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January 11, 2022 At Court

The IRS’s Procedural Battles in Micro-Captive Litigation

By David J. Slenn, Shumaker, Loop & Kendrick, LLP, Tampa, FL

Editor's note: As of January 24, David J. Slenn is at Akerman, LLP.

The ABA Tax Times Spring 2021 issue addressed the recent Tax Court opinion in Caylor Land v. Commissioner. Caylor represented the fourth straight IRS victory over abusive micro-captive transactions. Yet although the IRS has an unblemished record in the Tax Court against micro-captives on substantive grounds, it has faced numerous procedural battles in cases related to micro-captives.

These recent procedural battles include the Supreme Court’s decision in CIC Services v. Commissioner and a recent Tax Court case, Puglisi v. Commissioner. In CIC Services, the Supreme Court held the Anti-Injunction Act did not prevent a material advisor from challenging the validity of Notice 2016-66 (requiring reportable transaction reporting), thereby remanding the case to the district court. In Puglisi v. Commissioner, the taxpayers attempted to force the IRS to trial even though the IRS conceded all tax, interest and penalties associated with the taxpayers’ micro-captive deductions. As described in more detail below, the IRS recently filed a motion for summary judgment in CIC Services and a motion for decision in Puglisi.

I. Other Micro-Captive Cases of Interest

There are other pending cases worth noting but not covered in this article. The Delaware Department of Insurance is appealing a district court order granting an IRS petition to enforce a summons seeking certain Delaware micro-captive insurance company records. In addition, Moore Ingram Johnson & Steele LLP, a law firm that also provides captive management services, is appealing a Georgia district court order granting an IRS summons. Moore Ingram’s arguments on appeal involve the appropriateness of categorical privilege logging and whether collateral estoppel applies to privileged information that was at issue in two Kentucky district court privilege rulings. Moore Ingram’s oral argument begins with an observation about the IRS’s actions in the case as being part of a larger initiative to eliminate micro-captive insurance companies. Finally, in Celia R. Clark v. USA, an attorney who also provided captive management services in the first-decided micro-captive case, Avrahami v. Commissioner, is suing for a refund of section 6700 penalties and for improper disclosure of her return information under section 7431. The complaint also contains an allegation accusing the IRS of wrongful actions.

[It] has sought to destroy the microcaptive insurance industry. It has not done so by promulgating regulations, issuing revenue rulings, or providing affirmative guidance that taxpayers and tax practitioners could follow. Rather, the IRS has engaged in the unlawful “administrative repeal” of IRC Section 831(b), thwarting Congress’s intent by wrongfully penalizing taxpayers and practitioners in the microcaptive space, in a concerted effort to drive them out of that business.

The complaint further alleges that the IRS engaged in abusive tactics by allowing section 6700 penalties to accumulate against the plaintiff for years, “rather than provid[ing] clarity.”

II. CIC Services v. Commissioner

A. Notice 2016-66 & the Administrative Procedures Act

In CIC Services, the IRS argued that CIC (a company that provides captive management services) was prohibited from challenging Notice 2016-66 under the Anti-Injunction Act. The Supreme Court ruled the Anti-Injunction Act did not bar the taxpayer’s challenge, thereby setting the stage for CIC and the IRS to battle once again in federal district court, this time over whether Notice 2016-66 was invalid due to, inter alia, the IRS’s failure to engage in the Administrative Procedures Act (APA) notice and comment rulemaking requirements.

The broader implication in this case is whether the IRS may issue notices requiring reporting obligations for reportable transactions (or a particular category of reportable transactions) without first engaging in the APA requirements. The IRS issued Notice 2016-66 describing a micro-captive transaction as a “transaction of interest” because the IRS and Treasury Department believe certain micro-captive transactions “have a potential for tax avoidance or evasion, but for which the IRS and Treasury lack enough information to determine whether the transaction should be identified specifically as a tax avoidance transaction.”

