by Brian Harris and Anna Els
When Congress enacted the Administrative Procedure Act (APA) in 1946, the resulting legislation represented a delicate balance of opposing political interests seeking to complement the evolving role of administrative agencies in government regulation and the preservation of individual liberties.1 Section 702 of the APA symbolizes this premise of individual rights: “A person suffering legal wrong because of agency action, or adversely affected or aggrieved by agency action within the meaning of a relevant statute, is entitled to judicial review thereof.”2 The APA, thus, provides a mechanism to obtain judicial review of agency actions.
Nonetheless, the legislative history of the APA reveals that the protections afforded individuals were not intended to usurp existing procedural mechanisms.3 Section 703 of the APA specifically invokes such reasoning by providing that “[e]xcept to the extent that prior, adequate, and exclusive opportunity for judicial review is provided by law, agency action is subject to judicial review in civil or criminal proceedings for judicial enforcement.”4 Against these two divergent concerns, courts have been called upon to consider the applicability of the APA to the final actions of agencies, such as the IRS and Treasury Department, for which Congress has also enacted specific statutes addressing aspects of judicial review or rulemaking authority for that agency.
One particular venue that has consistently held that the APA does not govern its review of final agency actions is the U.S. Tax Court.5 IRS audits of individuals and corporations (as opposed to some partnership audits that are governed by the different TEFRA procedures, though not for long) generally conclude with the IRS issuing a notice of deficiency for which the taxpayer may then seek judicial review in the U.S. Tax Court.6 The notice of deficiency may state to varying degrees of specificity the facts and law upon which the IRS relies for its proposed assessment. Subsequent litigation the Tax Court has historically been de novo both as to the facts and legal theories that the government might develop during litigation to support the assessment. This sort of de novo review in the Tax Court is in contrast to the more traditional procedure for judicial review of final agency actions under the APA.
One of the principal purposes of the APA was bestowing adjudicative powers upon administrative agencies similar to the traditional judicial process.7 Agencies are specifically responsible for gathering facts and making conclusions of law within the context of the adjudicative process.8 The existence of a record is a fundamental aspect of the agency adjudicative process through which the parties submit evidence and challenge the introduction of facts through traditional methods of inquiry characteristic of judicial procedure.9 Typically, a reviewing court is confined to the record established at the agency level.10 This reasoning encourages a reviewing court to focus its analysis on the record originally established when the agency made its decision, rather than imbuing the record with the reviewing court’s opinion.11 Typically, the reviewing court’s role is limited to determining whether the evidence in the administrative record permitted the agency to reach its conclusions as a matter of law.12 In SEC v. Chenery Corp., 318 U.S. 80 (1943), which predates the APA, the Supreme Court acknowledged the importance of confining a court’s review of agency decisionmaking to the record at least with respect to issues to which Congress has specifically delegated to the agency.13
Taxpayers have recently argued for the application of the APA to Tax Court proceedings largely because the IRS did not adequately develop the facts or legal grounds supporting the proposed deficiency. That is, if the APA governed the Tax Court’s review, then the Tax Court would be confined to only reviewing the facts and legal grounds the IRS developed during the audit and articulated in the notice of deficiency, and as a result the IRS’ proposed assessment would not pass judicial review. It is within this perspective the Tax Court has considered the application of the APA to its review of IRS audits.
In the Tax Court’s recent decision in Ax v. Commissioner, 147 T.C. No. 10 (2016), the IRS challenged the deductibility of the taxpayer’s payment of insurance premiums to a captive insurance company.14 The IRS sought to amend its answer to raise new matters in support of its challenge to the deductibility of the premiums paid.15 That is, the IRS sought to uphold the proposed deficiency on grounds that it had not articulated in its final agency action. The taxpayer argued that the APA and precedent confined the IRS to those stated in the notice of deficiency.16 The taxpayer relied significantly on Chenery. The taxpayer also pointed to the Supreme Court’s refusal in Mayo Foundation for Medical Education & Research v. United States, 562 U.S. 44 (2011), to distinguish administrative review of tax law from other areas of law.17 However, the Tax Court found both Chenery and Mayo to be distinguishable.18
The Ax court noted that Chenery was inapposite because the court there addressed a scenario in which agency action was not reviewable by a court.19 The Mayo court was faced with assessing the weight of agency regulations when interpreting an ambiguous statute.20 The Tax Court also countered that the analysis in Mayo did not address the scenario in which adequate opportunity for judicial review predates the relief proffered by the APA and was, thus, incongruous.21 At the time of the enactment of the APA, the Internal Revenue Code of 1939 had already given explicit exclusive authority to the Tax Court to review deficiency notices issued by the IRS.22
Somewhat similar to Ax, the Fourth Circuit in QinetiQ U.S. Holdings, Inc. v. Commissioner, 845 F.3d 555 (4th Cir. 2017), was tasked with determining the validity of administrative action in the context of a notice of deficiency. While the taxpayer in Ax had capitalized upon the sparse wording of the notice of deficiency in an attempt to prevent the IRS from raising new matters, the QinetiQ taxpayer instead argued that such sparseness invalidated the deficiency notice for failure to provide a detailed explanation by the IRS.23 The taxpayer principally relied upon the Supreme Court’s holding that an agency maintain a “reasoned explanation for [the agency] action” as part of a court’s review of an agency record. Alleging that a notice of deficiency was a final agency action, the taxpayer argued that such reasoned explanation was lacking in the notice of deficiency issued.
