Tax Blog/Blawg

On November 20, 2023, the U.S. Court of Appeals for the Sixth Circuit in Mann Construction ruled that its 2022 decision – which had held that sub-regulatory pronouncements labeling transactions as “listed” or “reportable” (and thus subject to penalties for failure to disclose) are invalid under the Administrative Procedure Act – applies only to taxpayers in the Sixth Circuit because the IRS shrewdly mooted the case before the district court on remand was able to issue a nationwide vacatur.

As background, Congress has given the IRS a panoply of potent weapons to combat what the IRS may perceive as abusive transactions.  Among these is the authority to promulgate rules under which taxpayers who engage in specific transactions or types of transactions with the “potential” to evade taxes must disclose the transactions to the IRS.  Such transactions come in two flavors: “reportable” transactions and “listed” transactions.  A “reportable transaction” is one that has the potential for illegal tax avoidance or evasion.  A “listed transaction” is one that is the same as, or substantially similar to, a transaction that the IRS has identified as a tax avoidance transaction. 

A transaction’s status as reportable or listed does not carry any weight in determining whether the transaction which the IRS has identified as having the “potential” for tax evasion has actually been used by the taxpayer to illegally avoid taxes.  But being categorized as a reportable or listed transaction is still significant.  The initial import of such designations is that their disclosure is required.  But there’s more.  Congress further enacted a draconian set of penalties that may apply to taxpayers who fail to disclose either reportable or listed transactions.

In 2007, the IRS added a “listed transaction” that taxpayers must disclose or be subject to the aforementioned penalty regime.  It issued IRS Notice 2007-83, entitled “Abusive Trust Arrangements Utilizing Cash Value Life Insurance Policies Purportedly to Provide Welfare Benefits.”  The Notice designates certain employee-benefit plans featuring cash-value life insurance policies as listed transactions.  The IRS had concern that these transactions may enable small business owners to receive cash and other property from their business on a tax-favored basis.

In 2020, Mann Construction challenged in U.S. district court the imposition of penalties for its failure to disclose participation in a transaction the IRS alleged constituted a Notice 2007-83 transaction.  Mann Construction argued, among other things, that the IRS’ issuance of Notice 2007-83 had violated the notice-and-comment requirement in the Administrative Procedure Act.  The U.S. Court of Appeals for the Sixth Circuit agreed with the taxpayer that the IRS should have but failed to validate Notice 2007-83 through the APA’s notice-and-comment process.

In its decision, the Sixth Circuit emphasized the importance of the APA’s notice-and-comment rulemaking process: “The process serves regulated parties and the agency alike.  Notice and comment gives affected parties fair warning of potential changes in the law and an opportunity to be heard on those changes—and it affords the agency a chance to avoid errors and make a more informed decision.  The process also shines a light on delegations of authority from Congress to an executive-branch agency to ensure they remain subject to public scrutiny.  Courts must set aside agency actions that fail to follow these requirements.”  The Sixth Circuit remanded the case to the district court to issue an order that would “set aside” the improperly issued Notice, and provide corresponding relief to the taxpayer. 

On remand, the district court construed its task as requiring that it issue a nationwide vacatur of the IRS notice.  Notably, this impact is more profound that a typical ruling against the IRS in a tax refund action.  Ordinarily, a circuit court’s ruling on an issue of law is binding only for disputes brought in courts appealable to that circuit.  And ordinarily a district court’s ruling has very limited, if any, binding effect on anyone other than the parties to the litigation.  See Lowy, Legal Authorities in U.S. Federal Tax Matters – Research & Interpretation, 3rd Ed., TAX MANAGEMENT PORTFOLIO SERIES (2016).  However, under the Administrative Procedure Act, specifically 5 U.S.C. § 706(2), a reviewing court in a successful challenge under the APA must “set aside” the agency action.

The IRS, however, was one step ahead of the district court.  Before the district court issued its order vacating the IRS notice, the IRS mooted the case by refunding the penalty that had been imposed on the taxpayer.  When the district court nevertheless entered a decision ordering the nationwide vacatur, the IRS appealed to the Sixth Circuit and argued on procedural grounds that because the taxpayer had dropped all claims in the case other than its claim for monetary relief, which the IRS had fully remedied, the case was essentially over.  There were jurisdictional and standing issues that prevented the district court from vacating the notice, the IRS argued.  On November 20, 2023, the Sixth Circuit issued its decision and agreed with the IRS. 

The IRS’ maneuver may feel a bit like the kid on the playground that calls “time-out” split seconds before getting tagged.  But it worked, if the IRS intended only to live another day.  By beating the district court to the punch, the IRS dodged questions about the scope of judicial remedies when listing notices are invalidated, and the broader ramifications of the district court’s nationwide vacatur.  However, it has created the anomalous situation of having listing notices apply to taxpayers in parts of the country, and not in others, and has invited continued litigation over listing notices that were not validated through the Administrative Procedure Act’s notice-and-comment procedures. 

There are roughly 30 listing notices on this chopping block.  Now, every taxpayer hit with penalties for failure to disclose a transaction designation as a listed or reportable through sub-regulatory guidance such as an IRS Notice that did not pass through the notice-and-comment gauntlet in the Administrative Procedures Act will likely consider contesting the validity of the underlying pronouncement and any corresponding penalties.