Tax Regulations Could Face New Challenges

Given the size and complexity of today’s tax code, avoiding disputes with the IRS can be difficult. Even a carefully run business can inadvertently run afoul of a new rule, a revised procedure, or updated guidance.

In recent years, however, some taxpayers dealing with IRS notices or enforcement actions have begun to use the complexity of federal law in their own defense, claiming the IRS itself failed to follow proper procedures when drafting regulations. In several cases, federal courts have agreed with the taxpayers, calling into question the validity of a growing number of IRS rules.

Although these cases involve a variety of tax issues, they have a common element: the taxpayers successfully sued the IRS for violating the Administrative Procedure Act (APA), a 1940s-era law designed to spell out acceptable rulemaking processes for the many new executive branch agencies that were created during the New Deal and World War II.

The APA—What It Says and Why It Matters

More specifically, several courts recently ruled that the IRS did not comply with the APA’s requirement that any new or revised federal regulation must first be published in the Federal Register, after which the rulemaking agency must allow time for interested parties to offer comments or objections and then respond to any significant comments those interested parties made.

The APA makes some exceptions to this notice-and-comment requirement. “Legislative rules,” which are based on an express statutory delegation of authority by Congress and thus have the “force and effect of law,” are subject to the requirement. On the other hand, “interpretive rules,” which are merely an agency’s interpretation of a statute’s language, are exempt.

The distinction between these two categories might seem fuzzy, but the difference matters. From the time the APA was enacted in 1946, the Treasury Department and IRS have contended that tax regulations are interpretive rules, not legislative, and thus are not subject to the notice-and-comment requirements. As a result, taxpayers had few options for challenging IRS regulations and various revenue rulings, procedures, notices, and announcements.

A Turning Point

Things started to change in 2011, when the Mayo Foundation for Medical Education and Research challenged an IRS rule about how to classify full-time employees. Although the U.S. Supreme Court ultimately upheld that particular rule, it specifically rejected the IRS’s contention that tax regulations are merely interpretive rules. Rather, the court stated, tax regulations are indeed legislative rules, subject to the same APA notice-and-comment requirements that apply to other rulemaking agencies.

“We are not inclined to carve out an approach to administrative review good for tax law only,” the justices wrote. “To the contrary, we have expressly recognized the importance of maintaining a uniform approach to judicial review of administrative action.”

That language opened the door for challenges to various other tax rules where the IRS had not followed the APA’s notice-and-comment procedures. In addition to the U.S. Tax Court, several U.S. district courts and appeals courts have now heard cases based on this principle, and more are certain to come.

The cases so far have involved a range of issues such as the tax treatment of certain employee benefit plans, the required reporting of microcaptive insurance transactions, the tax deductibility of contributions to syndicated conservation easements, and acceptable cost allocation methods for certain stock options.

Looking beyond the technical tax questions themselves, the larger point is that courts at various levels in several jurisdictions have now begun to question—and in some cases invalidate—IRS tax rules, either because the agency failed to provide an APA-mandated notice-and-comment period or because it failed to address significant adverse comments from interested parties.

Unanswered Questions

A number of important questions remain unresolved. For example, courts have differed over how to determine if a comment is significant enough to require an agency response in the rule’s final language. The APA also allows a “good cause” exception if the agency can show that the notice and comment process would be impractical or unnecessary, as in the case of minor or technical amendments. One case currently being appealed revolves around this issue.

Because various courts have reached different conclusions over the same regulations, taxpayers could be treated differently based on which court hears their case unless the Supreme Court agrees to step in. Businesses that are directly concerned with the particular rules being contested, such as microcaptive insurance or conservation easements, have an obvious reason to follow these cases closely. But even companies that are unaffected by those specific issues might want to keep an eye on this potentially significant trend.

Avoiding tax disputes is still the best policy—and always will be. But with more judges now open to challenges of IRS regulations on procedural grounds, understanding the APA’s requirements could prove to be advantageous if an unwelcome IRS notice arrives.

Contact us today with any questions you may have about this matter.