I. Introduction
In the past several years taxpayers have won a number of challenges to tax guidance based on violations of administrative law. Federal courts are blithely invalidating Internal Revenue Service (“Service”) and Treasury guidance, ranging from regulations to notices, because of failure to follow various administrative law doctrines. These administrative law challenges have been substantive, procedural, or both. Courts engage substantive challenges under the Chevron doctrine by determining whether guidance is inconsistent with, or an unreasonable interpretation of, the statutory language. Procedural challenges involve failure to satisfy requirements of the Administrative Procedure Act (APA), in particular the need for and adequacy of notice-and-comment rulemaking. The guidance nullified in recent cases includes some finalized decades ago.
To demonstrate the potentially enormous consequences of these decisions, this Article examines how the Regulations defining “charitable” under section 501(c)(3) and the related hodge-podge of sub-regulatory guidance, especially revenue rulings, would fare under such application of current administrative law doctrine. The statute and guidance under “charitable” are very old indeed. The exempt purposes listed in section 501(c)(3) date back almost 150 years. The specified statutory purposes name “charitable,” but do so as a category equivalent to “religious,” “literary,” “educational,” etc. That is, “charitable” in the statute is clearly not a residual category or a term encompassing the other listed categories.
Regulations proposed in 1956 would have adopted the narrow, so-called “ordinary” meaning of “charitable,” that is, helping the poor or disadvantaged. Consistent with the statutory structure, such an interpretation of “charitable” would have given it a meaning distinct from, and parallel to, the other listed section 501(c)(3) purposes. Without explanation, significantly revised Regulations were proposed and promulgated in 1959. These 1959 Regulations adopted a broad meaning of “charitable,” one known as the “legal” meaning. This legal meaning, the Regulations explain, is “not to be construed as limited by the separate enumeration in section 501(c)(3) of other tax-exempt purposes which may fall within the broad outlines of charity as developed by judicial decisions.”
In adopting this legal definition, the 1959 Regulations transformed and, at least in one plausible reading, elevated the category of charitable exempt purpose to one of greater generality than the others listed. These Regulations also opened the door to Service guidance recognizing exempt purposes that the statute failed to include and allowing the addition of new ones, a need that statute had also ignored. Those 1959 Regulations stand unchanged to this day. They do not predate the APA, which was enacted in 1946, but they do predate key developments in administrative law on which recent cases have relied. Many instances of sub-regulatory guidance, particularly revenue rulings from the 1970’s, rely on the 1959 Regulations.
This examination represents a thought experiment. No court has yet invalidated the Regulations or revenue rulings defining charitable purpose under section 501(c)(3) based on violations of administrative law. Such a challenge, however, could easily arise. An organization challenging denial of exemption in a declaratory judgment action under section 7428 could raise administrative law issues like those in the recent cases discussed in this Article. Challenges based on the APA have already occurred in connection with charitable deductions, a tax provision closely related to the definition of charitable purpose.
The broad application of the Regulations defining charitable purpose and related revenue rulings, as well as their age, makes them a particularly good vehicle for considering the implications of recent tax cases invalidating guidance based on administrative law doctrines. Moreover, most tax lawyers have at least a passing familiarity with section 501(c)(3), making this approach to recent decisions generally accessible.
This thought experiment serves two different purposes. First, it demonstrates the enormous potential harm to the tax system from judicial invalidation of old tax guidance based on flaws in the administrative procedure. My hope in this regard is that exposing the possible consequences of this new trend will move Congress to act to limit it, perhaps by clarifying the extent to which the APA requirements apply to tax guidance. Further, I urge Congress to codify the approach of a recent district court decision, which applied a six-year statute of limitations, accruing from the date tax guidance is issued, to challenges for noncompliance with the APA. Second, application of administrative law doctrine to this body of tax laws exposes flaws regarding guidance not only as to charitable purpose but also to tax guidance more generally. I hope that this aspect of the Article encourages the Service to explore ways to increase public participation in the guidance process.
This Article joins the long and unusually heated debate about the extent to which these principles of administrative law should, and in fact do, apply to tax. Professor Kristin Hickman over many years and many articles has chastised the Service and Treasury for failure to follow what she believes is and should be clearly applicable law. Others strongly disagree, on both positive and normative bases. Some make a primarily positive argument, taking the position that various doctrines of administrative law do not apply generally to tax guidance under current law, in particular, required notice-and-comment for regulations issued under the general authority of section 7805(a). Another strand of this scholarship focuses on the harm to the quality and quantity of tax guidance that strict adherence to the APA would produce. That is, this latter category of work argues as a normative matter that various aspects of administrative law should not apply to tax guidance. Because I discuss cases taking the position that a wide variety of Service guidance documents must adhere to administrative law requirements related to notice-and-comment rulemaking, I take that application for granted. I also argue for statutory changes to limit application of administrative law doctrines to tax and, to that extent, take a normative position.
After this introduction, the Article reviews the statutory and regulatory provisions regarding charitable purpose under section 501(c)(3), with discussion of the statutory language in Part II and the applicable regulations in Part III. Part IV then discusses the recent tax cases that have relied on both substantive and procedural doctrines of administrative law to invalidate regulations as well as the consequences of applying those doctrines to the charitable purpose regulations. Part V explains the key role revenue rulings have played in defining charitable purpose. Part VI considers judicial application of administrative law to sub-regulatory guidance. These cases turn on procedural challenges under the APA. Part VII makes recommendations as to both guidance regarding charitable purpose and application of administrative law to tax. It calls for the Service to engage a broader set of taxpayer responses not only for any proposed new charitable purposes but also for other kinds of guidance. It also urges Congress to clarify the application of the APA to tax guidance and, urgently, to enact a statute of limitations for procedural challenges to tax guidance.