On remand, CIC sought and obtained a preliminary injunction on September 21, 2021 enjoining the IRS from enforcing the Notice against CIC. Although the court granted the injunction, it was limited to CIC, as opposed to a national, outright injunction as to Notice 2016-66. On October 8, 2021, CIC requested that the court reconsider the scope of the injunction and issue a national, outright injunction as initially requested. While reconsideration of the national injunction matter is pending, the IRS moved to dispose of the case on its merits through a motion for summary judgment (MSJ) on November 1, 2021.

B. IRS Motion for Summary Judgment

In its MSJ, the IRS acknowledged that the Court found CIC’s argument persuasive at first glance, but it suggested that a fuller examination of the issues should result in an IRS victory.

The MSJ addresses CIC’s three main arguments that the IRS violated the APA by not engaging in required notice and rulemaking requirements, engaged in arbitrary and capricious conduct by issuing Notice 2016-66, and did not comply with the Congressional Review Act. In its MSJ, the IRS argued that the Court focused on the wrong authorities for purposes of issuing its preliminary injunction. The IRS then argued that the notice and rulemaking requirements do not apply to Notice 2016-66 due to the scope of section 6707A and referencing Congressional enactments supporting the argument that notice and rulemaking were not required. The IRS also cited a recent Sixth Circuit opinion that found that IRS issuance of a notice regarding a listed transaction did not violate the APA. These arguments are discussed in more detail below.

1. Code Sections 6011 and 6707A & Treas. Reg. Section 1.6011-4

Section 6111 of the Code imposes reporting obligations on “material advisors.” When the court granted the injunction, it focused on section 6111(c), which authorizes the Secretary to “prescribe regulations which … provide such rules as may be necessary to carry out the purpose of this section.” Section 6111(c), however, is not the appropriate authority for issuing Notice 2016-66; instead, the relevant authorities for that notice’s issuance are section 6011 and Treas. Reg. section 1.6011-4. One only turns to section 6111 after a reportable transaction has been identified.

Section 6011 requires the filing of a return or statement when required by regulations. Treasury regulations promulgated under section 6011 provide the authority for the IRS to identify certain micro-captive transactions as “transactions of interest” through issuance of notices, as was done with certain micro-captive transactions through Notice 2016-66.

In its MSJ, the IRS argues that the court should have considered the interplay between section 6707A and Treas. Reg. section 1.6011-4, which the Court did not focus on when it issued the injunction. Although section 6111 imposes reporting obligations on material advisors, one cannot be a material advisor unless an underlying reportable transaction has first been identified pursuant to section 6011 and the regulation promulgated under that section. The potential for penalties for failure to include reportable transaction information with a return is found in section 6707A. The IRS then described the exceptions under the APA and turned to the history of these Code and Regulation sections as support for its argument that it did not violate the APA when it issued Notice 2016-66.

2. Administrative Procedures Act

Generally, federal agencies must go through notice and comment rulemaking before promulgating a rule. This means the agency must notify the public of the proposed new rule, give the public an opportunity to comment on the new rule, and then address the comments received. The IRS argues it does not need to engage in notice and comment rulemaking when Congress expressed a clear intent that an agency may use another procedure or when issuing “interpretive” rules. The IRS argues that Notice 2016-66 falls under both exceptions to notice and comment rulemaking.

3. Notice 2016-16 & Congressional Intent

The IRS notes that notice and rulemaking was conducted in 2003 when the IRS finalized a regulation under section 6011 allowing it to identify potentially abusive transactions, including six categories of reportable transactions. Congress enacted section 6707A in 2004, which required reporting of transactions identified under section 6011, with the potential for penalties due to non-compliance. At that time, regulations were already in existence that authorized the IRS to identify listed transactions by “notice, regulation, or other form of published guidance.”

