Treasury Needs To Act Fast To Save the Tax-Shelter Disclosure Regime
Yesterday's SCOTUS decision in CIC Services is a big victory for tax-shelter promoters challenging IRS reporting requirements. But the Biden administration can avert the worst-case scenario
The Supreme Court handed down its decision yesterday in CIC Services v. IRS, and it was a very Happy Tax Day indeed for micro-captive insurance promoters seeking to challenge the IRS’s tax shelter reporting requirements. In light of yesterday’s decision, it will also be a very good year for the tax shelter industry in the federal courts unless the Biden administration moves quickly. Treasury needs to initiate notice-and-comment rulemaking ASAP or else federal district courts across the country are going to start issuing injunctions against the IRS’s tax-shelter disclosure mandates.
CIC Services is a Tennessee-based firm that helps clients set up what it describes as a “legal tax shelter.” (I’ll leave out the specifics of CIC Services’ micro-captive insurance arrangement, but if you’re curious, read Charlene Luke’s excellent piece about micro-captives in the Hofstra Law Review.) In November 2016, the IRS invoked its authority under a George W. Bush-era law to issue Notice 2016-66, which designates a subset of micro-captive arrangements as “reportable transactions.” The significance of a reportable-transaction designation is that “material advisors” like CIC Services must (1) maintain records of clients who engage in reportable transactions, (2) furnish those records to the IRS upon request, and (3) file information returns with the IRS reporting these transactions. If CIC Services violates those requirements, it faces a potential penalty of $50,000 under I.R.C. § 6707.
CIC Services challenged Notice 2016-66 in federal district court, chiefly arguing that notice is invalid because the IRS hadn’t gone through an Administrative Procedure Act notice-and-comment process. The district court and the Sixth Circuit didn’t reach the merits of CIC Services’ Administrative Procedure Act claim because they found CIC Services’ suit to be barred by the Anti-Injunction Act. That statute—which dates back to 1867—reads (in relevant part):
[N]o 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 such tax was assessed.
Under the Anti-Injunction Act, plaintiffs seeking to challenge a federal tax provision in federal district court generally need to pay first and then sue for a refund. Alternatively, taxpayers can bring pre-payment challenges to deficiency notices in Tax Court, but the Tax Court has held that it doesn’t have jurisdiction over the particular penalty at issue here.
The lower courts’ Anti-Injunction Act ruling followed directly from Supreme Court precedent. In a 1974 case involving Bob Jones University, the high Court held that because the injunction sought by Bob Jones “would necessarily preclude the collection” of federal taxes, “a suit seeking such relief falls squarely within the literal scope of the [Anti-Injunction] Act.” The Court echoed that holding in another decision handed down the same day involving a nonprofit group called Americans United for the Separation of Church and State. CIC Services’ suit ran headlong into Bob Jones and Americans United because if the IRS’s reportable-transaction designation were struck down, the IRS couldn’t impose penalties for noncompliance under I.R.C. § 6707. The injunction sought by CIC Services “would necessarily preclude the collection” of § 6707 penalties.
There is one wrinkle: § 6707 is a penalty provision, whereas the Anti-Injunction Act and the Bob Jones and Americans United holdings refer to taxes. No matter. Chief Justice Roberts’s opinion for the Court in NFIB v. Sebelius (the 2012 Obamacare individual mandate case) states:
Congress can, of course, describe something as a penalty but direct that it nonetheless be treated as a tax for purposes of the Anti-Injunction Act. For example, 26 U.S.C. § 6671(a) provides that “any reference in this title to ‘tax’ imposed by this title shall be deemed also to refer to the penalties and liabilities provided by” subchapter 68B of the Internal Revenue Code. Penalties in subchapter 68B are thus treated as taxes under Title 26, which includes the Anti-Injunction Act.
The material advisor penalties in § 6707 are part of subchapter 68B, so the Chief Justice’s discussion in NFIB v. Sebelius—though dicta—is 100 percent on point. For lower courts bound by Supreme Court precedent, this was a straightforward case: Bob Jones/Americans United + NFIB = CIC Services loses.
