Taxpayers successfully challenge IRS reportable transaction notices in back-to-back cases

March 2022

BY

Todd SimmensManaging Partner, National Tax Policy and Legislation Technical Practice Leader

In two decisions published in March, the U.S. Court of Appeals for the Sixth Circuit, first, and a federal district court within the Sixth Circuit, second, held that two IRS notices requiring the reporting of certain transactions linked to tax avoidance must be set aside due to the agency’s failure to follow required rulemaking requirements.

In the first case, Mann Construction, Inc. v. US (6th Cir. Mar. 3, 2022), the Sixth Circuit held invalid Notice 2007-83 due to the IRS’s failure to follow the notice-and-comment rulemaking requirements under the Administrative Procedure Act. The case involved a requirement under the notice to report certain trust arrangements involving cash value life insurance policies.

Subsequently, a district court – for which the Sixth Circuit decision was binding – vacated Notice 2016-66 on the same grounds in CIC Services, LLC v. IRS (E.D. Tenn. Mar. 21, 2022). This case involved the IRS’s naming of micro-captive insurance transactions as transactions of interest.
 

Reportable Transactions

Penalties apply under Section 6707A for a taxpayer’s failure to include with a return or statement information required under Section 6011 on any “reportable transaction” identified by the IRS as having the potential for tax avoidance or evasion.

Different types of reportable transactions under the corresponding regulations include, among others, “listed transactions” and “transactions of interest.” Listed transactions refer to transactions that are the same as, or substantially similar to, types of transactions that the IRS has identified as tax avoidance transactions through published guidance. For transactions of interest, the IRS lacks sufficient information to deem the transactions as tax avoidance transactions, but it believes that such transactions have the potential for tax avoidance or evasion.  

Through a series of notices and other guidance documents published over the years – including the notices at issue in the current cases – the IRS has deemed various listed transactions and transactions of interest subject to the reporting requirements.
 

Contended Procedural Missteps

In the Sixth Circuit’s Mann Construction case, the taxpayers sought refunds of penalties imposed for their failure to report the listed transaction identified in Notice 2007-83 relating to an employee-benefit trust that paid premiums on a cash-value life insurance policy. The taxpayers challenged the validity of the notice for, among other reasons, the IRS’s failure to comply with the notice-and-comment requirements of the Administrative Procedure Act.

Generally, under these administrative requirements, agencies must, when issuing rules with the force of law, publish a proposed rule and allow time for public comment. The IRS did not follow this procedure when it issued the notice in question, which the IRS contended was merely an interpretive rule not subject to the notice-and-comment requirements.

The Sixth Circuit disagreed with the IRS and concluded that naming such new reporting requirements for specific types of transactions – with applicable penalties for failure to report – amounted to a legislative rule subject to notice-and-comment requirements. It further concluded that Congress did not here expressly exempt the IRS from this requirement. Due to such failure to follow the applicable rulemaking requirements, the court set aside the notice.

The district court in CIC Services, following the Sixth Circuit’s judgement, similarly held invalid the notice relating to micro-captive transactions. The same court had previously granted the taxpayer in the case a preliminary injunction based on similar reasoning.

The district court went further than Mann Construction and concluded that the relevant notice was also invalid under the Administrative Procedure Act because the IRS acted arbitrarily and capriciously in issuing it. The court reasoned that the IRS failed to document and support its case that micro-captive insurance arrangements have the potential for tax avoidance.

In addition to setting aside the micro-captive notice, the district court ordered the IRS to return documents and information provided to it under the notice by taxpayers and material advisers.
 

Impact of Decisions

The decisions demonstrate some courts’ willingness to invalidate IRS guidance imposing duties and penalties on taxpayers when that guidance has not gone through a notice-and-comment period.

The scope of the decisions is limited currently to the Sixth Circuit. The cases also remain subject to appeal to the Supreme Court of the United States. Moreover, if the IRS is ultimately unable to establish the validity of the existing notices in the courts, or to contain such risk, it may seek to correct the administrative deficit through issuance of new guidance identifying such reportable transactions following a notice-and-comment procedure.

Until action by the Supreme Court or further action by the IRS, it is prudent to continue to report such transactions identified in these notices and similar IRS published guidance to avoid the risk of becoming subject to applicable penalties.