The court also looked to I.R.C. §7522, which establishes basic requirements for the IRS’ explanation of its reasoning within a notice of deficiency.24 However, the statute does not elaborate upon what would invalidate a notice of deficiency. Instead, the provision merely states that failure to adequately describe the basis for the issuance of the notice of deficiency will not invalidate it. The QinetiQ taxpayer attempted to leverage a creative interpretation of the statute to avoid its repercussions.25 However, as in Ax, the QinetiQ court returned to the historical significance of the existence of the Tax Court as a forum of review that had predated the APA.26 The court could not reconcile the provisions of the Internal Revenue Code, which permits raising new evidence and issues before the Tax Court in a de novo review, with the APA, under which a reviewing court must adhere to the applicable standard of review.
The QinetiQ court also concluded that a notice of deficiency was not generally subject to the reasoned explanation requirement of the APA because such a notice did not fall within the confines of “final agency action,” which instead encompasses an agency determination of rights, obligations, or legal consequences. Following the issuance of a notice of deficiency, both the taxpayer and the IRS retain the right to raise new matters in subsequent proceedings before the Tax Court. Citing the arbitrary and capricious standard as an example of the rigidity of the APA, the court noted the sharp contrast between the narrow, deferential standard of a reviewing court subject to the APA, as opposed to the generous leeway provided to both the taxpayer and the IRS in Tax Court litigation with respect to the introduction of evidence. So far, the Fourth Circuit is the only circuit court to consider this issue, so it may not be the final word on this issue.
Such recent Tax Court decisions have reinvigorated the debate surrounding tax exceptionalism, whose followers have responded to the peculiarities of tax law by maintaining that tax is so inherently unique both substantively and procedurally that the APA’s procedures for administrative review do not apply.27 The concept of tax exceptionalism is not recent; the procedural variations present in IRS administrative practices continually suggest a fundamental difference between tax law and other areas.28 Courts have also acknowledged the exceptions present in various aspects of tax law and administration.29 Nonetheless, there is continued reluctance by scholars and courts alike to treat tax law as “separate but equal.”30
As the Supreme Court’s Mayo decision illustrates, however, courts have been more apt to apply traditional standards of review for tax rulemaking rather than adhering to tax exceptionalism and applying a different framework.31 The Mayo Foundation offered a residency program for medical students as part of their medical training and paid the residents for their time with patients, which generally ranged from 40 to 80 hours per week.32 Seeking a refund of the Federal Insurance Contributions Act (FICA) withholding from wages paid to the residents, the Mayo petitioners brought suit to challenge the IRS’ interpretation of I.R.C. §3121, which classified the medical residents as employees for purposes of their residency training.33
Mayo addressed the appropriate deferential standard to be applied to an agency regulation interpreting an ambiguous or silent statute.34 The Mayo Court was faced with two very different deferential standards in the context of agency interpretative rulemaking authority.35 The petitioners favored the standard of review articulated in National Muffler Dealers Assn., Inc. v. United States, 440 U.S. 472 (1979), which the Supreme Court had previously used in reviewing a tax regulation. The IRS contended that National Muffler had been superseded by Chevron U.S.A., Inc. v. Natural Resources Defense Council, Inc., 467 U.S. 837 (1984), which practitioners will recognize is the more modern standard commonly applied to the review of administrative regulations. In contrast to the more exacting standard of National Muffler, Chevron, on the other hand, promotes a more tolerant review of agency rulemaking by placing the emphasis on “whether the agency’s answer is based on a permissible construction of the statute.”36
Finding that Chevron yielded the appropriate standard for review of agency rulemaking authority, the court stated that “[a]bsent a justification to do so, this [c]ourt is not inclined to apply a less deferential framework to evaluate Treasury Department regulations than it uses to review rules adopted by any other agency” and that “[t]he principles underlying our decision in Chevron apply with full force to the tax context.”37 Despite its nod to the complexities of tax law, the Mayo court was careful to balance such intricacies with the need to promote a uniform approach to judicial review of all administrative agencies, noting the disinclination “to carve out an approach to administrative review good for tax law only.”38 The willingness of the Mayo court to acknowledge the complexities of tax law was limited to demonstrating that the challenges faced by the IRS in interpreting the Internal Revenue Code are “at least as complex as the ones other agencies must make in administering their statutes,” hence the necessity of consistency in the application of administrative discretion in the rulemaking context.39
