Federal tax cases against the IRS can be difficult. Even procedurally so. Under the pay-first, litigate-later rule, taxpayers are generally required, prior to filing suit against the United States: (1) to full pay the disputed tax, penalties, and interest at issue; and (2) then file an administrative claim for refund with the IRS. Only after these two prerequisites are met may a taxpayer file and maintain a lawsuit in federal court against the United States (or its instrumentalities, such as the IRS).
Another common bar to a federal lawsuit regarding federal tax matters—which works in conjunction with the pay-first, litigate-later rule—is the Anti-Injunction Act (“AIA”). The AIA—located in the Internal Revenue Code (the “Code”)—provides, with limited exceptions, that “no suit for the purpose of restraining the assessment or collection of any tax shall be maintained in any court by any person, whether or not such person is the person against whom the tax was assessed.” In layman’s terms, if a taxpayer fails to follow the pay-first, litigate-later rule and likewise does not fall within a limited exception of the AIA, the taxpayer’s lawsuit will often be tossed out because the federal court lacks subject-matter jurisdiction over the claim or claims.
Historically, the Supreme Court has interpreted the scope of the AIA broadly. This expansive interpretation of the AIA lies mainly in the AIA’s purpose, which is to prevent federal courts from deciding federal tax matters until after receipt of federal tax payments. Put in place shortly after the Civil War, the AIA serves to ensure that the federal government continues to receive a consistent flow of revenue through the payment of federal taxes and unimpeded by litigation.
But, in a recent decision, the Supreme Court appears to have scaled back somewhat on its expansive reading of the AIA. On May 17, 2021, the Supreme Court issued its opinion in CIC Services, LLC v. IRS, which held that a tax advisor was not barred under the AIA from challenging an IRS notice under the Administrative Procedure Act (the “APA”). Although there is little doubt that the AIA will continue to remain as a formidable barrier to many IRS challenges, the CIC Services decision is a welcome development for taxpayers.
The Code requires taxpayers and “material advisors” to provide certain information to the IRS each year. Generally, the IRS requests information in these instances to help it better police what it views as abusive or potentially abuse transactions. These transactions are referred to as “reportable transactions” and “listed transactions”.
If a taxpayer and/or material advisor fails to properly report the reportable transaction or listed transaction, either can be subject to civil penalties. Moreover, criminal sanctions may be imposed.
Some time ago, the IRS labeled micro-captive transactions as a “reportable transaction,” subject to reporting requirements. For those not familiar with micro-captive transactions, an insured party often deducts its premium payments as business expenses whereas the recipient of the payments (the insurer, often a related party) excludes such payment from gross income. This is permitted under the Code, provided certain requirements are met—however, the IRS has found that many taxpayers are engaging in these types of transactions without complying with the specified requirements. The result is a tax windfall–the benefit of a tax deduction without the corresponding inclusion of gross income.
In an attempt to better police these types of transactions, the IRS issued Notice 2016-66 (the “Notice”). The Notice identifies certain types of micro-captive agreements as reportable transactions, requiring, among other things, that taxpayers and material advisors “describe the transaction in sufficient detail for the IRS to be able to understand . . . [its] tax structure.” Armed with this new information, the IRS was hopeful that it could better determine which micro-captive transactions were legitimate and which were abusive.
However, after the IRS issued the Notice, CIC Services (“CIC”), a material advisor for micro-captive transactions, brought suit against the IRS in federal court. In its Complaint, CIC asserted that the IRS violated the APA when it issued the Notice without notice-and-comment procedures. The Complaint further asserted that the Notice was arbitrary and capricious under the APA because it imposed new reporting requirements without proven need. In its request for relief, CIC asked the federal court to “enjoin the enforcement of Notice 2016-66 as an unlawful rule” and to declare the Notice unlawful.
Because non-compliance with the Notice could result in a civil tax penalty, the government filed a motion to dismiss CIC’s Complaint under the AIA. In its motion, the government contended that CIC’s “requested relief would prevent the IRS from assessing a tax penalty against material advisors” that disregard the Notice’s reporting requirements. Both the district court and a majority of judges in the Sixth Circuit agreed with the government and held that the Complaint should be dismissed under the AIA. The Supreme Court granted certiorari to determine “whether the Anti-Injunction Act bars CIC’s suit complaining that Notice 2016-66’s reporting requirements violate the APA.”
The Majority Opinion
Because the AIA only bars suits “for the purpose of restraining the assessment or collection of any tax,” the Supreme Court first focused on whether CIC’s APA causes of action was filed for a purpose within the scope of the AIA. In determining the “suit’s purpose” here, the Supreme Court recognized that federal courts should not look into a taxpayer’s subjective motive in filing the suit. Rather, the Supreme Court acknowledged that federal courts must look into the lawsuit’s “objective aim—essentially, the relief the suit requests.” On this issue, the Supreme Court noted:
[The] aim is not best assessed by probing an individual taxpayer’s innermost reasons for suing. Down that path lies too much potential for circumventing the . . . [AIA]. Instead, this Court has looked to the face of the taxpayer’s complaint. We have asked about what the Government here calls “the substance of the suit”—the claims brought and injuries alleged—to determine the suit’s object. And most especially, we have looked to the ‘relief requested’—the thing sought to be enjoined.
