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May 26, 2022 At Court

The Federal Tax System’s Administrative Law Woes Grow

Kristin E. Hickman

The Supreme Court’s 2011 rejection of tax exceptionalism in Mayo Foundation for Medical Education and Research v. United States has prompted a bevy of lawsuits challenging tax regulatory actions—especially Treasury regulations and IRS Notices—for alleged noncompliance with the Administrative Procedure Act (APA). In turn, those lawsuits have given courts the chance to consider interesting new questions about how general administrative law requirements and doctrines will play out in the tax context. The past few months have seen several decisions with substantial implications both for litigation over past tax regulatory actions and for future tax administrative practices.

The first two cases, Hewitt v. Comm’r and Oakbrook Land Holdings, LLC v. Comm’r, create a circuit split over the content of the preambles to Treasury regulations. Black-letter administrative law doctrine holds that the APA requires agencies, in the preambles to final regulations, to respond to all significant comments they received through the notice-and-comment rulemaking process. We have some cases, but not a really extensive jurisprudence, defining what makes a comment significant for this purpose because most agencies adjusted their rulemaking practices decades ago to simply respond in their regulatory preambles to even minimally cogent comments. By comparison, Treasury and IRS regulation drafters have not always been as attentive to complying with APA procedural requirements as perhaps they should have been, including sometimes not responding specifically in regulatory preambles to comments that might arguably be considered significant. Presumably, Treasury and IRS laxity in this regard has been a consequence of the agencies’ insistence that most of their rules and regulations are “interpretative rules” in administrative law parlance, and thus exempt from APA notice-and-comment rulemaking proceduresa position that the Internal Revenue Manual continues to espouse.

In both Hewitt and Oakbrook Land Holdings, the IRS denied taxpayers deductions for charitable contributions of conservation easements, citing Treas. Reg. section 1.170A-14(g)(6). That regulation elaborates what it means for a conservation easement to be granted “in perpetuity” as required by section 170(h). It was adopted in 1986, several years after courts started requiring agencies to respond to significant comments in their regulatory preambles, but long before the Mayo Foundation decision and the current wave of tax-specific APA cases. In both Hewitt and Oakbrook Land Holdings, the taxpayers challenged the regulation as procedurally invalid, and thus arbitrary and capricious, under the APA for failing to respond to comments from the New York Landmarks Conservancy (NYLC) and others asking Treasury not to adopt the regulation based on concerns that the regulation would chill donations, penalize donors, and create corresponding windfalls for donees. A divided United States Tax Court in Oakbrook Land Holdings decided that a two-page “Summary of Comments” (highlighting 7 major groups of comments from among the more than 700 pages of commentary from 90 organizations and individuals) and a blanket statement that Treasury had “consider[ed] … all comments,” together with the underlying administrative record and actual changes to the regulations in reaction to comments, were adequate to satisfy the APA. The Eleventh Circuit in Hewitt rejected the Tax Court’s reasoning and declared the regulation invalid; but a divided Sixth Circuit panel in Oakbrook Land Holdings disagreed with the Hewitt court and affirmed the Tax Court.

Before both circuit courts, the government argued that none of the highlighted comments were significant, so Treasury was not required to respond to them. According to the government, Treasury’s “primary (if not exclusive) consideration” in adopting the regulation at issue was the meaning of the statutory requirement that the conservation purpose of a conservation easement be “protected in perpetuity.” The comments on which the litigation focused did not explain why the regulation that was proposed would not further that statutory goal or offer alternative approaches beyond simply not adopting the regulation.

The Sixth Circuit panel majority in Oakbrook Land Holdings agreed with the government. At the outset, the panel majority held that Treas. Reg. § 1.170A-14(g)(6) is a legislative rule subject to notice-and-comment rulemaking requirements generally, rather than an exempt interpretative rule. Nevertheless, the court observed that agencies are not required to respond to all comments submitted in a rulemaking, just the significant ones. The panel majority held that NYLC’s comments were not significant because they “did not engage with [the statute’s] perpetuity requirement and whether the rule served [Treasury’s expressed] end, [so] left Treasury to guess at the connection, if any, between the organization’s problems and the … regulation’s basis and purpose.” Other comments similarly “[bore] no relation to” the statutory perpetuity requirement. Comments that were more directly on point but to which Treasury did not respond were not significant because, in the court’s assessment, they were “speculative,” “wrong,” too “cursory,” or insufficiently detailed in proposing alternatives. Finding none of the unaddressed comments to be significant, the court then concluded that Treasury satisfied its APA obligations by responding to the comments that it did.