The Supreme Court’s decision
But CIC Services did not lose here—it won big. The Supreme Court’s opinion, written by Justice Kagan, was unanimous. And true to form for Justice Kagan’s opinions, it is a very easy read. After laying out the background and the sides’ arguments, Justice Kagan dives into the analysis on page 9:
To begin with, we agree with CIC’s reading of its complaint. The complaint contests the legality of Notice 2016–66, not of the statutory tax penalty that serves as one way to enforce it. CIC alleges that the Notice is procedurally and substantively flawed; it brings no legal claim against the separate statutory tax. And CIC’s complaint asks for injunctive relief from the Notice’s reporting rules, not from any impending or eventual tax obligation.
Up to this point, Justice Kagan has said little to distinguish CIC Services’ suit from Bob Jones and Americans United. Bob Jones University challenged a 1971 IRS revenue ruling that denied 501(c)(3) status to schools with racially discriminatory admissions policies. Americans United challenged a 1969 IRS letter ruling that concluded that the organization engaged in too much lobbying to be a 501(c)(3). In both cases, the Court held that the Anti-Injunction Act barred the organization’s suit. But the facts of both cases fit quite neatly into Justice Kagan’s description of CIC Services’ complaint:
To begin with, we agree with [Bob Jones/AU]’s reading of its complaint. The complaint contests the legality of [the 1971 revenue ruling/1969 letter ruling] … [Bob Jones/AU] alleges that the [IRS ruling] is procedurally and substantively flawed; it brings no legal claim against the separate statutory tax [that it will have to pay under the Federal Unemployment Tax Act due to the loss of 501(c)(3) status]. And [Bob Jones/AU]’s complaint asks for injunctive relief from the [IRS ruling], not from any impending or eventual tax obligation.
So what separates CIC Services (which wins) from Bob Jones and Americans United (which lost)? Justice Kagan lists “[t]hree aspects of the regulatory scheme here” that, “taken in combination, refute the idea that this is a tax action in disguise” subject to the AIA’s bar:
“[T]he Notice imposes affirmative reporting obligations, inflicting costs separate and apart from the statutory tax penalty”;
“[T]he Notice’s reporting rule and the statutory tax penalty are several steps removed from each other”; and
“[V]iolation of the Notice is punishable not only by a tax, but by separate criminal penalties.”
Those three considerations really do distinguish CIC Services’ case from Bob Jones and Americans United, which weren’t about reporting requirements backed by criminal penalties. (Indeed, if Bob Jones and Americans United had retained their 501(c)(3) status, they would have been subject to more reporting requirements.) As Justice Kavanaugh crisply summarizes it in his concurrence, “the Court in effect carves out a new exception to Americans United and Bob Jones for pre-enforcement suits challenging regulations backed by tax penalties.” (To which I would add: at least as long as those tax penalties are also backed by separate criminal penalties.)1
A mixed verdict
While I was hoping for a different result (and was one of the lawyers on an amicus brief filed by former government officials in support of the IRS’s position), this is definitely an issue on which reasonable minds can differ. As I wrote three years ago in an online essay for the Virginia Law Review (responding to an article by Kristin Hickman and Gerald Kerska):
Against a present-day backdrop, the AIA stands out as peculiar in several respects. First, the fears that seem to have motivated the statute’s enactment appear outmoded today. In light of our modern pay-as-you-go tax system as well as the United States’ access to deep and liquid capital markets, it is hard to imagine any injunction seriously disrupting the flow of federal revenue. … Meanwhile … [t]he in terrorem effect of certain Treasury regulations may be so great that the rules will remain immune from challenge unless they can be contested in a pre-enforcement action. … [T]here is certainly something disconcerting about the notion that the IRS could issue legally defective rules and escape judicial oversight.
