Court Declares IRS Micro-Captive Notice 2016-66 Unlawful: What Taxpayers Should Do Now
On May 17, 2021, the United States Supreme Court handed the IRS a significant loss when it concluded that CIC Services, LLC (“CIC”) could continue its lawsuit against the IRS for violations of the Administrative Procedure Act (“APA”). A summary of the Supreme Court’s decision in CIC Services can be found here.
Although CIC won the battle, it had not yet won the war. Rather, CIC won on procedural grounds when the Supreme Court held that the Anti-Injunction Act did not foreclose the federal courts from reviewing its merit-based APA challenge. Accordingly, CIC was required to continue its fight against the IRS to prove that the IRS had failed to comply with the APA. The case was therefore remanded back to the United States District Court for the Eastern District of Tennessee (“Federal Court”) for a decision on the merits.
But prior to the Federal Court reaching a decision on the APA issue, things really got interesting. Specifically, on March 3, 2022, the Sixth Circuit Court of Appeals (the court in which CIC’s appeal would lie) rendered its decision in Mann Construction, Inc. v. United States, No. 21-1500 (6th Cir. Mar. 3, 2022). More on that case is here. In that case, the Sixth Circuit held that another IRS Notice—Notice 2007-83—was invalid because the IRS failed to comply with the notice-and-comment procedures of the APA.
A few weeks after Mann Construction was decided, the Federal Court issued its decision in CIC Services, LLC v. IRS, No. 3:17-cv-110 (E.D. Tenn. Mar. 21, 2022). This article discusses that decision.
The Federal Court Finds the Notice is Unlawful.
CIC raised two arguments in its summary judgment motion regarding the lawfulness of the Notice. First, CIC contended that the Notice must be set aside under the APA because it was a “legislative rule,” which required notice-and-comment procedures. Second, and alternatively, CIC contended that the Notice was unlawful because the IRS had acted arbitrarily and capriciously in issuing the Notice.
The Federal Court agreed with CIC on both points. As an initial matter, the Federal Court spent little time in concluding that the Notice was a legislative rule—rather than an “interpretative rule,” as argued by the IRS, particularly in light of the Sixth Circuit’s recent decision in Mann Construction. And similar to the decision in Mann Construction, the Federal Court held that the IRS had failed to follow the required notice-and-comment procedures for implementation of the legislative rule.
As an additional matter, the Federal Court also agreed with CIC that the IRS had acted arbitrarily and capriciously in promulgating the Notice. More specifically, under the APA, the Federal Court correctly observed that a court must “hold unlawful and set aside agency action, findings, and conclusions found to be . . . arbitrary, capricious, an abuse of discretion, or otherwise not in accordance with the law.” 7 U.S.C. § 706(2)(A). And in determining whether an agency action is arbitrary and capricious under the APA, courts must “determine only whether the [agency] examined ‘the relevant data’ and articulated ‘a satisfactory explanation’ for [its] decision, ‘including a rational connection between the facts found and the choice made.’” Dep’t of Com. V. New York, 139 S. Ct. 2551, 2569 (2019).
Under the above standard, courts are generally limited to evaluating the agency’s contemporaneous explanation in light of the existing administrative record. Dep’t of Com., 139 S. Ct. at 2573. Then, courts must examine the administrative record to determine if the agency:
has relied on factors which Congress has not intended it to consider, entirely failed to consider an important aspect of the problem, offered an explanation that runs counter to the evidence before the agency, or is so implausible that it could not be ascribed to a difference in view or the product of agency expertise.
Atrium Med. Ctr., 766 F.3d at 567.
In analyzing the IRS’s actions under these standards, the Federal Court agreed with CIC that the administrative record failed to include relevant data and facts regarding the IRS’s determination to designate micro-captive transactions as “transactions of interest,” i.e., reportable transactions. Under the plain language of the Notice, the IRS simply stated that it was aware of micro-captive transactions and “believed” that these transactions may have the potential for tax avoidance or evasion. However, the IRS failed to articulate more on any facts that would support its belief. The Federal Court also criticized the administrative record itself as being inadequate to support any basis to hold in favor of the IRS.
The Federal Court Sets the Notice Aside as Unlawful.
After concluding that the IRS had failed to comply with the APA, the Federal Court turned to the proper relief to provide to CIC. In its complaint, CIC Services requested for the Federal Court to: (i) enter a judgment declaring the Notice unlawful and setting it aside; (ii) enjoin all agencies from enforcing the notice and offering documents produced by any individual or entity in response to the Notice in judicial or administrative proceedings; and (iii) require the IRS to destroy or return materials produced in response to the Notice. The Federal Court agreed that some, but not all, of the requested relief was warranted:
In this case, vacating the Notice in its entirety is appropriate. The IRS did not comply with notice-and-comment procedures, and it acted arbitrarily and capriciously. While it may be able to rectify these deficiencies if it pursues promulgating a new rule, nothing about its actions supports leaving the Notice in place while it takes the actions necessary to comply with the APA or vacating the Notice as to CIC only, especially given the Sixth Circuit’s prior observations that the IRS ‘does not have a great history of complying with the APA procedures . . . and that it does not follow the basic rules of administrative law.’
At least some of CIC’s requests for permanent injunctive relief are also warranted. The Notice required taxpayers and material advisors to expend time and resources, which they cannot recoup, to comply with the Notice’s reporting requirements for more than four years. In turn, the IRS has received documents and information it was not entitled to because it failed to comply with the APA. Under these circumstances, it is entirely reasonable and equitable to require the IRS to return to the taxpayers and material advisors information and documents it collected pursuant to the Notice.
The Court will not, however, enter an injunction barring agencies from offering documents produced by any individual or entity in response to the Notice in judicial or administrative proceedings. The notice is merely one source of information for the IRS, and granting such relief risks depriving the IRS of the use of such documents for the public’s benefit even if it acquires them lawfully in the future. The IRS may attempt to promulgate an APA-compliant rule requiring taxpayers and material advisors to produce the same information in the future. The Court decline’s CIC’s invitation to, in effect, create future litigation over how and when the IRS received information in its possession. Accordingly, the Court will order that the IRS return all documents and information produced pursuant to the Notice to taxpayers and material advisors.
The Federal Court’s decision in CIC Services is another win for taxpayers. Although it is anyone’s guess as to whether the IRS chooses to appeal the decision, it seems unlikely given the Sixth Circuit’s governing law under Mann Construction.
Significantly, the Sixth Circuit’s decision in Mann Construction and the Federal Court’s decision in CIC Services only applies to limited taxpayers in those courts. That is, other federal courts may not necessarily agree with the rationale of those decisions. Accordingly, taxpayers in other jurisdictions should watch carefully to see how other federal courts decide these issues in the future.
Moreover, taxpayers who have already paid civil penalties related to IRS notices—particularly those at issue in Mann Construction and CIC Services—should seek the advice of tax counsel to determine whether certain actions should be taken, such as the filing of a refund or protective refund claim. Taxpayers in these circumstances should be aware that they may forever lose entitlement to a refund of the civil penalty if they fail to follow these procedures within prescribed deadlines.