II. Statutory Exempt Purposes in Section 501(c)(3) and Predecessors
Any study of the potential impact of administrative law on regulatory and sub-regulatory guidance regarding charitable purposes must start with discussion of the statute to which any such guidance relates. Administrative guidance must follow from, and be consistent with, relevant statutory provisions. The language of the statute can also affect which provisions of the APA apply to guidance issued under it.
Statutory language detailing exempt purposes under section 501(c)(3) has changed remarkably little since the Tariff Act of 1894, the Act which included the corporate income tax that the Supreme Court held unconstitutional in Pollock v. Farmers’ Loan & Trust. Co. The 1894 Act had specified that the corporate tax did not apply “to corporations, companies, or associations organized and conducted solely for charitable, religious, or educational purposes.” The Corporate Income Tax Act of 1909 repeated these three same purposes. Following ratification of the Sixteenth Amendment, the Revenue Act of 1913 also repeated these same purposes, adding “scientific” and reordering the named purposes. Congress added “prevention of cruelty to children or animals” as an exempt purpose in 1918 and “literary” in 1921.
Section 101(6) of the 1939 Code, the predecessor of current section 501(c)(3), exempted from taxation “[c]orporations, and any community chest, fund, or foundation, organized and operated exclusively for religious, charitable, scientific, literary, or educational purposes, or for the prevention of cruelty to children or animals.” In enacting the Internal Revenue Code of 1954, Congress added “testing for public safety” to the list of exempt purposes under section 501(c)(3), apparently to overrule Underwriters’ Laboratories Inc. v. Commissioner.
In the most recent change to section 501(c)(3) itself, Congress in 1976 amended it to include organizations “to foster national or international amateur sports competition (but only if no part of its activities involve [sic] the provision of athletic facilities or equipment.)” Congress quickly came to view the facilities and equipment prohibition as unsatisfactory. In 1982, it enacted section 501(j), retroactive to 1976, under which the facilities and equipment prohibition did not apply to “qualified organizations.”
So stood the exempt purposes listed in section 501(c)(3) at the adoption of the Internal Revenue Code of 1939, the Internal Revenue Code of 1954, the adoption of Internal Revenue Code of 1986, and the 2017 amendments wrought by the Tax Cuts and Jobs Act. At no time did Congress act to correct glaring omissions or recognize new purposes. Unlike some other more recent provisions of the Internal Revenue Code or of section 501(c), section 501(c)(3) does not give the Secretary specific authority to promulgate regulations, authority that would recognize the ability to recognize new exempt purposes. Of the purposes missing from the statutory list, perhaps most prominent is the absence of promoting health as an exempt purpose, even though this segment of the sector is the largest by revenue and expense.
Congress, to address what it sees as needed changes, has continued to follow the approach of section 501(j). It has not amended section 501(c)(3). Instead, it has added detailed provisions to section 501, such as section 501(q) for credit unions and section 501(r) for hospitals, even though neither of these categories earns mention in the statutory list of permitted purposes. Section 501(r) codifies—and complicates—the community-benefit standard established in Revenue Ruling 69-545 for hospital exemption. Because section 501(r) relates so closely to that revenue ruling, I discuss it in Part V, the section of the Article on revenue rulings.
In addition to failing to include promotion of health as an exempt purpose, the absence of any statutory provision allowing for new section 501(c)(3) purposes or a broadly worded catch-all or residuary clause strikes me as particularly surprising. As the Supreme Court observed in Bob Jones University v. United States, “[t]he form and history of the charitable exemption and deduction sections of the various income tax Acts reveal that Congress was guided by the common law of charitable trusts . . . . The House Report on the Tax Reform Act of 1969 . . . described ‘charitable’ as ‘a term that has been used in the law of trusts for hundreds of years.’”
The history of charitable trusts demonstrates the importance of a residuary clause. Historians of philanthropy often trace the modern law of charitable trusts to the Preamble to the Elizabethan Statute of Charitable Uses. It listed a number of purposes that were to be considered charitable, including relief of the aged, impotent and poor people, schools of learning, and churches, along with other categories we seldom encounter today, such as relief or redemption of prisoners. It did not include a catch-all or residuary clause. But, as one historian has cautioned, “[t]he categories of charitable uses were never regarded as excusive but as typical of the kinds of philanthropic activities which the state wished to encourage. Public benefit was the key, and the relief of poverty its principal manifestation . . . . Other uses, principally religious, fell outside the preamble but also were considered charitable.”
Scholars of philanthropy also look to Commissioners of Income Tax v. Pemsel. There, Lord Macnaghten explained that “charity” in the legal sense has “four principal divisions: trusts for the relief of poverty; trusts for the advancement of education; trusts for the advancement of religion; and trusts for other purposes beneficial to the community, not falling under any of the preceding heads.” Section 28 of Restatement (Third) of Trusts expands this list of charitable purposes to six: “(1) the relief of poverty; (2) the advancement of knowledge or education; (3) the advancement of religion; (4) the promotion of health; (5) governmental or municipal purposes; and (6) other purposes that are beneficial to the community.”
The American Law Institute (ALI) Restatement of the Law, Charitable Nonprofit Organizations (ALI Restatement) adopts the list of charitable purpose found in Restatement (Third) of Trusts. The ALI Restatement emphasizes that the definition includes not only longstanding specific purposes, such as relief of poverty and promotion of health, but also other “purposes that are beneficial to the community.” It remarks that the Restatement (Third) Trusts, “draws from common law by incorporating the important concept that charitable purposes evolve over time to take into account the changing needs of different communities. . . . There is a clear intent that the charitable class will evolve over time.”
Because section 501(c)(3) itself lacks both a provision explicitly authorizing new permitted purposes under section 501(c)(3) and a broad statutory catch-all, this paper looks next at whether the applicable Regulations authorize new section 501(c)(3) purposes. The Regulations both as proposed and adopted in 1959 arguably do so, although not as explicitly as they could. In contrast, it is not at all clear that the Regulations proposed in 1956 (and withdrawn by the 1959 proposed regulations) would have done so. Had the Regulations adopted in 1959 followed those proposed in 1956, with its narrow interpretation of “charitable” as relief for the poor and needy, perhaps Congress would have had no choice but to amend section 501(c)(3) from time to time.