The Eleventh Circuit in Hewitt reached the opposite conclusion. That court focused particularly on the relationship between NYLC’s comments and congressional goals. The court observed, as NYLC did, that Congress’s ultimate statutory goal was to protect the environment through the donation of conservation easements. According to the court, NYLC’s comments explained in some detail how the regulations would undermine that goal. “In other words,” according to the court, the comments “challenged a fundamental premise” of the regulations by demonstrating how they “would lead to inequitable results that were inconsistent with the statute, and would deter future contributions.” Moreover, the court said that “NYLC’s comment was specific to, and cast doubt on, the reasonableness of the … regulation in light of one of Congress’s committee reports which, according to Treasury, was ‘reflected’ in the final regulations.” Finally, the court rejected the government’s assertion that its blanket statement regarding its consideration of “all comments” was adequate.

In short, the key split between the Sixth and Eleventh Circuits over the requirement that an agency respond to significant regulations comes down to a fundamental disagreement over what makes a comment significant. According to the Sixth Circuit, comments are significant only if they address in some detail the specific statutory provision under interpretation, the precise goal the agency sought to accomplish with the regulation in question, and how the agency’s goal might be better achieved. By comparison, the Eleventh Circuit considers a wider array of comments to be significant, including those that raise concerns about unintended consequences and broader statutory goals. This split has tremendous implications not only for Treasury but for agencies across the administrative state that dedicate substantial effort to responding to comments submitted in the course of notice-and-comment rulemaking. As of this writing, the government is still debating whether to seek certiorari in Hewitt, and the taxpayers in Oakbrook Land Holdings have sought an extension of time to decide whether to seek en banc review. The dispute regarding the validity of Treas. Reg. section 1.170A-14(g)(6) and the significance of comments to which Treasury did not respond in adopting that regulation is far from over.

Another pair of decisions, Mann Construction, Inc. v. United States and CIC Services, LLC v. IRS, raised a different set of issues that are more specific to the tax context. Both of these cases concern the reliance of the reportable transaction regime of section 6707A on IRS notices, which do not go through notice-and-comment rulemaking procedures but impose information reporting requirements on private parties. Mann Construction addresses IRS Notice 2007-83, concerning cash value life insurance policy arrangements as reportable transactions. CIC Services involves IRS Notice 2016-66, regarding micro-captive insurance transactions as reportable transactions. Mann Construction is a refund action, with the taxpayers seeking a refund of penalties assessed and paid under section 6707A. Last May, in CIC Services, LLC v. IRS, the Supreme Court held that the Anti-Injunction Act did not require material advisors to decline to report and suffer penalties before challenging the validity of an IRS notice on APA-based grounds. The Supreme Court remanded the CIC Services case for consideration of the merits.

Only days before the Supreme Court decided CIC Services, a federal district court in Michigan granted summary judgment to the government in Mann Construction. The taxpayers argued that IRS Notice 2007-83 violated the APA because the IRS did not use notice-and-comment rulemaking procedures in issuing it. The district court disagreed, holding that Congress in section 6707A defined reportable transactions “by reference to Treasury regulations that allow the IRS to identify listed transactions by ‘notice, regulation, or other form of published guidance,’” and thereby authorized the IRS to forgo notice and comment. Accordingly, according to the district court, IRS Notice 2007-83 was not procedurally invalid.