The IRS notes that CIC did not challenge the section 6011 Treasury regulations identifying listed transactions and transactions of interest as reportable transactions. In its complaint, CIC challenged the IRS’s failure to engage in notice and rulemaking only as to Notice 2016-66. The IRS argues that a finding that Notice 2016-66 violated the APA would not make sense given the legislative history behind sections 6011 and 6707A, which in turn authorizes the Treasury Department to define a listed transaction and a reportable transaction.

The IRS also points to an amendment to the section 6011 regulations in 2007, where “transactions of interest” were added as a category of reportable transactions. The Treasury Decision publishing these regulations notes that “several commentators requested that the IRS and Treasury Department provide notice to taxpayers that the IRS and Treasury Department are considering designating a particular transaction as a transaction of interest and requesting comments prior to publishing guidance identifying a transaction as a transaction of interest.” As to this request for comments, the amendment provides “[t]he IRS and Treasury Department do not believe that the regulations should be amended to include language requiring the IRS and Treasury Department to provide advance notice for transactions of interest as suggested by the commentators. However, the IRS and Treasury Department may choose to publish advance notice and request comments in certain circumstances. The determination of whether to provide advance notice and a request for comments will be made on a transaction by transaction basis.”

The IRS points to another amendment to section 6707A in 2010. By this time, it states, the IRS had already started to identify transactions of interest under the 2007 regulation, without notice and comment. Congress, the IRS notes, would have been aware of this since it expressly described how “listed transactions” and “transactions of interest” were identified by “publications issued by the Treasury Department.” The IRS cites the Technical Explanation of Tax Provisions in Senate Amendment 4594 to H.R. 5297. The Joint Committee on Taxation provided a summary of then-current law (i.e., as of 2010) which included statements indicating that transactions of interest were described in publications issued by the Treasury Department.

There are five categories of reportable transactions: listed transactions, confidential transactions, transactions with contractual protection, certain loss transactions and transactions of interest.
Transactions falling under the first and last categories of reportable transactions are transactions that are described in publications issued by the Treasury Department and identified as one of these types of transaction. A listed transaction is defined as 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 the reporting disclosure requirements. A “transaction of interest” is one that is the same or substantially similar to a transaction identified by the Secretary as one about which the Secretary is concerned but does not yet have sufficient knowledge to determine that the transaction is abusive.

4. Mann Construction, Inc. v. United States

The IRS then points to a recent decision in the Eastern District of Michigan involving a challenge to a notice issued with respect to a listed transaction. In Mann Construction, Inc. v. United States, the court was faced with “whether an IRS notice requiring disclosure of a potentially abusive transaction was issued without notice and comment in violation of the APA.”

The Mann court recounted the IRS’s struggle with a “new generation of tax shelters” during the 1990s, when Treasury developed a reporting regime but lacked the authority to penalize taxpayers for failure to disclose. The court noted the resolution of the issue.

Congress addressed this problem in 2004 by passing the American Jobs Creation Act of 2004, Pub. L. 108-357, 118 Stat. 1418 (2004), which created I.R.C. § 6707A. Section 6707A laid the statutory foundation for the new reporting regime by establishing penalties for nondisclosure and defining “reportable transaction” and “listed transaction” by reference to Treasury regulations. See U.S.C. § 6707A. Since then, the IRS has identified many listed transactions by notice, in effect requiring taxpayers to disclose their participation or face substantial penalties under I.R.C. S 6707A. One of these revenue notices is IRS Revenue Notice 2007-83, the subject of controversy here.

The Mann court ruled in favor of the IRS, dismissing the taxpayers’ complaint. Its holding noted the reference to section 6707A and identification of applicable transactions through various means.

Congress responded with section 6707A, which not only added penalties for the failure to disclose reportable transactions, but [also] defined “listed transaction” by reference to Treasury regulations that allow the IRS to identify listed transactions by “notice, regulation, or other form of published guidance.” 26 U.S.C. § 6707A; 26 C.F.R. § 1.6011-4. This reference is significant because revenue notices, like revenue rulings and procedures, are normally issued without the notice and comment required by the APA.