III. Charitable Purpose in the Regulations
Professor Richard Schmalbeck has written that “the regulations under the early Revenue Acts and the 1939 Code were extremely general, and quite unhelpful in drawing the lines that the charitable sector needed.” He also has observed: “[s]hortly after gifts were made deductible, Treasury issued in 1919 what appear to be the first regulations defining charity,” which “reflected something of a scattered attention span, mentioning a few things in some detail, and many others not. “ Organizations to aid “the general body of litigants by improving the efficient administration of justice” were deemed exempt, but “societies to encourage the performance of first class orchestral music” were not.
Applicable Regulations issued in 1924—which remained unchanged until 1959—provided:
Corporations organized and operated exclusively for charitable purposes comprise, in general, organizations for the relief of the poor. The fact that a corporation established for the relief of indigent persons may receive voluntary contributions from the person intended to be relieved will not necessarily deprive it of exemption. An association whose sole purpose is the instruction of the public, or an association whose primary purposes is to give lectures on subjects useful to the individual and beneficial to the community may be exempt as an educational corporation, even though such an association has incidental amusement features. Associations formed to disseminate controversial or partisan propaganda are not educational within the meaning of the statute.
After adoption of the Internal Revenue Code of 1954, Treasury and the Service in 1956 proposed a Regulation “following the Service’s historically restrictive interpretation” that “employed a ‘relief of the poor’ concept.” Proposed Regulation section 1.501(c)(3)-1(b) provided that “[o]rganizations formed and operated exclusively for charitable purposes include, generally, organizations for the relief of poverty, distress, or other conditions of similar public concern.” That is, the Proposed Regulation took a narrow view of the meaning of “charitable.” Moreover, the Proposed Regulation included no language permitting additional charitable purposes beyond those specifically stated.
“Following an extensive study by the Service,” these Proposed Regulations were withdrawn in 1959 and new Proposed Regulations were issued. The 1959 Proposed Regulations were adopted as final later the same year. (Unlike more recent Notices of Proposed Rulemaking or Treasury Decisions today, neither the 1959 Proposed Regulations nor the Treasury Decision adopting them include any helpful discussion of the reasoning behind the choices made.) With an addition to the Regulations in order to define “scientific” two years later, these 1959 Regulations have stood unchanged from the date of adoption to today. Professor Schmalbeck characterized the Regulations as “hopelessly incomplete,” offering definitions of “only four of the eight statutory subcategories within the charitable realm” along with testing for public safety.
This Article focuses on the regulatory definition of charity. The regulatory definition begins by specifying that “[t]he term charitable is used in . . . its generally accepted legal sense.” As the Joint Committee on Taxation has explained:
[T]here are two approaches to the meaning of the term charitable—the legal sense and the ordinary and popular sense. The legal sense is derived from the law of charitable trusts and is broader than the ordinary sense of the term, which generally means the relief of the poor and distressed. Since 1959, Treasury regulations have defined the term “charitable” in the legal sense. . . . This definition is broad, encompassing several ideas that would not generally be considered as charitable in the ordinary sense.
As noted earlier, adopting the legal rather than the ordinary sense of “charitable” represents a major change from the 1956 Proposed Regulations. By endorsing such a broad meaning for “charitable,” this Regulation fills the statutory gap regarding new exempt purposes.
The Regulation, in the same sentence, goes on to assert that the term charitable “is, therefore, not to be construed as limited by the separate enumeration in section 501(c)(3) of other tax-exempt purposes which may fall within the broad outlines of charity as developed by judicial decisions.” Professor Schmalbeck asked “why would one think that ‘charitable’ would limit or be limited by the other enumerated categories? They are listed in a sequence, and presumably apply independently. . . . It is speaking about the ‘subset’ usage, not the usage that applies to the entire charitable sector.” Unlike Professor Schmalbeck, I cannot tell whether the clause “which may fall within the broad outlines of charity as developed by judicial decisions” modifies “other exempt purposes” or the term “charitable.” Perhaps the drafters of the Regulation felt constrained by the exempt purposes listed in section 501(c)(3) and had to acknowledge these other categories as distinct, even though they could easily function as sub-categories of this now broadly defined “charitable” purposes. Alternatively, this statement may also reflect the guiding principle, as the Supreme Court recognized in Bob Jones, that the law of charitable trusts undergirds all categories of section 501(c)(3).
Next the Regulation parades a list of permitted charitable purposes: “[r]elief of the poor and distressed or of the underprivileged; advancement of religion; advancement of education or science; erection or maintenance of public buildings, monuments, or works; lessening of the burdens of Government; and promotion of social welfare. . . .” The ordinary meaning of charitable as relief of the poor has not disappeared. It remains and leads the list. Some of the other listed purposes are broad; some are narrow. The Regulations nowhere define them further, although, as discussed in a later section of this paper, in some cases revenue rulings do so. The inclusion of “social welfare” is particularly grating, when the next paragraph of section 501(c) explicitly exempts organizations established “for the promotion of social welfare.” The continued absence of promotion of health is notable as well.
The Regulation then offers an additional separate and enumerated list of organizations “(i) to lessen neighborhood tensions; (ii) to eliminate prejudice and discrimination; (iii) to defend human and civil rights secured by law; or (iv) to combat community deterioration and juvenile delinquency.” For Schmalbeck, this list reflects issues that were particularly salient in the late 1950’s, although to me they resonate with current issues of equity and inclusion. The list, however, has never been updated.
The Joint Committee has written that:
[I]n general the legal definition of charitable is best understood as including activities that are intended to benefit the general welfare or public interest (including activities in the ordinary sense of the term), which itself can be construed broadly or narrowly, and which will expand and contract over time to reflect changing notions of the public interest.