A three-judge panel of the Sixth Circuit reversed the district court’s Mann Construction decision. With Chief Judge Jeffrey Sutton writing, the panel held unanimously that section 6707A does not create an exception from APA notice-and-comment rulemaking requirements for reportable transactions. The panel made clear that IRS Notice 2007-83 was a legislative rule generally subject to APA notice-and-comment rulemaking procedures, rather than an exempt interpretative rule. As the panel observed, “[l]egislative rules have the ‘force and effect of law,’” while interpretative rules “do not.” IRS Notice 2007-83 carried such legal force, according to the panel, because it imposed a new reporting obligation on taxpayers as well as civil and criminal penalties upon those who failed to comply, and because it exercised “an express and binding delegation of rulemaking power.” The panel then said that, although Congress need not “employ magical passwords,” the cross-reference contained in section 6707A was insufficiently explicit to demonstrate congressional intent to exempt rules and regulations from APA procedural requirements. The panel also rejected an argument that congressional inaction regarding the IRS’s longstanding practice of relying on Notices in connection with the reportable transaction regime represented ratification thereof. Accordingly, the panel “set aside” IRS Notice 2007-83 for its lack of notice-and-comment rulemaking procedures, in violation of the APA.

On remand from the Supreme Court, the CIC Services case and IRS Notice 2016-66 went back to a federal district court in Tennessee, within the Sixth Circuit. The material advisers challenging IRS Notice 2016-66 argued that the Sixth Circuit’s Mann Construction reasoning regarding IRS Notice 2007-83 applied equally to its case and asked the district court to set aside IRS Notice 2016-66. The government, meanwhile, endeavored to distinguish Mann Construction and also asked the district court to delay resolving the merits of CIC Services until the government decided whether to seek certiorari in Mann Construction. Alternatively, in the event the court found Notice 2016-66 in violation of the APA, the government argued that the district court should remand the notice to the IRS for more procedures without vacating it. Shortly thereafter, the district court in CIC Services delivered what one commenter referred to as a “smackdown” of the IRS. Citing Mann Construction, the district court held that IRS Notice 2016-66 was procedurally invalid for its lack of notice-and-comment rulemaking procedures. Additionally, the district court found IRS Notice 2016-66 arbitrary and capricious for failing “to include relevant data and facts supporting the IRS’s decision to designate micro-captive arrangements as … reportable transactions.” The district court then rejected remand without vacatur as a remedy, vacated IRS Notice 2016-66 “in its entirety,” and ordered the IRS to return any and all documents or information that it received in compliance therewith to the taxpayers and material advisers who produced it.

This last aspect of the district court’s remedy in CIC Services likely is more symbolic than impactful. The IRS has had documents and information filed in compliance with IRS Notice 2016-66 for years, and any knowledge gleaned from it cannot just be purged from the awareness of IRS personnel. Still, the CIC Services court’s emphasis on improperly obtained information and its rejection of IRS Notice 2016-66 for additional reasons beyond those articulated by the Sixth Circuit in Mann Construction, represent as thorough a repudiation of the IRS’s actions as one can imagine. Taken together, the Mann Construction and CIC Services decisions suggest a real problem for the IRS’s approach to reportable transactions in the Sixth Circuit—and, potentially, other circuits to come.

The most recent decision concerning tax and the APA was a federal district court order granting partial summary judgment in Liberty Global, LLC v. United States that declared temporary Treasury regulations issued under section 245A in violation of APA procedural requirements. Readers likely will recall that, for many years, Treasury routinely issued temporary regulations without notice and comment, postponing those procedures until afterward. Since 1996, section 7805(e) has required Treasury, when it issues temporary regulations, to also issue a notice of proposed rulemaking and finalize the temporary regulations within three years. The APA expressly authorizes agencies to forgo notice and comment in promulgating regulations if they contemporaneously issue findings that those procedures would be “impracticable, unnecessary, or contrary to the public interest”—also known as the good cause exception. Until 2019, however, Treasury was not in the habit of claiming good cause when it issued temporary Treasury regulations. Instead, Treasury relied first on its belief that most Treasury regulations were exempt altogether from notice-and-comment procedures as interpretative rules, and then on its interpretation of section7805(e) as an authorization of temporary Treasury regulations without a demonstration of good cause—positions the Internal Revenue Manual still asserts. In 2019, however, Treasury issued a policy statement about its regulatory practices indicating that it would no longer issue temporary regulations without a simultaneous claim of good cause. The section 245A temporary regulations issued a few months later were the first instance of this new practice, with paragraphs of the preamble dedicated to explaining why Treasury thought it appropriate to forgo notice and comment before issuing the regulations.