In the subsequent case of Loving v. I.R.S., 742 F.3d 1013 (D.C. Cir. 2014), the D.C. Circuit applied the traditional Chevron analysis to consider a challenge to a regulation that the IRS had implemented to regulate tax return preparers. After applying the Chevron analysis, the court determined the IRS had exceeded its interpretive rulemaking authority both because the agency’s construction was foreclosed by the statute (Chevron step 1) and because it was unreasonable “in light of the statute’s text, history, structure, and context” (Chevron step 2).40
In Cohen v. U.S., 650 F.3d 717 (D.C. Cir. 2001) (en banc), the taxpayers challenged administrative procedures established by the IRS for the refund of telephone excise taxes. The taxpayers argued that they were entitled to review the procedure under the APA, and the government that it was inapplicable.41 The D.C. Circuit remanded the case to the district court for consideration of the taxpayer’s APA claim.42 In doing so, the court observed that “Congress has seen fit to provide broadly for judicial review of those actions, affecting as they do the lives and liberties of the American people. This is fully in keeping with fundamental notions in our policy that the exercise of governmental power, as a general matter, should not go unchecked.”43
However, not all such challenges are successful. In Florida Bankers Ass’n v. U.S. Dept. of the Treasury, 799 F.3d 1065 (D.C. Cir. 2015), the taxpayers brought suit to challenge IRS regulations imposing penalties for failing to report interest paid to certain foreign residents. The banks challenged the regulation imposing this requirement as being promulgated in violation of the requirements of the APA.44 The court ultimately sided with the IRS and held that the Anti-Injunction Act and the Declaratory Judgment Act barred the taxpayers’ suit.45 The outcome of Florida Bankers Ass’n was likely driven more by the procedural posture of the case — an affirmative challenge against the regulation — rather than a general prohibition against challenging regulations under the APA.
In Altera Corp. and Subsidiaries v. C.I.R., 145 T.C. 91 (2015), on appeal before the Ninth Circuit, the IRS asserted an income tax deficiency based on its application of a final regulation addressing qualified cost-sharing agreements. The taxpayers defended against the asserted deficiency by challenging the validity of the regulation, and the court held that the regulation was invalid because the IRS had failed to engage in the notice and comment rulemaking and reasoned decisionmaking as required by the APA.46
The APA provides for specific procedural requirements to be followed by agencies in promulgating new rules.47 Legislative rules proposed by an agency mandate a notice and comment period during which the agency gives notice of the rulemaking to the public, invites comments, and selectively responds to comments made.48 As the term suggests, legislative rules “have the force and effect of law.”49 Following publication of the final rule, there is essentially a 30-day grace period until the rule is effective.50
This is in contrast to interpretive rules, which the Supreme Court has also held are exempted from traditional rulemaking procedures.51 This may be explained by the fact that an interpretative rule lacks the force and deference accorded a legislative rule.52 The Supreme Court has noted that the purpose of interpretative rules is to notify the public of “the agency’s construction of the statutes and rules which it administers.”53 Interestingly, the IRS generally views treasury regulations as interpretative rules that are removed from the reach of the APA’s notice and comment requirements.54 Its perception of rules as interpretative generally lacks explanation, however.55 In fact, the IRS has consistently relied upon the interpretative exceptions set forth in the APA to enact regulations while avoiding notice and comment, although as Altera Corp. illustrates, this may be at the agency’s own peril.56
Within the confines of rulemaking, the procedural implementation of treasury regulations and other IRS guidance and publications sometimes deviates significantly from other administrative rules implemented under the APA.57 One significant difference under I.R.C. §7805(b) provides that promulgated rules may take effect retroactively.58 Such a striking procedural variation does not incentivize the IRS to consider the ramifications of implementing a legislative rule as opposed to an interpretative rule.59 Arguably, challenging a rule that could then be reenacted retroactively is a risky proposition for a taxpayer.60
When implementing temporary treasury regulations, for example, the IRS does not adhere to the standard notice and comment period typically applicable under normal agency rulemaking scenarios.61 Both the government and taxpayers are required to observe temporary regulations, although a taxpayer may not rely upon proposed regulations unless expressly permitted in the notice of proposed rulemaking.62 Courts generally view regulations issued in noncompliance with APA notice requirements to be invalid unless one of the four exceptions is met.63 Nonetheless, the IRS’ issuance of technical guidance has substantial weight despite the lack of adherence to the APA. Taxpayers may be subject to fines and other penalties for failure to adhere to IRS regulations and other guidance.
