The state of litigation concerning listed transactions has changed dramatically since the Supreme Court’s unanimous decision in CIC Services, LLC v. Internal Revenue Service in May of 2021. Prior to the Court’s decision, the IRS relied on the Anti-Injunction Act to shield itself from litigation based on the Service’s failure to go through the required notice and comment before issuing a Notice. In CIC Services, the Court rejected that view, unanimously holding that a suit to enjoin a Notice does not trigger the Anti-Injunction Act. Following CIC Services, litigants have been successfully challenging IRS Notices under the Administrative Procedure Act. This article will provide a summary of recently decided as well as ongoing cases centered around these Notices.
Introduction
The Administrative Procedure Act (APA) requires “legislative rules” to go through notice and comment process, which requires the IRS to publish a notice of its proposed rule, give interested parties the opportunity to submit comments, and then “consider and respond” to them. This process “shines a light on delegations of authority from Congress to an executive-branch agency to ensure they remain subject to public scrutiny.”[1]
The APA identifies two categories of rules: legislative and interpretative. Legislative rules “have the force and effect of law,” while interpretative rules simply “advise the public of the agency’s construction of the statutes and rules it administers.” Of the two categories, legislative rules are the only ones required to go through the notice and comment process. Courts have provided guidance on how to identify a legislative rule. Legislative rules “affect individual rights and obligations.”[2] They also “create new law, impose new rights or duties, or expand the footprint of a regulation.”[3] A key identifier of a legislative rule is that “failure to comply” with a legislative rule “comes with the risk of penalties and criminal sanctions.”[4]
Notice 2017-10, along with similar Notices that are at the center of current litigation, are unquestionably legislative rules under these standards. In Mann Construction, the Sixth Circuit found that Notice 2007-83, which identified certain trust arrangements involving cash value life-insurance policies as listed transactions, to be a legislative rule because the Notice defined a set of transactions that taxpayers must report, a duty they did not have before the Notice was issued. In addition, satisfying the reporting requirement under the Notice required “significant time and expense,” and violating it risked “penalties and criminal sanctions.” Using the same analysis, Notice 2017-10 will be considered a legislative rule subject to the APA’s notice and comment process. Notice 2017-10 is derived from the same congressional delegation, imposes the same reporting requirement, and carries the same significant penalties as Notice 2007-83.
In addition to CIC Services and Mann Construction, which involve Notices similar to 2017-10, two cases, GBX Associates LLC v. United States and Green Rock LLC v. Internal Revenue Service, are currently in litigation which directly challenge Notice 2017-10 for violating the APA. These cases are discussed in more detail below.
CIC Services, LLC v. Internal Revenue Service, et al.
CIC Services, LLC was a material advisor to taxpayers participating in micro-captive transactions. It brought suit against the IRS challenging Notice 2016-66 as invalid under the APA. Notice 2016-66 designated certain “micro-captive transactions” as “transactions of interest” and subjected pertinent taxpayers and their material advisors to certain reporting requirements. Noncompliance with these requirements resulted in both civil tax penalties and criminal prosecution as possible repercussions.
The IRS argued the suit was barred by the Anti-Injunction Act, which generally requires persons contesting a tax’s validity to pay the tax prior to filing a legal challenge. The Supreme Court unanimously disagreed with the service’s argument, holding that “[B]ecause the IRS chose to address its concern about micro-captive agreements by imposing a reporting requirement rather than a tax, suits to enjoin that requirement fall outside the Anti-Injunction Act’s domain.” The Court remanded the case to District Court to be decided on its merits.
On March 21, 2022, the District Court for the Eastern District of Tennessee granted summary judgment in favor of CIC Services and vacated Notice 2016-66 because it failed to comply with the notice and comment requirements under the APA. The District Court also found that it was appropriate to set aside the Notice as agency action that was arbitrary and capricious. The court ordered the IRS to return to taxpayers and material advisors all documents and information collected pursuant to the Notice, stating “…the IRS has received documents and information it was not entitled to because it failed to comply with the APA. . . it is entirely reasonable and equitable to require the IRS to return to the taxpayers and material advisors information and documents it collected pursuant to the Notice.”
Following the court’s order, the IRS filed a motion for reconsideration. In this motion, the IRS did not challenge the court’s decision to vacate the Notice for failure to comply with the APA, but rather argued that the court did not have the authority to order the IRS to return documents and information collected pursuant to the Notice to taxpayers and material advisors who were not parties in the suit.