Granting partial summary judgment to the taxpayer, the court reached three holdings. First, the court held that section 7805(e) does not authorize Treasury to issue temporary regulations without following notice-and-comment rulemaking procedures unless the agency validly claims good cause. Second, the court held that Treasury assertions of good cause in issuing the section 245A regulations were flawed–i.e., that Treasury lacked good cause for forgoing notice and comment. Finally, the court held that Treasury’s procedural error was not harmless, and thus it could not be excused on that basis. These holdings are notable for a couple of particular reasons.

First, the Liberty Global order represents yet another instance of a federal judge rejecting Treasury’s argument that section 7805(e) authorizes it to issue temporary regulations without notice and comment and without a valid good cause claim. The Liberty Global order reflects the opinion of only one federal district court judge, and the government is likely to appeal the decision to the Tenth Circuit. Nevertheless, although a few other judges have rejected Treasury’s interpretation of section 7805(e), no court to consider the question has adopted it. The slow but steady accumulation of authority in favor of a harmonized reading of section 7805(e) and the APA should push Treasury to pay more attention to APA requirements.

On the other hand, the Liberty Global order represents the first time post-Mayo Foundation that any court evaluated a serious assertion of good cause by Treasury in connection with a set of temporary Treasury regulations. Although the court’s evaluation of Treasury’s good cause claim was well reasoned, it is not unassailable. Treasury offered four justifications for claiming good cause. Of the four, three were questionable, but a fourth—describing the potential for taxpayer abuse of the loophole Treasury sought to plug—arguably was more solid. A substantial jurisprudence exists elaborating the courts’ conception of what is or is not good cause, but such claims are inherently very case-specific. The Tenth Circuit may well evaluate Treasury’s good cause claim differently on appeal.

Beyond their individual holdings, facts, and circumstances, what more should we draw from these cases? We have some way to go before any of them, and the issues they present, will be fully resolved. It is clear, however, that many lower-court judges are in no mood to give Treasury and the IRS a pass for being insufficiently attentive to APA procedural requirements, even when violations are many years or even decades past. The Supreme Court’s decision last May in the CIC Services case notwithstanding, long time understandings regarding the justiciability limitations imposed by the Anti-Injunction Act mean that taxpayers often had no opportunity to seek judicial review of Treasury regulations and IRB guidance documents until long after they took effect. That justiciability limitation meant less litigation at the outset, but at the cost of more potential upheaval down the road. Unfortunately for the tax system, the decades-long (and arguably continuing) failure of Treasury and the IRS to pay scrupulous attention to their obligations under the APA means that many Treasury regulations and IRB guidance documents are susceptible to challenge. Policy matters, but procedure does, too.

As courts consider the interaction between the APA and the Internal Revenue Code, Treasury and the IRS will win some cases and lose others. But surely it is time for Treasury and the IRS to concede that they may have erred and to engage with administrative law more seriously and proactively. Tax administration can be tough, but the APA and general administrative law principles give agencies a fair amount of latitude to address difficult circumstances. Clinging to outdated understandings, like continuing to insist (in the Internal Revenue Manual, if not in litigation) that most Treasury and IRS rules and regulations are interpretative rules exempt from APA procedural requirements undermines Treasury and IRS credibility and benefits no one—not the tax system, and not taxpayers. The tax system, and taxpayers, would be better served if Treasury and the IRS instead were to focus more of their efforts on figuring out how to work with APA requirements going forward, and perhaps then on reexamining existing rules and regulations with an eye toward shoring them up against legal challenges for APA noncompliance.

    Kristin E. Hickman

    McKnight Presidential Professor in Law, Distinguished McKnight University Professor, Harlan Albert Rogers Professor in Law, University of Minnesota Law School

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