Under this analytical lens, the Supreme Court disagreed with the government’s position that CIC’s Complaint sought to prevent the IRS from collecting the civil penalty for non-reporting. Instead, the Supreme Court concluded that the Complaint sought to contest only the legality of the Notice. In reviewing the words used in the Complaint, the Supreme Court also found relevant that CIC had brought no legal claim against the civil penalty—rather, it merely sought injunctive relief from the Notice’s reporting rules.
In CIC Services, the government also contended that an injunction against the Notice would be the same as an injunction against the penalty—i.e., “two sides of the same coin.” The Supreme Court disagreed for at least three reasons.
First, the Supreme Court recognized that because the Notice imposed affirmative reporting obligations on material advisors such as CIC, there would be costs separate and apart from the civil penalty. More specifically, the Supreme Court recognized that the Notice’s reporting obligations would impose on CIC significant expense and time in responding and complying with the Notice. The Supreme Court reasoned that CIC’s claims for relief therefore were distinguishable from any claim related to the potential civil penalty for non-compliance.
Second, the Supreme Court noted that the Notice’s reporting rule and the civil penalty, at least in this case, were too attenuated, i.e., they were “several steps removed from each other.” That is, for the IRS to assess the civil penalty against CIC for failure to follow the guidelines in the Notice, the following would have to occur: (1) CIC would have to withhold required information regarding the micro-captive transaction; (2) the IRS would have to determine that a violation of the Notice occurred; and (3) the IRS would then have to decide to impose the civil penalty. The Supreme Court concluded that this “threefold contingency matters in assessing whether the Anti-Injunction Act applies.”
Third, the Supreme Court found significant that CIC could potentially be subject to criminal sanctions for its non-compliance with the Notice. Thus, under the government’s interpretation of the AIA, CIC would effectively have to break the law, pay the civil penalty, and then try to challenge the Notice and its reporting requirements. In the Supreme Court’s words, “the existence of criminal penalties explains why an entity like CIC must bring an action in just this form, framing its requested relief in just this way.”
Justice Sotomayor wrote a concurring opinion in CIC Services. In that opinion, she agreed that the three factors identified in the majority opinion, taken in combination, show that CIC’s lawsuit against the IRS falls outside the ambit of the AIA. However, Justice Sotomayor wrote separately to highlight that the Court’s decision may be different if CIC “were a taxpayer instead of a tax advisor.” On this point, Justice Sotomayor noted that “[w]hether such suits may proceed will depend on a context-specific inquiry into ‘the relief the suit requests’ and the ‘aspects of the regulator scheme’ at issue.”
Justice Kavanaugh also wrote a separate, concurring opinion. In that opinion, Justice Kavanaugh wrote separately to underscore what remains (and does not remain) in two prior decisions of the Supreme Court—Alexander v. Americans United, Inc., 416 U.S. 752 (1974) and Bob Jones Univ. v. Simon, 416 U.S. 725 (1974).
In both Americans United and Bob Jones, the Supreme Court had adopted a bright-line rule to determine whether a pre-enforcement suit was barred by the AIA. Under that rule, if a pre-enforcement suit would “necessarily preclude” the assessment or collection of a tax, the suit was barred by the AIA, requiring the taxpayer to bring a refund suit after paying the tax. In Justice Kavanaugh’s view, both Americans United and Bob Jones required federal courts to improperly “look to the effects of a suit.”
In recognizing the majority decision in CIC Services, Judge Kavanaugh noted that the Supreme Court had effectively “carve[d] out a new exception to Americans United and Bob Jones for pre-enforcement suits challenging regulations backed by tax penalties.” And Judge Kavanaugh agreed with the Supreme Court’s new holding to narrow those decisions because the broad “effects” rule articulated in those decisions would be hard to square with the text of the AIA.
The government liberally uses the AIA as a shield against most lawsuits filed by taxpayers in federal courts. This practice will not change, even in light of the CIC Services decision. However, the decision provides important reminders to tax attorneys that the wording of the Complaint can often be outcome-determinative as to whether the relief requested therein is barred under the AIA. In cases where it is likely that the government will raise the AIA as a bar, tax practitioners are well advised to read CIC Services for a roadmap as to what causes of action and relief fall outside the purview of the AIA. Moreover, only time will tell how broadly or narrowly the federal courts interpret the decision vis-à-vis other federal cases where the government raises the AIA as a bar to suit.
Freeman Law aggressively represents clients in tax litigation at both the state and federal levels. When the stakes are high, clients rely on our experience, knowledge, and talent to help them navigate all levels of the tax dispute lifecycle—from audits and examinations to the courtroom and all levels of appeals. Schedule a consultation or call (214) 984-3000 to discuss your tax needs.