by Steve Johnson
A warrior who does not use all weapons risks unnecessary defeat. Taxpayers engaged in controversy with the IRS have often neglected to use — or even know they had — substantial arguments available to them under the Administrative Procedure Act (APA), 5 U.S.C. §551, et seq., and administrative common law. This article encourages taxpayers’ counsel to explore such arguments. The article first establishes that administrative law principles apply in tax. The article then illustrates the possibilities through six examples of administrative law arguments that, depending on the facts of the particular case, could prove successful in litigating against the IRS.
Administrative Law Applies to Tax
Administrative law issues have popped up in tax decisions for decades, but their appearance has been comparatively rare. The failure of counsel to raise such issues more consistently, while unfortunate, is understandable for several reasons.
First, when it comes to substantive tax law, both sides can push the agenda. Both taxpayers and the IRS have incentive to search for improved arguments when old arguments are not working well; but only taxpayers are likely to gain from administrative law arguments. Failing to follow required administrative procedures can cause the IRS to lose, but following them cannot, by that fact alone, cause the IRS to win. Understandably, therefore, the IRS is content to allow administrative law to sleep undisturbed. If it is to be jarred from slumber, the burden is on taxpayers’ counsel to do so.
Second, the pressures of practice challenge the ability of taxpayers’ counsel to shoulder this burden. Counsel’s last substantial exposure to the area may have been a general administrative law course taken as a student. Now the sheer volume of core tax work consumes the whole day. “What? I can’t even keep up with all the tax advance sheets! You mean I now have to learn administrative law, too??” We’ve all been there.
Third, there’s some cultural oil-and-water. To be sure, ambiguity lurks in many nooks of tax law, but there also is clarity in many respects. Tax does have bright lines and is determinative in important respects. That is much less the case in administrative law. “[T]he [APA] is not the tax code. [Administrative law] cases…provide rules of thumb, general principles meant to guide interpretation, not rigid rules that narrowly confine it.”1 Shifting mental gears from the largely determinative to the highly fluid can be daunting for the practitioner.
Fourth, agency-specific enabling statutes trump the general principles of the APA and administrative common law. The Internal Revenue Code often prescribes procedures to be followed in tax cases. When it does, those procedures control. However, when Code procedures are not detailed, exclusive, or applicable, general administrative law rules can operate in important ways.
For these reasons, tax law’s historic neglect of administrative law is understandable, but it is unfortunate — especially for taxpayers. More importantly, such neglect is no longer feasible. Recent years have seen a dramatic upsurge in administrative law issues in tax, and this tide is irreversible.
Under §551(1), with exceptions not here applicable, the APA applies to each “agency” of the federal government. Treasury and the IRS are clearly within the act’s definition of “agency.” In Mayo Foundation for Medical Education & Research v. United States, 131 S. Ct. 704, 713 (2011), the Supreme Court stated that, absent a contextually relevant justification, the Court was “not inclined to carve out an approach to administrative review good for tax only. To the contrary, we have expressly recognized the importance of maintaining a uniform approach to judicial review of administrative action.” The walls of the citadel of tax parochialism have crumbled.2 Effective representation of clients in controversies with the IRS requires the lawyer to be able to bring general administrative law principles to bear.
The full scope of the possibilities has not yet been comprehensively mapped. The potential for creative lawyering is great. This is illustrated by six examples: 1) possibility of earlier challenge to tax rules; 2) challenge to tax regulations based on the APA’s notice-and-comment requirements; 3) challenge to tax regulations under the Regulatory Flexibility Act (RegFlex), 5 U.S.C. §§601-612; 4) challenge to tax regulations under the APA’s arbitrary-and-capricious standard; 5) challenge to notices of deficiency and other IRS adjudicatory determinations under the APA’s arbitrary-and-capricious standard; and 6) challenge to inconsistent IRS positions. These six topics are discussed below.
Earlier Challenge to Tax Rules
When a regulated party is aggrieved by a rule issued by a nontax federal agency, the party often seeks injunctive and declaratory relief even before the agency seeks to enforce the rule. Plaintiffs have to surmount various hurdles — constitutional and prudential standing, finality, ripeness, exhaustion of remedies, and similar requirements — but that often proves feasible.