By adopting the legal sense of the term “charitable,” the Regulation can be read as an “umbrella” category, putting other categories under its protection as subcategories. In other words, it seemingly operates to encompass the other listed purposes, some of which have additional regulatory requirements. If so, it stands in some tension with these other categories, despite the ambiguous language regarding the seeming overlap with “other exempt purposes.”
The validity of the 1959 Regulations with their broad definition is crucial to the operation of the sector. The next section examines how they would likely fare if challenged under current understandings of administrative law.
IV. Tax Regulations and Administrative Law
In 1946, the APA emerged from the New Deal. It has been hailed as the “bill of rights for the new regulatory state,” striking a balance “between promoting individuals’ rights and maintaining agencies’ policy-making flexibility.” Its key achievements included establishing notice-and-comment rulemaking. Section 553 of the APA requires that, in general, agencies anticipating adoption of certain kinds of binding rules give notice of the regulation as proposed, invite public comments, and consider the comments received. After the required notice,
the agency shall give interested persons an opportunity to participate in the rule making through submission of written data, views, or arguments with or without opportunity for oral presentation. After consideration of relevant material presented, the agency shall incorporate in the rules adopted a concise general statement of their basis and purpose.
More precisely, APA section 553 requires these procedures, including public notice-and-comment, for what are known as legislative rules. Legislative rules are understood as regulations that have the force of law and impose duties and obligations on affected parties. Legislative rules stand in contrast to interpretive rules, which do not bind the public but instead give an agency’s view of matters under its jurisdiction. Interpretive rules do not require notice-and-comment.
Notice-and-comment, as the Court of Appeals for the D.C. Circuit has explained, “reintroduce[s] public participation and fairness to affected parties after governmental authority has been delegated to unrepresentative agencies.” As Supreme Court has written, “In enacting the APA, Congress made a judgment that notions of fairness and informed administrative decisionmaking [sic] require that agency decisions be made only after affording interested persons notice and an opportunity to comment.” Notice-and-comment procedures are intended to serve fundamental purposes of democracy as well as to improve the regulatory product by bringing to regulators’ attention considerations that might be missed.
Notice-and-comment, of course, is not a panacea. Promulgating regulations is burdensome, such that administrative agencies may try to avoid it. This effort requires many levels of review and considerable investment of administrative resources. Moreover, well-funded interests affected by a proposed regulation are far more likely to comment than individuals or small entities without such resources. That is, comments may well be one-sided; attracting broad public participation in the rulemaking process is seldom achieved. Such may be a particularly acute problem for tax matters. As Professor Clint Wallace explained in a 2017 study, in contrast to financial regulation rulemaking “there are no groups that frequently and consistently submit public interest comments that are substantively sophisticated and benefit from all the tax benefits to be derived from structuring details to benefit from specific tax rules.”
The Regulations defining charitable in the legal sense were enacted just a little more than a decade after the APA. Perhaps at that time its provisions were salient to bureaucrats throughout the federal government, including the Treasury Department and the Service. Both the 1956 and 1959 Notices of Proposed Rulemaking (NPRM) cited the general authority of section 7805 as the statutory basis for the set of Regulations being proposed. Section 7805(a) gives the Secretary of Treasury authority “to prescribe all needful rules and regulations for the enforcement of this title, including all rules and regulations as may be necessary by reason of any alteration of law in relation to internal revenue.” Both sets of Proposed Regulations regarding charitable purpose acknowledged the application of the APA to regulations promulgated pursuant to the general authority of section 7805(a). They state that these Regulations are proposed, and notice is given “pursuant to the Administrative Procedure Act.” They also announced that “[n]otice is hereby given, pursuant to the Administrative Procedure Act, approved June 11, 1946, that the regulations set forth in tentative form below are proposed to be prescribed by the Commissioner of Internal Revenue, with the approval of the Secretary of the Treasury.”
To me, these statements strongly imply but, admittedly, do not explicitly state, that the legislative rulemaking procedures of APA section 553, with its requirement of notice-and-comment, apply to regulations authorized by section 7805(a). Even if such is the correct reading, the references to the APA in these Regulations from the 1950’s suggesting they required notice-and-comment may be a rare exception. As Peter Richman and Taylor Cranor wrote in a recent study, “[b]y the early 20th century . . . the consensus was that most tax rules were interpretive.”
For the several past decades, however, Treasury and the Service have explicitly taken the position that the APA does not require notice-and-comment for regulations promulgated under the general authority of section 7805(a). Although other executive agencies treat regulations promulgated under language similar to that of section 7805(a) as legislative rules and thus subject to section 553 of the APA, our tax agencies have long taken the position that regulations promulgated pursuant to the general authority of section 7805(a) “are interpretive in character and thus exempt from public notice-and-comment requirements by the APA’s own terms.” They deem notice-and-comment to be required only for the limited set of regulations that tax lawyers have deemed “legislative,” namely those promulgated pursuant to a specific grant of authority in a substantive code section, such as section 1502, section 170(a)(1), or section 337(d). As discussed below, however, Treasury and the Service have nonetheless afforded notice-and-comment for regulations they deem interpretive.
Case law has expanded the requirements for notice-and-comment rulemaking. The Supreme Court 1983 decision, Motor Vehicles Manufacturers v. State Farm Mutual Auto Insurance, demanded “reasoned decisionmaking [sic]” from agencies in the context of an APA section 553 rulemaking. The case held that an agency risks a judicial finding that a rule is invalid as arbitrary and capricious under APA section 706, unless it engages in reasoned decision-making. Such decision-making requires the agency to “examine the relevant data and articulate a satisfactory explanation for its action,” including a “rational connection between the facts found and the choice made.” As the Court explained, an agency decision could well prove arbitrary and capricious
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 for its decision 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.
The State Farm requirements have come to be known as the “hard look” doctrine.