The court begrudgingly granted the IRS’s motion, “If this were simply a matter of determining an equitable result, the IRS would have to return all documents and information produced pursuant to the Notice. . .” Nonetheless, the court granted the motion because CIC Services did not assert class claims, nor did it follow procedural rules necessary to seek injunctive relief on behalf of nonparty taxpayers. “While CIC successfully demonstrated that the Notice must be set aside for failure to comply with the requirements of the APA, CIC is ultimately the only plaintiff in this action.”
The holdings in CIC Services, LLC are important for three reasons. First, the Supreme Court essentially opened the door for taxpayers to challenge a number of IRS Notices for violating the APA, whereas before they had been barred by the Anti-Injunction Act. Second, the District Court’s granting of summary judgment in favor of CIC Services established a precedent that should excite taxpayers who wish to challenge one of these Notices on the same grounds. Third, the District Court made clear that unless class claims are asserted or the procedural rules necessary to seek injunctive relief on behalf of nonparties are followed, similarly situated nonparty taxpayers will not be granted the same relief as the litigants of the suit.
Mann Construction, Inc. v. U.S.
Decided by the U.S. Court of Appeals for the Sixth Circuit on March 3, 2022, Mann Construction concerns Notice 2007-83, which designates certain trust arrangements that use cash value life insurance policies as listed transactions. The IRS argued that the Notice was exempt from the notice and comment requirement because it was an interpretative, not legislative, rule. The IRS alternatively argued that even if the rule was legislative, Congress expressly exempted the Service’s designations of listed transactions from the APA requirements. The Sixth Circuit rejected both arguments.
The court found that Notice 2007-83 was undoubtedly a legislative rule. The Notice’s disclosure requirements created new substantive duties, and noncompliance of those duties resulted in “exposure to financial penalties and criminal sanctions.” The court rejected the IRS’s argument that the Notice merely interpreted the term “tax avoidance transaction” under Section 6707A, and further rejected the Service’s claim that the Notice’s primary purpose was to inform taxpayers that the IRS would challenge tax benefits claimed under these arrangements, not to impose new obligations. Even if this was the primary objective purpose of the Notice, the court found that the Notice imposed reporting obligations that would not otherwise exist and was thus a legislative rule.
The court also rejected the IRS’s argument that Congress exempted the Notice from the notice and comment procedures required by the APA. Congress has, in some instances, exempted certain agency rulemaking from the APA’s notice and comment requirement, and courts have said that Congress does not need to use “magical passwords in order to effectuate an exemption,”[5] however, a clear indication that Congress intended to exempt the rule must exist. Here, the court found no such clear indication. The court further rejected the IRS’s argument that Congress had ratified the IRS’s failure to meet the APA’s notice and comment requirements by subsequent legislative inaction, stating, “It takes far more than the clanging silence we have here to infer that Congress has expressly altered the prerequisites for creating a rule that imposes financial and criminal penalties.”
The court’s holding in Mann Construction effectively nullifies the Section 6707A penalties for taxpayers that did not meet the disclosure requirements set forth in Notice 2007-83. The same logic used by the court in this case would seemingly apply to other Notices, including Notice 2017-10, where the IRS designates certain transactions as listed but failed to follow the comment and notice procedure required by the APA. Two cases, GBX Associates LLC v. United States and Green Rock LLC v. Internal Revenue Service, are currently being litigated and will definitively address the issue of whether Notice 2017-10 is valid law based on the IRS’s failure to follow the APA requirements.
GBX Associates LLC v. U.S., et al.
GBX Associates is currently being litigated in the District Court for the Northern District of Ohio, which, like CIC Services and Mann Construction, is in the Sixth Circuit. GBX brought suit, alleging that the IRS issued Notice 2017-10 without following the notice and comment requirements under the APA. In its complaint, GBX Associates further alleges that the reporting requirements imposed by Notice 2017-10 are significant, compliance therewith is burdensome, and the potential penalties for failure to comply with the reporting requirements are extreme.
GBX is a real estate investment and development firm that focuses on the acquisition, preservation, and rehabilitation of historic buildings in urban centers. GBX uses Historic Preservation Easements, which are qualified real property interests for which the Internal Revenue Code allows a deduction when such are contributed to a qualified organization exclusively for conservation purposes.[6] The IRS considers these Historic Preservation Easements as substantially similar to the listed transactions described in Notice 2017-10, and thus subjects these transactions to the reporting requirements purported by the Notice.