As these cases illustrate, the courts continue to define the way in which the APA interacts with tax practice and the Internal Revenue Code. Separately, there is the consideration of whether one scheme might be preferable to the other especially in the context of final agency decisions. From the taxpayer perspective, it is likely that neither scheme is preferable in all circumstances, while the IRS most likely would prefer limited application of the APA and continued de novo review in the Tax Court.
A pro se taxpayer, for example, may benefit substantially from the “blank slate” of the Tax Court, which affords the opportunity to expand the record well beyond what the taxpayer might have presented during the audit. The majority of cases that are litigated in the Tax Court are brought by pro se litigants, many of which have likely not participated in the audit or appeals processes. The Tax Court is often, though certainly not always, the first point at the process in which the taxpayer is seriously engaged. Precluding those taxpayers from offering new evidence at trial may deprive them of the ability to obtain a just result for their case.
The concept of a “blank slate” may be unsettling to taxpayers, however, in the context of an imprecise and sparingly worded notice of deficiency. While siding with the IRS, the QinetiQ court was at least cognizant of the implications of the average taxpayer attempting to defend against a notice of deficiency in court with only a vague understanding of its contents.64 More fundamentally, all taxpayers should be entitled to at least some level of reasoned explanation from the IRS as to the basis for the taxes that it proposes to assess at the end of the audit process rather than waiting for the IRS to develop that basis in subsequent litigation.
In QinetiQ, the IRS argued that it often lacks sufficient information at the time it issues the notice of deficiency to adequately elaborate upon its reasoning. Furthermore, from an efficiency standpoint, the IRS emphasized that requiring a detailed notice of deficiency in all cases would deplete vulnerable government resources, namely time and money. The QinetiQ taxpayer rejected the IRS’ pragmatic approach to the resolution of tax disputes, instead observing that the issue was more fundamental: a taxpayer’s right to a reasoned explanation from the government of why additional tax may be assessed. Efficiently and effectively balancing IRS resources with adequate notice to a taxpayer is a daunting prospect.
Courts will continue to define the application of the APA to the Internal Revenue Code and other authorities that govern tax practice in the years to come. In recent cases, the courts have shown reluctance to apply the APA to some aspects of tax practice while in others, such as rulemaking, they have tended to harmonize tax practice with general administrative law. And for those policymakers who might consider statutory changes to the interplay between these two schemes in the coming months as Congress considers tax reform, there are myriad interests to balance on each side.q
1 Roni A. Elias, The Legislative History of the Administrative Procedure Act, 27 Fordham Envtl. Law Rev. 207 (Winter 2016).
2 5 U.S.C.A. §702, 1976. Cynthia Tripi, Administrative Law: Availability of Judicial Review of Administrative Action, 55 George Washington L. Rev. 729, 729-730 (May/Aug. 1987).
3 Sen. Comm. Print, 25 in APA Legislative History at 36. Methods of review under the APA are “of two kinds: (a) those contained in statutes and (b) those developed by the courts in absence of legislation.”
4 5 U.S.C.A. §703.
5 See, e.g., Ax v. Commissioner, 147 T.C. No. 10 (Apr. 11, 2016); Andrew R. Roberson, Elizabeth Erickson & Jeffrey M. Glassman, Ax v. Commissioner: The Tax Court Reaffirms That It Is Not Subject to the APA (Apr. 12, 2016).
6 26 U.S.C. §§6212-13.