Apart from the strictures of the APA, judicial deference to administrative agencies is another important aspect of administrative law. Chevron v. United States, decided in 1984, introduced the famous two steps for judicial review of actions by administrative agencies acting with the force of law in interpreting a statute. At Step One, the reviewing court determines whether Congress has answered the question at hand. If the answer is yes and the administrative action is inconsistent with the Congressional directive, the administrative action is invalid as ultra vires. If the answer is no, courts proceed to the second step. Under Step Two, courts defer to reasonable agency interpretation if there is silence or ambiguity in the statutory text. Chevron itself involved action by the Environmental Protection Agency (EPA), which, after a change in administrations, promulgated a definition of “source” under the Clean Water Act different from and stricter than the one that had been in place under the prior administration. The Court deferred to the agency’s change of position. It rejected the nondelegation doctrine and reasoned that, in making policy decisions, executive agencies, answerable to the President, are more politically accountable than federal courts.
For both the APA requirement of notice-and-comment and Chevron deference, tax law has been a late, reluctant, and less than full participant in the administrative law party. Instead, “tax exceptionalism” has long dominated. As Professor Lawrence Zelenak explained in 2014, tax exceptionalism is “the notion that tax law is somehow deeply different from other law, with the result that many of the rules that apply trans-substantively across the rest of the legal landscape do not, or should not, apply to tax.” Tax exceptionalism has been ascribed to a variety of factors. They include the insular nature of the tax bar, the lack of knowledge of administrative law within the Service after a restructuring in 1988, and the establishment of the Treasury Department procedures long before that of the many administrative agencies established by the New Deal.
The Supreme Court did not explicitly reject tax exceptionalism regarding judicial deference until 2011, many decades after Chevron. In Mayo Foundation for Medical Education and Research v. United States, the Court clearly stated that the Chevron framework applied to regulations promulgated under the general authority of section 7805(a), which, as noted earlier, instructs the Secretary of Treasury to “prescribe all needful rules and regulations” for the enforcement of Title 26 of the U.S. Code. In Mayo, the Supreme Court applied Chevron to uphold a regulation promulgated under section 7805(a) subjecting medical residents to tax under the Federal Insurance Contribution Act. In so doing, Mayo rejected an important aspect of tax exceptionalism.
Even after the date of Chevron, federal courts, including the Supreme Court, had continued to rely on an older, specific Supreme Court tax precedent, National Muffler Dealers Association v. United States, when reviewing tax regulations. National Muffler adopted a multi-factor test less deferential than Chevron. Mayo rejected such use of National Muffler. The Supreme Court in Mayo wrote that absent a justification to do so, “we are not inclined to carve out an approach to administrative review good for tax law only. To the contrary, we have expressly [r]ecogniz[ed] the importance of maintaining a uniform approach to judicial review of administrative action.” This statement suggested, but did not hold, that the procedural aspects of the APA would also apply to regulations promulgated under the general authority of section 7805. But Mayo did not specifically address whether and when tax regulations had to comply with the notice-and-comment requirements of APA section 553. In particular, Mayo did not consider whether the APA required notice-and-comment for regulations promulgated under the general authority of section 7805(a), such as the one at issue in the case.
Nonetheless as the Internal Revenue Manual explains, “[a]lthough most IRS/Treasury regulations are interpretative, and therefore not subject to the notice-and-comment provision of the APA, the Service usually solicits public comment when it promulgates a rule.” For many years the NPRMs for regulations to be promulgated pursuant to the general authority of section 7805 would make explicit statements echoing the IRM position, under a section of the preamble named Special Analyses: “[S]ection 553(b) of the Administrative Procedure Act (5 U.S.C. section 553) does not apply to these regulations.” The boilerplate language did not explain what the inapplicability of APA section 553 meant. Proposed regulations with this language denied the applicability of section 553(b)(1)-(3) at the same time as they followed its commands by not only giving notice of the proposed rulemaking but also seeking and pledging to consider submitted comments: “Before these proposed regulations are adopted as final regulations, consideration will be given to any comments that are submitted timely to the IRS as prescribed in this preamble.”
Treasury and the Service affirmed this approach in a “Policy Statement on the Tax Regulatory Process” issued in March 2019. The purpose of the statement was “to clarify and affirm their commitment to sound regulatory practices.” It reiterated that the APA “exempts interpretive rules from notice-and-comment requirements.” Nonetheless, “as a matter of sound regulatory policy,” the Policy Statement announced that the agencies “will continue to adhere to their longstanding practice of using the notice-and-comment process for interpretive tax rules published in the Code of Federal Regulations.”
As best I can determine, as of December of 2016, with a few discrete exceptions relating to tax shelter transactions, discussed below, NPRMs invoking the authority of section 7805 have made no reference to APA section 553 whatsoever. They remain mute regarding the applicability of the APA even though the IRM has asserted and continues to assert that APA section 553 does not apply to most tax regulations. Language promising consideration of submitted comments remains unchanged. Thus, current NPRMs finesse the issue of whether or not the APA requires notice-and-comment by remaining silent regarding APA section 553.
The Service also long ignored the demands of State Farm. The IRM used to instruct drafters of regulations that “it [was] not necessary to justify the rules that are being proposed or adopted or alternatives that were considered.” Only in 2014 was the IRM revised to require regulation drafters to “describe the substantive provisions of the regulations in clear concise plain language without restating particular rules contained in the regulatory text.” The current provision of the IRM, adopted August 2, 2018, provides that “Final regulations are issued after considering the public comments on the proposed regulation. The preamble of a final rule ‘discusses and analyzes public comments received and explains the agency’s final decision.’”