Traditionally, the situation has been different in tax. Taxpayers who disagree with a Treasury regulation or other binding rule typically have been unable to challenge it until tax court litigation after an IRS audit and issuance of a notice of deficiency, or until refund litigation after assessment and payment. The Anti-injunction Act, I.R.C. §7421(a), and the Declaratory Judgment Act, 28 U.S.C. §2201(a), usually have been interpreted to prevent pre-enforcement challenge to tax regulations.
In the last several years, however, parties increasingly have brought suit against tax regulations and other provisions under the general judicial review provisions of the APA,3 rather than under the remedies established by the I.R.C. Notwithstanding the Anti-Injunction Act and the Declaratory Judgment Act, many of these suits have been allowed to go forward in whole or in part.4
Pre-enforcement injunctive and declaratory relief likely will continue to be unavailable in bread-and-butter tax cases. But recent decisions create great confusion as to where the boundaries of the Anti-Injunction Act and Declaratory Judgment Act are. Thus, in at least some kinds of tax suits under the APA, pre-enforcement litigation may be easier in the future than it has been in the past.5
Notice-and-comment Challenges to Regulations
The APA prescribes that, in order to make binding rules, the agency must publish notice of its proposed rulemaking and afford interested persons the opportunity to submit comments.6 Exceptions include merely interpretive rules and situations of “good cause” found and briefly explained by the agency.7
Treasury often, though not always, submits proposed regulations for notice and comment, even though it claims that it usually is not legally compelled to do so. Treasury claims that tax regulations promulgated under the general authority of I.R.C. §7805(a) (rather than specific authority in particular Code sections) are interpretive rules and so are exempt from APA notice-and-comment requirements. This is quite wrong. For judicial review purposes, there is no meaningful distinction between general authority and specific authority regulations.8 Any regulation (or, for that matter, any subregulation pronouncement) — whether general authority or specific authority in nature — that Treasury intends to have binding effect is a legislative rule, not an interpretive rule, and so is not exempt from notice-and-comment requirements.9
There are substantial reasons to believe that Treasury has often violated the APA notice-and-comment requirements and, as a consequence, that many tax regulations are invalid.10 This issue has been raised in a number of recent cases.11 There may well be opportunity to raise it when challenging infelicitous tax regulations or other binding rules in future cases.
RegFlex Challenges to Regulations
When an agency promulgates a proposed rule, RegFlex requires it either to analyze the rule’s impact on small businesses or to certify that the rule will not have significant economic impact on a substantial number of small businesses.12 Such an agency certification is reviewed by the courts under APA principles.13
Treasury commonly includes a RegFlex certification in its explanations accompanying final tax regulations, and few taxpayers thus far have challenged tax regulations on RegFlex grounds. Nonetheless, there have long been suspicions that Treasury sometimes performs RegFlex analyses in perfunctory fashion and, accordingly, that some tax regulations may be vulnerable on this score.14
A RegFlex challenge was raised unsuccessfully in Florida Bankers Association v. Department of Treasury, 2014 WL 114519 at *6-7 (D.D.C. Jan. 13, 2014). The district court upheld regulations requiring U.S. banks to report to the IRS on accounts held by foreign persons, to enable the IRS to provide the information to foreign revenue agencies. The court construed RegFlex as adverting only to a regulation’s direct impact on small businesses (such as reporting, recordkeeping, and other compliance costs), not to its indirect economic impacts (such as, in Florida Bankers, the possibility of capital flight out of U.S. banks).15 Whether other courts will take a similarly narrow view of the statute and whether other contexts will yield successful RegFlex challenges remain to be seen.
Arbitrary-and-capricious Challenges to Regulations
The APA directs a reviewing court to “hold unlawful and set aside agency action…found to be…arbitrary, capricious, an abuse of discretion, or otherwise not in accordance with law.”16 Agency action is arbitrary and capricious when, for example, the agency relied on considerations irrelevant to the statute, failed to consider a significant aspect of the problem, or failed to reasonably explain why it made the choices embodied in the regulation.17
The arbitrary-and-capricious standard is not a license for courts to second guess policy judgments based on agency expertise. Courts review the adequacy of agency explanations from a common-sense approach rather than mechanistically.18 Nonetheless, the standard has teeth. Nontax regulations often have been invalidated as arbitrary and capricious. This is spreading into tax. In several recent cases, courts have invalidated tax regulations on this basis or individual judges have indicated a willingness to do so on appropriate facts.19
A well respected tax litigator stated: “The APA’s arbitrary and capricious standard provides a powerful tool for taxpayers to use in challenging IRS regulations.”20 Counsel should consider invoking it in a situation in which Treasury appears to have ignored or undervalued important issues, failed to respond to comments submitted to it, or failed to explain why it chose one option over others.