5. Interpretive Rule Exception

Agencies are required to use notice and comment rulemaking to issue “legislative” rules, but not “interpretive” ones. In granting CIC Services’ request for a preliminary injunction, the court found Notice 2016-66 to be a legislative rule because CIC would not have to report micro-captive transactions without that notice. In its MSJ, the IRS argued that a legal effect (here, the filing requirement) is not the test for determining whether a rule is legislative or interpretive. Instead, the IRS asserted that the notice merely identifies a transaction of interest: the reporting requirement was not imposed by Notice 2016-66 but rather by the regulation that defines reportable transactions (i.e., Treas. Reg. section 1.6011-4) and the statutes that require material advisors to provide information on them or face penalties (i.e., sections 6011, 6111 and 6707A).

Although Notice 2016-66 identifies a transaction of interest, CIC did not challenge the regulatory concept of a transaction of interest as set forth in the defining regulation (Treas. Reg. section 1.6011-4(b)). In granting CIC’s injunction, the court homed in on the unlimited discretion the IRS has in identifying transactions of interest, “in contrast to the more clearly defined types of reportable transactions identified by the Secretary in 26 C.F.R. § 1.6011-4(b)(1)-(5).” It is worth noting that a “listed transaction” is defined in the regulations as “a transaction that is the same as 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.” Similarly, a “transaction of interest” is defined in the regulations as “a transaction that is the same as or substantially similar to one of the types of transactions that the IRS has identified by notice, regulation, or other form of published guidance as a transaction of interest.” It is not clear how a listed transaction, which results in heavier penalties, can be considered a “more clearly defined” type of reportable transaction than a transaction of interest, given these quite similar definitions in the regulations.

6. Arbitrary and Capricious

CIC claimed that Notice 2016-66 was irrational and thus violated the APA. This was so, it said, because the IRS already had access to most of the information needed to assess the validity of captive insurance transactions and the scope of the Notice encompasses both legitimate and non-legitimate captive insurance transactions. The IRS countered that CIC’s position is inconsistent with its prior statements in which CIC conceded that captive insurance transactions have “a potential for tax avoidance or evasion.” Consequently, the IRS argues that it did not act arbitrarily or capriciously by taking the position that certain micro-captive transactions have the potential for tax avoidance or evasion.

C. IRS Notices as Prophylactic Measures

The IRS argues in its MSJ appeal not only on the legal basis but also from a public policy perspective. The IRS must be nimble enough to respect taxpayer rights but also identify transactions as potentially abusive at an early stage (and not “in the rear-view mirror”) to prevent widespread damage to taxpayers and the government alike. Once an abusive transaction takes hold, it can persist for years and cause extraordinary losses in tax revenue. For example, the IRS gave notice of syndicated conservation easements as a listed transaction in 2017, but by then the transaction had spread to the point where the number of transactions continued to rise after the 2017 listing.

Identifying potentially abusive transactions at an early stage can help taxpayers seek counsel as to whether a proposed transaction ultimately results in more harm than good. To the extent a transaction is designated as a reportable transaction, it can be expected that advisers, including tax preparers, will exercise more care to ensure tax compliance. Consequently, an IRS announcement can act as a prophylactic measure, thereby preventing an abusive transaction from spreading like a harmful virus.

For taxpayers who unwittingly participate in abusive transactions, the financial loss can be devastating, as years of denied deductions subject to interest and penalties can mount. Further, the cost of retaining independent counsel to review and extract clients from abusive transactions can be high. All of this can be mitigated by prompt issuance of guidance that can help protect taxpayers from potentially disastrous consequences. Information gathered from Form 8886 (filed in response to Notice 2016-66) assists the IRS with sending so-called “soft letters” that can provide taxpayers with an opportunity to obtain independent counsel and amend tax returns prior to being picked for audit and subjected to penalties. In contrast, those who profit from the sale of certain products will generally be opposed to IRS publications suggesting the products might be abusive.

