making when designating micro-captive insurance arrangements as transactions of interest must be set aside as illegal. ⁴² The court examined the...