Arbitrary-and-capricious Challenges to IRS Adjudications
Tax practitioners often do not think of the IRS as engaging in adjudication, but it does. For APA purposes, an order (the product of adjudication) is any final agency action other than rulemaking.21 Thus, for administrative law purposes, the IRS engages in adjudication when it makes many types of determinations, including those set out in notices of deficiency, notices of transferee or fiduciary liability, jeopardy and termination assessment notices, collection due process notices of determination, and trust fund recover penalty 60-day letters.
I.R.C. §7522(a) directs the IRS to identify the liability amounts and to state the basis of its determinations in notices of deficiency and some other notices. However, §7522(a) does not indicate the requisite level of detail in such statements, and §7522(b) provides that an inadequate description does not invalidate the notice.
Since §7522 is not a ground for invalidation of an inadequately descriptive notice, the question is whether the APA arbitrary-and-capricious standard can provide such a ground. That standard applies to all types of agency actions — IRS adjudications as well as Treasury regulations. Yet the traditional view in tax circles has been that because deficiency and refund litigation is de novo, the APA standard is displaced.22
However, there are two sides of the story. There is authority invalidating IRS determinations, not because they are wrong as a matter of substantive law, but because they are inadequately explained.23 These waters are deep, and commentators have only recently begun to plumb those depths.24 One may expect this issue to be the subject of additional litigation in the future.
Challenges to Inconsistent IRS Positions
The IRS tries to be consistent. Sometimes, however, it takes positions in litigation that cannot be squared with prior revenue rulings or other published IRS guidance. When that happens, should the IRS lose simply because of its inconsistency? Should the courts hold the IRS to prior, not yet formally revoked published positions? The issue is an old one and has produced case law which is itself inconsistent.25 Barnes Group Inc. v. Comm’r, T.C. Memo. 2013-109 (April 16, 2013), recently provoked another round of controversy as to the issue.26
Administrative law could be part of future iterations of this controversy. First, the arbitrary-and-capricious standard could provide a basis on which to challenge IRS changes of position. Second, in some circuits, the APA’s notice-and-comment requirements also may be invoked. The D.C. Circuit is the most influential circuit in administrative law after the Supreme Court. That circuit takes the position that “an agency cannot significantly change its position, cannot flip-flop, even between two interpretive rules, without prior notice and comment.”27 IRS positional changes are rarely preceded by notice and comment. Other circuits are split as to the D.C. Circuit’s position, and certiorari petitions have been filed with the Supreme Court.28 But Supreme Court resolution, if it comes at all, is more a year away.
The brief discussions above omit numerous nuances as to the six examples. Of course, the six do not come close to exhausting the catalog of administrative law issues that, in appropriate cases, may be deployed by taxpayers challenging IRS positions. The big message is this: Administrative law is here to stay in tax law, and its influence in tax litigation will only grow in the years to come. Taxpayers’ counsel who fail to add these arrows to their quiver may find themselves inadequately armed.
1 Wos v. E.M.A., 133 S. Ct. 1391, 1403 (20130) (Breyer, J., concurring).
2 See, e.g., Steve R. Johnson, Preserving Fairness in Tax Administration in the Mayo Era, 32 Va. Tax Rev. 269, 275-80 (2012).
3 5 U.S.C. §§701-706.
4 E.g., National Federation of Independent Business v. Sebelius, 132 S. Ct. 2566, 2582-83 (2012); Cohen v. United States, 650 F.3d 717, 726 (D.C. Cir. 2011); Halbig v. Sebelius, 2014 WL 129023 at *6-11 (D.D.C. Jan. 15, 2014); and Florida Bankers Association v. Department of Treasury, 2014 WL 114519 at *6-7 (D.D.C. Jan. 13, 2014).