III. Puglisi v. Commissioner

In Puglisi v. Commissioner, the IRS disallowed deductions for premiums paid to a micro-captive domiciled in Delaware. After engaging in initial discovery, the IRS decided to concede the micro-captive deductions and the associated interest and penalties. Importantly, in the IRS’s response to the petitioner’s first request for admissions, the IRS denied that the micro-captive structure reflected insurance for federal tax purposes. Instead of accepting the IRS concession, the petitioner pushed for a trial on the merits. In response, the IRS filed a Motion for Entry of Decision requesting that the Tax Court deny the petitioner’s request for a trial. The petitioner objected to this motion, setting the stage for the Tax Court (Judge Gustafson) to decide whether to hear the case on the merits.

A. The Tax Court Order

On November 5, 2021, the Tax Court issued an order granting the IRS’s motion for entry of decision. In so holding, the court provided an overview of the nature of deficiency cases and decisions.

[T]he point in a deficiency case is to ‘redetermine the amount’ of the deficiency determined in the [statutory notice of deficiency] as to a particular taxpayer for a particular year, not to publish commentary on the law or to offer assistance on matters other than the deficiency before the Court. … In the statutory language applicable to the Tax Court, the ‘decision’ in a deficiency case is an ‘order specifying the amount of the deficiency’, sec. 7459(c); and a ‘report’, see sec. 7459(a), is the Court’s opinion that may explain its decision.

Given there was no longer any dispute over the amount of the deficiency, Judge Gustafson believed it was proper to enter a decision. He noted, however, that this was not what the taxpayers wanted. They objected, he said, not because they wanted a different decision as to amount but because they wanted an opinion prior to entry of the same decision as to amount. The court was “persuaded that the Commissioner’s position is correct.”

In holding for the IRS, Judge Gustafson found that going to trial would amount to rendering an advisory opinion, which the Tax Court will generally not do. Although Judge Gustafson could have rejected the IRS’s concession, he decided not to as the limited case law supporting the rejection of an IRS concession was the exception, not the general rule. Judge Gustafson noted that the IRS disclosed its intention to concede less than five months after the first status reports were filed. Further, he noted that the case involved “factual disputes that, as suggested by petitioners’ own projections, would likely require discovery, motions to compel, and a lengthy trial involving fact and expert witnesses.”

The petitioners also suggested the IRS had conceded the case for abusive tactical reasons. Judge Gustafson said the decision to accept the IRS concession now would not prejudice the Tax Court’s discretion in the management of future cases involving this particular captive structure (utilizing “Series A” of the captive program). He went on to note that if many petitioners with similar micro-captives had coordinated their efforts because they felt the issues were ideal litigation vehicles for their position, that would not be subject to criticism. Similarly, there is no reason to “criticize the Commissioner for conceding cases in which his position is weaker in order to devote his resources to litigating cases that are more promising for his position.”

B. Micro-Captive Industry Victory?

Micro-captive arrangements are often sponsored and managed by companies that promote certain structural characteristics that distinguish themselves from other captive management companies as potentially “safer” for federal tax purposes. So far, the IRS has pursued trial with certain taxpayers in the first four micro-captive cases involving different management companies, with all four cases resulting in IRS victories. The impact of this approach is obvious. Once the first taxpayer utilizing a certain structure (e.g., a management company-sponsored “risk pool” or a pooling variant) loses, it calls into question the viability of the program for all others who participated in the sponsored structure. Of course, these cases are highly fact-sensitive and require looking at all the facts and circumstances when gauging the strength of a transaction.

While some may suggest Puglisi is a victory (since, undoubtedly, it is for the taxpayer), the IRS technically “won” on its Motion for Entry of Decision to avoid a trial. Further, the IRS denied that the structure was insurance for federal income tax purposes. It may well be strategically coordinating its inventory of other cases involving this particular captive manager as it has for others. 

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