In Altera Corp. v. Commissioner, the Tax Court and the Court of Appeals for the Ninth Circuit considered State Farm’s relationship to Chevron. The Regulation at issue in Altera, Regulation section 1.482-7(d)(2), required qualified cost-sharing agreements between related entities to include the cost of stock based-compensation in order to comply with the statutory arm’s length standard. The Tax Court held the Regulation to be invalid because it did not satisfy the requirements of Chevron or State Farm. The Tax Court concluded that “whether State Farm or Chevron supplies the standard of review is immaterial because Chevron step 2 incorporates the reasoned decisionmaking [sic] standard of State Farm.” According to the Tax Court, the preamble to the Regulation failed to examine relevant data, failed to respond to comments submitted, and failed to provide a reasoned basis for its conclusion based on the administrative record. The opinion also stated that “in promulgating the final rule Treasury invoked its general legislative rulemaking authority under section 7805(a)” and that the “final rule is therefore a legislative rule.” That is, the Tax Court asserted that at least this general authority Regulation was subject to APA section 553.
The Tax Court’s decision apparently influenced administrative practice. Professor Hickman in 2017 noted that, in three high-profile 2016 rulemakings, “Treasury and the IRS have included lengthier explanatory preambles offering greater insight into the drafters’ thinking” and that “[p]ractitioners point to Altera as the reason.” As noted earlier, Treasury and the Service amended their language in NPRMs shortly after the Tax Court’s decision in Altera.
In 2019, however, the Ninth Circuit reversed the Tax Court’s Altera opinion. The appellate court distinguished Chevron from State Farm: “State Farm is used to evaluate whether a rule is procedurally defective as a result of flaws in the agency’s decisionmaking [sic] process. . . . Chevron, by contrast, is generally used to evaluate whether the conclusion reached as a result of that process—agency’s interpretation of a statutory provision it administers—is reasonable.” The Ninth Circuit found the Chevron issue to be straightforward. According to the Ninth Circuit, the statute did not speak directly to treatment of stock compensation costs. Thus, under Chevron, tax administrators could clarify the ambiguity so long as the clarification was reasonable. Moreover, the Regulation met the reasonableness test of Chevron.
The Court of Appeals disagreed sharply with the Tax Court’s application of State Farm and thus with the conclusion that the Regulations were invalid:
Here, Treasury gave sufficient notice of what it intended to do and why, and the submitted comments were irrelevant to the issues Treasury was considering. Because the comments had no bearing on “relevant factors” to the rulemaking, nor any bearing on the final rule, there was no APA violation. . . . . Treasury’s regulatory path may be reasonably discerned. Treasury understood section 482 to authorize it to employ a purely internal, commensurate with income approach in dealing with related companies. It provided adequate notice of its intent and adequately considered the objections.
The Ninth Circuit opinion noted that the Tax Court had held that the 2003 amendments to the arm’s length Regulation constituted a final legislative rule subject to the requirements of the APA. It did not otherwise comment on that holding, although it did test the Regulations under the procedures applicable to notice-and-comment rulemaking.
The opinion, however, did not confront head-on whether regulations promulgated under the authority of section 7805 are “legislative rules” under the APA and thus must—rather than may—follow APA section 553. This question remains unresolved in the Ninth Circuit, under my reading of the case, and for most other circuits.
The Eleventh and Sixth Circuits, however, have now both addressed this legislative rule issue. The cases involve the same Regulation regarding the charitable contribution deduction for conservation easements. Although they reach different conclusions as to the validity of the Regulation, they both apply current administrative law doctrine to treat the Regulation as legislative.
The Eleventh Circuit decided the first of these two cases, Hewitt v. Commissioner, in December of 2021. The case held a regulation regarding conservation easements to be procedurally invalid. The appellate court determined that the regulation was arbitrary and capricious under section 706 of the APA for failure to respond, as required by State Farm, to significant comments on the regulations as proposed.
In reaching its decision, the Eleventh Circuit reversed the Tax Court decision in the case, as well as its own decision in TOT Property Holdings, LLC v. Commissioner, which had upheld the particular conservation easement Regulation at issue. (Hewitt explains that, while it did uphold the Commissioner’s interpretation of the regulation in TOT Property Holdings, it did not consider its validity under the APA because the taxpayers had not made such a challenge.) The Eleventh Circuit also rejected the reasoning of the Tax Court’s opinion in Oakbrook Land Holdings, LLC v. Commissioner, which had upheld the Regulation.
The Regulation at issue involves the statutory provision requiring that deductible conservation easements exist in perpetuity. This statutory requirement creates a dilemma in those relatively few cases in which a court extinguishes the easement. Regulation section 1.170A-14(g)(6)(ii), which I will call “the extinguishment Regulation,” addresses that possibility by providing that the perpetuity requirement remains satisfied in the case of judicial extinguishment if certain requirements are met. They include a requirement that, in the case of extinguishment, the gift provide a proportional allocation of the proceeds between the donee and the donor. That is, under the terms of the gift, the donee needs to have a property right in the sales proceeds at least equal to the proportional value of the perpetual easement at the time of the gift.
The extinguishment Regulation, along with other conservation easement regulations, was proposed on May 23, 1983, a scant month after the Supreme Court issued its State Farm decision. The NPRM stated that “[a]lthough this document is a notice of proposed rulemaking that solicits public comments, the regulations proposed herein are interpretative and the notice-and-comment procedures of 5 U.S.C. 553 [of the APA] do not apply.” A hearing on the Proposed Regulations was held on September 15, 1983. Treasury and the Service finalized the Regulations more than two years later, on January 14, 1986. The Preamble to the Final Regulations summarized comments on seven issues raised by the Proposed Regulations, including access, third party mineral rights, and valuation, but made no mention of judicial extinguishment. In particular, it did not address whether extinguishment proceeds to the donee could be reduced by appreciation in the value of the property attributable to donor improvements.