I went on to argue that “even if the AIA has outlived its original purpose, and even if it yields normatively unattractive consequences in certain circumstances, the statute still serves at least two useful ends.” One is to relieve a bit of the strain on an underfunded IRS. For example, when the IRS wants to act quickly against a tax shelter, it can issue temporary regulations that won’t be subject to immediate challenge. That gives the agency more time to complete notice-and-comment rulemaking—which, in turn, raises the probability that the regulation ultimately survives judicial scrutiny. Second, the AIA protects the IRS from forum shopping by challengers to its regulations. “Without the AIA,” I noted, “sophisticated taxpayers and the interest groups that represent them would enjoy a ‘general hunting license’ to fire at the IRS in different jurisdictions until one of their shots strikes flesh.”
To be sure, the AIA is a rather roundabout way of writing a statute to achieve the goals I have laid out for it. A more direct approach would be for Congress to (1) fund the IRS appropriately and (2) establish limits on forum choice that mitigate the risk of nationwide injunction shopping. The latter objective might be accomplished through a jurisdictional statute that allows pre-enforcement challenges to Treasury regulations exclusively in the U.S. District Court for the District of Columbia, with appeal to the D.C. Circuit.
I think I still agree with all of that. And now that Congress is considering a big boost to the IRS’s budget (far beyond what we could have contemplated even this past fall), maybe the long-term consequences of a narrower Anti-Injunction Act aren’t so dire.
And while I agree with Justice Kavanaugh that CIC Services carves out a new exception to the Anti-Injunction Act, it’s worth noting that the Court already has created two equitable exceptions to the AIA: the Enochs v. Williams Packing & Navigation Co. exception (for cases in which a plaintiff can show “irreparable injury” and “certainty of success on the merits”), and the South Carolina v. Regan exception (for cases in which Congress has provided no alternative remedy to the aggrieved party). Like the Enochs and South Carolina exceptions, the CIC Services exception is atextual. (“No suit for the purpose of restraining the assessment or collection of any tax shall be maintained in any court by any person … unless the tax is a tax penalty for violating a reporting requirement and is separately enforced by a criminal penalty”???) But I also don’t think it’s the worst thing in the world for the Court to engage in some common-law judging—especially in an area like this one that has always involved a heavy dose of federal common law.
Turning the other Cheek
[A digression from the rest of the post, but a point worth noting because we shouldn’t allow the carceral state to expand its reach by accident]: One very disappointing portion of the Court’s opinion is footnote 3, which addresses an issue lurking in the background of the case: whether CIC Services would face misdemeanor liability under I.R.C. § 7203 if it “willfully” violated the reporting requirement, paid a civil penalty, and then sued for a refund. (The penalty for violating § 7203 is a fine of up to $25,000—or up to $100,000 for a corporate defendant like CIC Services—plus up to one year in prison.) CIC Services argued that if the Anti-Injunction Act barred a pre-enforcement challenge, then the only way it could contest Notice 2016-66 would be to risk misdemeanor liability. The IRS argued that § 7203 couldn’t plausibly apply here because as long as CIC Services genuinely believed that the Administrative Procedure Act rendered Notice 2016-66 invalid, its violation of Notice 2016-66 wouldn’t have been willful. (Everyone now concedes that CIC Services’ Administrative Procedure Act argument is made in good faith.)
Footnote 3 sides with CIC Services on this issue (note how weird it is that “sides with CIC Services” means “agreeing that CIC Services would be subject to potential criminal penalties”):
[T]his Court’s precedent precludes the Government’s effort to erase the criminal penalties from this case. We have held in no uncertain terms that “a defendant’s views about the validity” of a tax provision—even if held “in good faith”—do not “negate[ ] willfulness or provide[ ] a defense to criminal prosecution.” Cheek v. United States, 498 U. S. 192, 204, 206 (1991). So in failing to report transactions as the Notice requires, an advisor like CIC would risk criminal punishment.