In its complaint, GBX Associates asserts that Notice 2017-10 constitutes a legislative rule that is subject to the APA’s notice and comment procedures as a matter of law, and that the IRS violated the APA when it issued the Notice without first providing notice and an opportunity for public comment. GBX Associates seeks an Order from the court declaring Notice 2017-10 unlawful and permanently enjoining enforcement of the Notice.
GBX Associates’ Complaint was filed on March 11, 2022, and the court denied its Motion for Speedy Hearing and Expedited Declaratory Judgment on April 5, 2022. GBX Associates subsequently filed a Motion for Summary Judgment on June 10, 2022. In response, the IRS filed a Cross-Motion for Summary Judgment on June 24. In its Cross-Motion, the government stated, “[t]he United States concedes that the Notice is unlawful under the APA based on controlling Sixth Circuit Authority in Mann Construction, Inc. v. United States. Mann held that another IRS listed transaction notice was a legislative rule and that, because the IRS issued it without following notice-and-comment procedures, it was promulgated in violation of the APA. The United States agrees that the analysis in Mann applies to the Notice and that the Court should, under 5 U.S.C. § 706, ‘hold unlawful and set aside’ the Notice as to GBX.”
Conceding the Notice as unlawful to GBX Associates, the government is motioning the court to set aside the Notice as to GBX Associates only. The court has yet to rule on the matter. In light of the aforementioned decisions in CIC Services and Mann Construction, as well as the government’s concession, it seems certain the court will follow the precedent established in the same Circuit and will invalidate Notice 2017-10 due to the IRS’s failure to follow the law set forth in the APA. Whether the court will invalidate the Notice nationwide or only as to GBX is an important holding that is yet to be seen.
Green Rock LLC v. Internal Revenue Service, et al.
Like GBX Associates, Green Rock brought suit alleging that Notice 2017-10 is unlawful because the IRS did not follow the APA notice and comment requirements. Green Rock brought suit in the District Court for the Northern District of Alabama, which is in the Eleventh Circuit. In its Brief in Support of Plaintiff’s Motion for Summary Judgment, Green Rock alleges, “The IRS didn’t go through notice and comment before issuing Notice 2017-10, even though that Notice imposes significant duties and liabilities on material advisors to conservation-easement transactions. . . The IRS used to believe this defect could not be challenged in an ordinary APA suit, thanks to the Anti-Injunction Act. But the Supreme Court recently rejected that view in CIC Services. . .” Green Rock also cites to Mann Construction in support of its argument.
The IRS filed a Cross-Motion for Summary Judgment on September 26, 2022, arguing that the American Jobs Creation Act of 2004 “clearly implies that Congress allowed the IRS to identify listed transaction without notice and comment,” an argument similar to the one the Sixth Circuit rejected in Mann Construction. It is yet to be determined when the court will rule on the matter, and it will be interesting to see if the Eleventh Circuit will join the Sixth Circuit in invalidating these Notices for the IRS’s failure to follow the APA’s notice and comment requirements.
Conclusion
Following courts’ aforementioned decisions, both GBX and Green Rock appear likely to prevail in their suits to enjoin the enforcement of Notice 2017-10. The IRS did not follow the notice and comment procedures required by the Administrative Procedure Act, and the veil of protection the IRS enjoyed under the Anti-Injunction Act was removed following the Supreme Court’s decision in CIC Services.
As we await the courts’ decisions in GBX Associates and Green Rock, taxpayers and advisors alike should plan and prepare to challenge the IRS’s blatant failure to follow appropriate procedures. Both taxpayers and their advisors should likewise be cognizant of the District Court’s decision in CIC Services which stated that the injunction did not apply to nonparty taxpayers since no class claims were asserted and the appropriate procedural rules were not followed. The courts’ upcoming decisions in GBX Associates and Green Rock may indeed show that the issue is ripe for a class action suit permanently enjoining the enforcement of Notice 2017-10 and ordering the return of any documents submitted pursuant to the Notice.
[1] Mann Constr., Inc. v. United States, 27 F.4th 1138, 1141 (6th Cir. 2022) (vacating Notice 2007-83 for failing to go through notice and comment).
[2] Chrysler Corp. v. Brown, 441 U.S. 281, 302 (1979).
[3] Children’s Hosp. of the King’s Daughters, Inc. v. Azar, 896 F.3d 615, 620 (4th Cir. 2018).
[4] Mann Constr. 27 F.4th at 1143.
[5] Marcello v. Bonds, 349 U.S. 302, 310 (1955).
[6] 26 U.S.C. Section 170(h).