In 2020 the Tax Court issued its opinion in Oakbrook Land Holdings, LLC v. Commissioner, upholding the procedural and substantive validity of the extinguishment Regulation. The Tax Court, however, rejected the government’s characterization of it as an interpretative rule. The Tax Court found that “[b]ecause the regulation imposes a requirement not explicitly set forth in the statute, it is appropriately treated as a legislative rule.” As a result, State Farm’s requirement of responding to significant comments applied. The Tax Court found State Farm to be satisfied. It appeared to determine the significance of comments based in large part on quantity. It observed that “[o]f the 90 commenters only 13 mentioned the judicial extinguishment provision. Of those 13 most devoted only a few sentences to this subject, generally at the end of a submission that emphasized other matters.” Moreover, according to the Tax Court, “[m]ost of the commenters who mentioned the judicial extinguishment provision supported it.” It described the New York Landmarks Conservancy (NYLC) as the “only commentator to mention donor improvements.” The Tax Court also wrote that the age of the regulation gave weight to the presumption of reasonableness. It concluded that changes to the Proposed Regulation, although involving only a slight rewording, demonstrated that comments on it had received consideration.
The Eleventh Circuit viewed the same record very differently. For it, the fact that 13 of 90 commentators discussed the extinguishment Regulation argued in favor of significance. As to the significance of the NYLC comments in particular, Hewitt looked to Judge Toro’s concurrence in the Tax Court’s Oakbrook Land Holdings. It quoted Judge Toro’s opinion that NYLC had asserted that the Proposed Regulation contradicted Congress’s major policy decisions and that it had “offered comments that, ‘if adopted, would require a change in an agency’s proposed rule,’ and that ‘were both “relevant and significant,” [as to] require a response,’” whether the comment is made by many or only one. The appellate court pointed to committee reports describing encouraging donations as the purpose of the legislation as support for NYLC’s comments. It looked to legislative history as to the importance of “preservation of our country’s natural resources and cultural heritage” and the need to allow conservation easement deductions for “preservation of unique or otherwise significant land areas or structures.”
Legislation, however, often has many different purposes, reflecting varying views of those who supported it. As Judge Harold Leventhal once famously quipped, use of legislative history is “the equivalent of entering a crowded cocktail party and looking over the heads of the guests for one’s friends.” Commentators can easily assert that a proposed regulation is inconsistent with one of the policies prompting legislation and should be discarded. Thus, I suggest that use of legislative history, standing alone, does not necessarily adequately distinguish significant comments requiring a response from insignificant ones that do not. For example, the Sixth Circuit opinion in Oakbrook Land Holdings, discussed below, emphasized a different Congressional concern—the use of conservation easements as tax avoidance transactions.
Judge Holmes’s dissent in the Tax Court’s Oakbrook Land Holdings case offered what I consider a better test for identifying significant comments than that in Hewitt. Judge Holmes noted that “multiple serious comments” had “identified problems with the regulation when it was proposed and explained why those problems mattered.’’ Moreover, he continued, “[c]omments with this level of detail and dispute among the commenters would seem enough to conclude that Treasury had before it ‘significant’ comments,’ deserving responses.” That is, Judge Holmes suggested a test based on detail and degree of dispute. While not all parties applying such a test would come to the same result, it offers (in my view) more guidance than the test articulated in Hewitt.
Ten weeks after the Eleventh Circuit’s opinion in Hewitt, the Sixth Circuit issued its conflicting opinion in Oakbrook Land Holdings. The Sixth Circuit rejected a variety of APA challenges—adequacy of concise statement of basis and purpose, response to comments, reasonableness under Chevron Step Two, and arbitrary and capricious administrative action—to the same regulation considered in Hewitt. It found the “basis and purpose” of the rule to be “apparent.” The opinion emphasized that the legislative history as well as the statutory perpetuity requirement in section 170(h)(5)(A) itself reflected concern with “tax-avoidance transactions in which the taxpayer could obtain a deduction for a gift to charity of the use of part of his property.” It concluded that the NPRM stated Congress’s “animating concerns” by specifying the need to provide “a workable framework for donors, donees, and the Internal Revenue Service to judge the deductibility of open space easements.” The petitioners had characterized the failure to address submitted comments as the “main procedural deficiency with the rule.” The Sixth Circuit, however, found that Treasury was not required to respond to the NYLC’s criticism of the Regulation or that of other commentators because the comments did not engage with the statutory perpetuity requirement.
Under Chevron Step Two, the court concluded that the extinguishment Regulation, which erred on the side of providing a greater percentage of extinguishment proceeds to the donee, represented a reasonable interpretation of section 170(h)(5)(A). It rejected the argument that Treasury was arbitrary or capricious in adopting the Regulation. Citing State Farm and Judulang v. Holder, the majority also wrote that the petitioners “have not pointed to an alternative to the proceeds regulations that was both well-established and that Treasury ignored,” a seemingly narrow and fact-based interpretation of arbitrary and capricious. Importantly, although the Sixth Circuit, unlike the Eleventh Circuit, upheld the Regulation, it did not hesitate to apply current APA standards to a regulation from the 1980s.
The dispute as to how judges should apply Chevron and State Farm to tax regulations also surfaced in the 2023 decision of the Tax Court in 3M v. Commissioner. The Tax Court there upheld Regulation section 1.482-1(h)(2) against both substantive and procedural challenges. Six judges joined the opinion of the Court, two judges concurred in the result only, and eight judges dissented. The Regulation at issue, promulgated in 1994 and known as the “blocked income” Regulation, established a number of requirements that must be satisfied before the Service will take foreign restrictions on payment into account for purposes of allocating income in controlled transactions. In that case, Brazil limited royalties that a Brazilian domestic company could pay a foreign parent to 1%, well below the arm’s-length price. The Service mailed a notice of deficiency stating that the income of the 3M consolidated group should be increased by $23,651,332 to reflect the arm’s-length compensation 3M Brazil should have paid for the intellectual property it received. The notice stated that the Brazilian restrictions on payment would not be taken into account because the conditions for doing so under Regulation section 1.482-1(h)(2) had not been met.