7 See Elias, The Legislative History of the Administrative Procedure Act, 27 Fordham Envtl. L. Rev. 207 (Winter 2016).
8 Id. at 214.
9 Id. at 220.
10 Nat’l Audubon Soc’y v. Hoffman, 132 F.3d 7, 18 (2d Cir. 1997) (citing Florida Power & Light Co. v. Lorion, 470 U.S. 729, 743-44 (1985)).
11 Leland E. Beck, Report to the Administrative Conference of the United States, Agency Practices and Judicial Review of Administrative Records in Informal Rulemaking at 6 (May 14, 2013) (citing Chenery Corp., 318 U.S. at 196).
12 Id. at 7 (citing Occidental Eng’g Co. v. INS, 753 F.2d 766, 769 (9th Cir. 1985)).
13 Chenery Corp., 318 U.S. at 94.
14 Ax, 147 T.C. at 4.
15 Id. at 7.
16 Id. at 9.
17 Id. at 18.
18 Id. at 10-19.
19 Id. at 11.
20 Id. at 18.
21 Id. at 19-20.
22 I.R.C. §272(a)(1) (1939).
23 QinetiQ, 845 F.3d at 559.
24 Id. at 561.
25 Roger J. Jones, Andrew R. Roberson & Jeffrey M. Glassman, APA Challenge to Notice of Deficiency: QinetiQ Oral Arguments, Lexology, Tax Controversy 360 (Oct. 31, 2016).
26 QinetiQ US Holdings Inc., 845 F.3d at 560-561.
27 James Puckett, Procedurally Taxing, A Fresh Look at Tax Exceptionalism: Tax is a Little Different (Sept. 28, 2016).
28 James Puckett, Structural Tax Exceptionalism, 49 Georgia L. Rev. 1067, 1072 (Nov. 17, 2015).
29 Id. at 1070.
30 Id. at 1068.
31 Mayo, 562 U.S. at 44.
33 Id. at 50.
34 Id. at 54.
36 Id. at 54.
37 Id. at 55.
40 Loving, 742 F.3d at 1021-22.
41 Cohen, 650 F.3d at 736.
43 Id. at 723 (quoting Natural Res. Def. Council, Inc. v. Hodel, 865 F.2d 288, 318 (D.C. Cir. 1988)).
44 Florida Bankers Ass’n, 799 F.3d at 1067.
45 Id. at 1072.
46 Altera Corp., 145 T.C. at 134.
47 5 U.S.C. §553 (2012).
49 Id.; Perez v. Mortgage Bankers Ass’n, 135 S. Ct. 1199, 1203 (U.S. 2015) (quoting Chrysler Corp. v. Brown, 441 U.S. 281, 302-303 (1979)).
50 5 U.S.C. §553(d).
51 Id.; Perez, 135 S. Ct. at 1199.
52 Id at 1208.
53 Id. at 1204 (citing Shalala v. Guernsey Memorial Hospital, 514 U.S. 87, 99 (1995)).
54 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, 1729 (2007).
55 Id. at 1759.
56 Id. at 1733.
57 See generally Hickman, Coloring Outside the Lines: Examining Treasury’s (Lack of) Compliance with Administrative Procedure Act Rulemaking Requirements, 82 Notre Dame L. Rev. 1727, 1729 (2007).
58 See Puckett, Structural Tax Exceptionalism, 49 Georgia L. Rev. 1067, 1072 (Nov. 17, 2015); 26 U.S.C. §7805(b) (2012).
59 See Puckett, Structural Tax Exceptionalism, 49 Georgia L. Rev. at 1096.
61 Hickman, Coloring Outside the Lines: Examining Treasury’s (Lack of) Compliance with Administrative Procedure Act Rulemaking Requirements, 82 Notre Dame L. Rev. at 1760.
62 Id. at 1759.
63 Id. at 1760.
64 See Jones, Roberson & Glassman, APA Challenge to Notice of Deficiency: QinetiQ Oral Arguments, Lexology, Tax Controversy 360 (Oct. 31, 2016).
Brian Harris is a board certified tax attorney who concentrates his practice in tax controversy and litigation. Before joining Akerman LLP, he was a trial attorney with the U.S. Department of Justice, Tax Division.
Anna Els is an associate at Akerman LLP who concentrates her practice in trusts and estates.
This column is submitted on behalf of the Tax Law Section, Joseph B. Schimmel, chair, and Christine Concepcion, Michael D. Miller, and Benjamin A. Jablow, editors.