As a number of other law professors (including Rachel Barkow, Brian Galle, and Andy Grewal have pointed out on Twitter), the footnote is hard to square with Cheek. That case involved an American Airlines pilot who became a tax protester and ceased to file returns or pay taxes. He was convicted under § 7203, the misdemeanor statute that CIC Services cites. The Supreme Court threw out the conviction. Justice White, writing for the Court’s majority, said:
In this case, if Cheek asserted that he truly believed that the Internal Revenue Code did not purport to treat wages as income, and the jury believed him, the Government would not have carried its burden to prove willfulness, however unreasonable a court might deem such a belief. … [I]n our complex tax system, uncertainty often arises even among taxpayers who earnestly wish to follow the law, and it is not the purpose of the law to penalize frank difference of opinion or innocent errors made despite the exercise of reasonable care.
Justice White then went on to say: “Claims that some of the provisions of the tax code are unconstitutional are submissions of a different order.” Justice Scalia, concurring in the judgment, criticized the majority’s distinction between statutory and constitutional claims, arguing that in both cases, a good-faith belief in the invalidity of a tax provision should defeat § 7203 liability. Every justice in Cheek agreed that a good-faith belief in the invalidity of a tax requirement should *not* trigger misdemeanor liability ***at least as long as the belief is not based on a view that a tax statute is unconstitutional***. Justice Scalia agreed with the previous sentence even without the asterisked caveat. No member of the Cheek Court endorsed the proposition that footnote 3 of yesterday’s opinion now states “in no uncertain terms” as the law of the land.
My hope is that the Justice Department will make clear to federal prosecutors that—footnote 3 aside—they should not bring § 7203 charges against any defendant whose failure to comply with a tax requirement is based on a good-faith belief that the requirement is statutorily invalid. I also hope that district courts will read Cheek closely and put greater weight on the justices’ opinions in that case—where the issue was squarely presented—than on a footnote that addresses the issue in passing. Congress, too, can help out by clarifying that a violation of a tax requirement won’t be considered “willful” for purposes of § 7203 if the violation is based on a good-faith belief that the requirement is invalid. It would be a real shame if the Court’s effort to shield CIC Services from the hypothetical possibility of criminal liability leads to real people actually spending time in prison.
The immediate implication of yesterday’s decision is that the IRS’s reportable-transaction designations can be challenged in federal district court by tax-shelter promoters, without the promoters having to follow the Anti-Injunction Act’s pay first/sue later procedure. This is no small thing. Not only can CIC Services’ challenge to Notice 2016-66 move forward, but we’ll also likely see challenges to Notice 2017-10 (designating syndicated conservation easement deals as reportable transactions) and Notices 2015-73 and 2015-74 (designating certain basket option contracts that are popular among hedge funds as reportable transactions). We may see challenges to some of the three dozen or so reportable-transaction designations that the IRS issued before 2015.
The plaintiffs bringing these challenges all will make arguments similar to CIC Services’: the reportable-transaction designation is invalid because it didn’t go through the Administrative Procedure Act’s notice-and-comment rulemaking process. This is far from a frivolous claim. As summarized by then-Judge Kavanaugh in a 2014 D.C. Circuit decision, an agency action generally requires Administrative Procedure Act notice and comment if it “purports to impose legally binding obligations or prohibitions on regulated parties” and “would be the basis for an enforcement action for violations of those obligations or requirements.” Notice 2016-66 and the IRS’s other reportable-transaction designations certainly do that.
In our amicus brief, we argued that CIC Services’ notice-and-comment claim still wasn’t certain to succeed on the merits. As the brief put it:
The American Jobs Creation Act of 2004 explicitly instructs Treasury and the IRS to designate reportable transactions “under regulations prescribed under section 6011.” … Then and now, the § 6011 regulations have provided for reportable-transaction designations via “published guidance.” … Before the AJCA’s passage, the IRS had issued more than twenty reportable-transaction designations via revenue ruling or notice in the Internal Revenue Bulletin without going through [Administrative Procedure Act] § 553 rulemaking. … [T]he IRS has adhered to the very procedure that Congress told the agency to follow.