3M challenged the validity of the Regulation on which the Service based the deficiency on both substantive and procedural grounds. A 1972 Supreme Court case, Commissioner v. First Security Bank of Utah, figured prominently for both sets of challenges and in all the opinions. The Supreme Court there held that the Service could not apply section 482 to allocate to the bank insurance commissions received by an insurance agency controlled by the bank because receipt of insurance premiums by the bank would violate applicable banking law.
The Tax Court’s opinion in 3M concluded that First Security supported the validity of the regulation under both Step One and Step Two of Chevron. Because, according to the Court, First Security relied on a regulation no longer in effect, that very reliance showed both that the language of the statute was ambiguous and that a gap existed for the agency to fill. In contrast, Judge Buch’s dissenting opinion took the position that First Security established an interpretation of the statutory language that was controlling and that, consequently, the Regulation did not withstand scrutiny under Chevron because it conflicted with that language. In her concurring opinion, Judge Kerrigan determined that First Security did not control because she found the facts of First Security to be distinguishable on its face and because there was a significant change to the statute in 1986, long after the Supreme Court handed down its decision in First Security.
First Security also carried weight in connection with the State Farm requirement that an agency must respond to significant comments. The four comments submitted regarding the proposed blocked income Regulation at issue relied on First Security and related cases, in particular Proctor & Gamble Co. v. CIR. The Tax Court’s opinion in 3M took the position that because issues regarding the relationship of the Regulations under section 482 and those cases were longstanding, the government did not have to respond to their rehashing in issuing this Regulation. Judge Toro in dissent strongly disagreed: “Supreme Court precedent, uniform court of appeals authorities, and hornbook administrative law have long recognized that an agency must both explain its reasoning and respond to significant comments submitted in response to its proposed rulemaking,” But “the record here leaves no doubt that Treasury failed to comply with these requirements.” For example, “Treasury offered no explanation for its choices with respect to the rule. Not a single sentence.”
For purposes of this Article, the 3M case is especially notable for the angst the judges openly expressed about the application of administrative law doctrines to the Regulation at issue there and to tax regulations more generally. Judge Kerrigan is “wary” of the approach taken in Judge Toro’s dissent. She worries that the result of the “heightened scrutiny” Judge Toro would require “would likely be the undoing of years of regulatory promulgation. This would create uncertainty for both taxpayers and Treasury, performing a disservice to the tax system as a whole.” Judge Toro is not unsympathetic to these concerns. He realizes that it “may seem unfair” to “subject to an APA challenge regulations long on the books.” He believes, however, that current law gives him no choice. As Judge Toro sees the matter, “if the current state of the law is unsatisfactory from Treasury’s perspective, relief must come from Congress (or perhaps the Supreme Court), not us.”
The cases discussed in this Part IV have enormous implications to the validity of the Regulations defining charitable purpose, should the Regulations face challenges. Various opinions in each of these cases assume that federal courts should apply current understandings of administrative law regarding Chevron or State Farm to tax guidance issued decades ago. Nothing in the opinions suggests that regulations from the 1950’s, such as the charitable purpose Regulations, would be treated any differently from those from the 1980’s, such as the conservation easement Regulations. Moreover, even if these old charitable purpose Regulations never face challenge, any new or amended Regulations would have to run the gauntlet of current administrative law norms.
Any regulatory re-adoption of the legal definition of charity could run afoul of either Step One or Step Two of Chevron. Nothing in the statutory language as to exempt purposes establishes “charitable” as an over-arching or residual category. As noted earlier, the statute also lacks a category or regulatory authority for new purposes. Thus, some judges could conclude that an expansive position taken in any new Regulations with language like that in the current Regulations fails Step One by contradicting Congress’s clear statement.
A 1923 ruling from the Service suggests the kind of reasoning that could be employed. It determined that a civic association was not charitable because the statute required the organization to satisfy the ordinary sense of charitable, relief of the poor. The ruling relied on the structure of section 501(c)(3) to reach its conclusion: Since the Code listed “charitable” along with religious, scientific, literary and, educational, the term could not be all-inclusive; an all-inclusive meaning would have eliminated the need for the other listed purposes.
The 1959 Regulations, with their adoption of the legal definition of charity, took a far broader view of the meaning of “charity” than this 1923 ruling. Many revenue rulings published after 1959 rely on this broad definition, as discussed further in Part V below. The consequences of a judicial decision invalidating the current charitable purpose Regulations, or new ones with similar language, under Step One of Chevron would be enormous. Indeed, they are difficult even to contemplate.
At the same time, the ambiguity as to whether charity is to be understood in its ordinary or legal sense dates back hundreds of years, as Pemsel demonstrates. This ambiguity may be sufficient, for at least some judges facing the question, to move the question of regulatory validity to Step Two. If so, the current Regulations or new ones like them would likely be upheld as reasonable interpretations. That is, any new or repromulgated Regulations repeating or including the current regulatory language could well pass muster under Chevron’s Step Two.
Even so, if the 1959 Regulations were challenged, a court might hold the regulations invalid under the APA for failing to discuss significant comments, even though the requirement to discuss such comments did not exist at the time of the regulations’ issuance. Recent court decisions invalidating regulations have not taken the age of regulations into account. Of course, a Treasury Decision adopting new or revised final regulations would also need to respond to all significant comments received on the proposed version. Such, in fact, has been recent practice, but Hewitt and Oakbrook Land Holdings may call for expanding detail even further in preambles to final regulations.
Applying these principles of administrative law to the charitable purpose Regulations under section 501(c)(3), moreover, does not exhaust inquiry. The Service has relied on revenue rulings rather than the Regulations to set forth explanation of, and requirements for, various charitable purposes, both within the categories listed in Regulation section 1.501(c)(3)-1(d)(2) and for categories that have emerged over time. Part V below considers the substance of such rulings, and Part VI the issues they pose under administrative law.