5 Cf. Kristin E. Hickman, A Problem of Remedy: Responding to Treasury’s (Lack of) Compliance with Administrative Procedure Act Rulemaking Requirements, 76 Geo. Wash. L. Rev. 1153, 1200-14 (2008) (urging rethinking of Anti-injunction Act and Declaratory Judgment Act doctrine to allow easier pre-enforcement challenge to tax regulations).
6 5 U.S.C. §553(b)-(d).
7 5 U.S.C. §553(b)(3)(A)&(B).
8 Mayo, 131 S. Ct. at 714.
9 See Steve R. Johnson, Intermountain and the Growing Importance of Administrative Law in Tax Law, Tax Notes at 837, 843-46 (Aug. 23, 2010).
10 See, e.g., Kristin E. Hickman, Coloring Outside the Lines: Examining Treasury’s (Lack of) Compliance with Administrative Procedure Act Rulemaking Requirements, 82 Notre Dame L. Rev. 1727 (2007).
11 E.g., Cohen, 650 F.3d at 721 (dealing with a notice by which the IRS attempted to create a binding rule); Burks v. United States, 633 F.3d 347, 360 n.9 (5th Cir. 2011), cert. den., 132 S. Ct. 2099 (2012); Intermountain Ins. Serv. of Vail, LLC v. Comm’r, 134 T.C. 211, 239, 245-47 (2010) (Halpern & Holmes, JJ., concurring), rev’d & remanded, 650 F.3d 691 (D.C. Cir. 2011), vacated, 132 S. Ct. 2120 (2012).
12 5 U.S.C. §§603-605.
13 5 U.S.C. §611(a)(2).
14 See, e.g., Michael Asimow, Public Participation in the Adoption of Temporary Tax Regulations, 44 Tax Law. 343, 345, 360-72 (1991).
15 Florida Bankers Association, 2014 WL 114519 at *10-11.
16 5 U.S.C. §706(2)(A).
17 E.g., Motor Vehicle Mfrs. Ass’n v. State Farm Mut. Auto. Ins. Co., 463 U.S. 29, 43 (1983).
18 E.g., Florida Bankers, 2014 WL 114519 at *9.
19 E.g., Dominion Resources, Inc. v. U.S., 681 F.3d 1313, 1319 (Fed. Cir. 2012); Mannella v. Comm’r, 631 F.3d 115, 127 (3d Cir. 2011) (Ambro, J., dissenting); Carpenter Family Inv., LLC v. Comm’r, 136 T.C. 373, 395-96, 404 (2011) (Halpern & Holmes, JJ., concurring).
20 Patrick J. Smith, The APA’s Arbitrary and Capricious Standard and IRS Regulations, Tax Notes at 271, 272-73 (July 16, 2012).
21 5 U.S.C. §551(6) and (13).
22 E.g., O’Dwyer v. Comm’r, 266 F.2d 575, 580 (4th Cir. 1959).
23 E.g., Fisher v. Comm’r, 45 F.3d 396, 397 (10th Cir. 1995), non acq. 1996-2 C.B. 2.
24 See Steve R. Johnson, 63 Duke L. J. ___ (forthcoming 2014); Patrick J. Smith, The APA’s Reasoned-Explanation Rule and IRS Deficiency Notices, Tax Notes at 331 (Jan. 16, 2012).
25 See, e.g., Steve R. Johnson, An IRS Duty of Consistency: The Failure of Common Law Making and a Proposed Legislative Solution, 77 Tenn. L. Rev. 563 (2010).
26 Timothy Jacobs, Barnes Group: Tax Court Turns a Blind Eye to Rauenhorst, Tax Notes at 481 (July 29, 2013).
27 Transp. Workers Union of Am. v. TSA, 492 F.3d 471, 475 (D.C. Cir. 2007).
28 Mortgage Bankers Ass’n v. Harris, 720 F.3d 966 (D.C. Cir. 2013), cert. petitions filed, Nos. 13-1041 and 13-1052 (Feb. 28, 2014).
Steve Johnson is professor of law at Florida State University College of Law. He teaches tax, administrative law, and statutory interpretation. He has authored or co-authored two books and scores of articles on tax procedure and tax crimes.
This column is submitted on behalf of the Tax Law Section, Joel David Maser, chair, and Michael D. Miller and Benjamin Jablow, editors.