I think this is a good argument. But let’s be clear: While CIC Services’ notice-and-comment argument isn’t certain to succeed, any sensible person betting on the outcome would bet on CIC Services. Moreover, the IRS will probably lose every other Administrative Procedure Act challenge to a reportable-transaction designation that hasn’t gone through notice and comment. Treasury and the IRS should not confuse the statement the IRS has a good argument on its side for an assertion that the IRS is likely to win. CIC Services’ likelihood of success here, though less than the 100 percent that would trigger the Enochs exception, is still very very high.
There’s no reason, though, why Treasury and the IRS need to leave themselves vulnerable to this line of attack. Treasury and the IRS should publish the existing reportable-transaction designations in the Federal Register (with an updated preamble) as a proposed rule, give interested parties 60 days to submit comments, and then finalize the rule in due course. At the same time, Treasury and the IRS can publish a temporary or interim final rule that applies the reportable-transaction designations to transactions that occur while the notice-and-comment process is ongoing. Yes, this is all cumbersome. But it’s better than having the whole reportable-transaction designation regime come crumbling down, which is the likeliest result if Treasury and the IRS don’t address the notice-and-comment issue now.
The reportable-transaction regime is a powerful tool in the fight against tax shelters. By requiring material advisors and their clients to report potentially abusive transactions, the IRS not only can identify returns ripe for audit, but also can deter taxpayers from entering into these transactions in the first place. It’s unfortunate that the IRS has only applied this tool to two types of transactions in the last half-decade (micro-captives and syndicated conservation easements). Surely more than two tax shelters have emerged in the last half-decade! Hopefully, shoring up the Administrative Procedure Act status of reportable-transaction designations will encourage Treasury and the IRS to wield this tool more often. (Two good candidates: frozen cash value life insurance and transactions in which taxpayers claim stepped-up basis for assets in an intentionally defective grantor trust upon the grantor’s death.)
A legislative fix?
Since CIC Services is ultimately a statutory decision (though a statutory decision involving a heavy layer of common-law gloss), it also raises the question of whether Congress should intervene. A few preliminary thoughts on that subject:
The situation pre-CIC Services was obviously not first-best. The IRS issued reportable-transaction designations that federal courts were likely to strike down under the Administrative Procedure Act, but the Anti-Injunction Act stood in the way of pre-enforcement challenges, and taxpayers and material advisors were understandably reluctant to trigger penalties just so that they could challenge the designations in refund proceedings. So the whole tax-shelter disclosure regime existed in a weird legal limbo. I don’t think anyone really wants to return to the pre-May 17, 2021 status quo.
The worst-case scenario would be if Treasury and the IRS don’t fix the Administrative Procedure Act notice-and-comment problem because they’re waiting for Congress to intervene, and then Congress doesn’t intervene. The only winners in that scenario are tax shelter promoters and their clients.
The three main options for Congress are:
(A) Patch up the Anti-Injunction Act so that challenges like CIC Services’ still are subject to the bar;
(B) Create an carveout from the Administrative Procedure Act notice-and-comment requirement for reportable-transaction designations;
(C) Address the underlying problems: (1) an under-resourced IRS, and (2) the lack of any serious statutory limits on forum shopping or nationwide injunctions in pre-enforcement challenges to tax provisions once the AIA bar is removed.
Any time the options are “patch up,” “create a carveout,” or “address the underlying problems,” it’s pretty clear which option the author favors. Trying to do the second part of option C through budget reconciliation might raise Byrd rule complications, but I’ll leave that issue for later. And the key point for now is that the Biden administration shouldn’t wait for a comprehensive congressional fix. Treasury and the IRS can save the tax-shelter disclosure regime on their own if they move fast.
As a D.C. Circuit judge, Kavanaugh wrote an opinion (in a case called Florida Bankers Association v. United States) that essentially followed the Bob Jones/“Americans United” + NFIB equation to its logical conclusion. In his concurrence in CIC Services, Justice Kavanaugh explained that “[m]any courts have taken Americans United and Bob Jones at their word,” but that the Supreme Court is freer to modify its own precedent.