AIA Bars Suit Attempting to Invalidate Insurance Transaction Disclosure Requirements

Earlier this month in CIC Services v IRS a federal district court in Tennessee dismissed a suit that a manager of captive insurance companies and its tax advisor had brought that sought to invalidate IRS disclosure obligations on advisors and participants in certain micro captive insurance arrangements. The case illustrates the still-long reach of the Anti-Injunction Act, which, despite some recent cracks, serves as a formidable barrier to challenging IRS rules outside traditional deficiency or refund procedures.

I will briefly summarize the case and highlight the court’s rationale in dismissing the suit.

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A 2016 Notice indicated that IRS felt that micro captive insurance transactions had the potential for tax avoidance and classified them as transactions of interest. (For background on micro captive insurance companies and the IRS Notice, see a Tax Adviser article here). Failure to comply with the disclosure obligations could lead to hefty civil penalties under Sections 6707(a), 6707A and 6708(a).

CIC, a manager of captives, and an individual who also managed captives and provides tax advice to them, sued in federal district court, claiming in part that the Notice imposed substantial costs and that the IRS in the Notice effectively promulgated legislative rules in APA parlance without complying with mandatory notice and comment requirements. The plaintiffs sought an injunction prohibiting the IRS from enforcing the Notice and a declaratory judgment claiming that the notice was invalid.

The district court held that the Anti-Injunction Act prohibited the suit. The outcome is a fairly straightforward application of the law, though the AIA landscape is somewhat in flux as a result of the Supreme Court’s discussion of the related Tax Injunction Act in the Direct Marketing case from a few years ago. As you may recall, Direct Marketing involved a Colorado law that required out-of-state retailers to provide the state with information reports on their sales to residents of the state. In Direct Marketing, the Supreme Court held that the requirements were not sufficiently connected with the collection or assessment of tax for the challenge to be barred by the Tax Injunction Act, legislation that is similar to though slightly different from the AIA in that it imposes restrictions on cases involving taxes imposed by the states rather than the federal government

The CIC Services case essentially follows the same logic as the majority Florida Bankers case, where the DC Circuit held that the AIA prevented bankers from challenging heightened reporting requirements when the failure to comply would lead to civil tax penalties under Subchapter 68B of the Code (for a criticism of Florida Bankers, see Part 2 of a PT guest post by Pat Smith here).

In this case, Plaintiffs’ claims and their requested injunction necessarily operate as a challenge to both the reporting requirement and the penalty or tax imposed for failure to comply with the reporting requirement. Because the Notice contemplates assessing penalties for non- compliance pursuant to 26 U.S.C. §§ 6707(a), 6707A, and 6708(a), all found within Subchapter 68B of the Internal Revenue Code, Plaintiffs seek, at least in part, to restrain the IRS’s assessment or collection of a tax. Accordingly, the Court lacks subject-matter jurisdiction over Plaintiffs’ claims because they are barred by the AIA and the tax exception to the DJA.

CIC argued in the alternative that they be given the chance to amend the complaint “[i]n the event this Court concludes that the complaint should be dismissed based upon one or more curable pleading defects.” In particular, plaintiffs in their briefing told the court that they had in fact complied with the Notice requirements and would not be subjected to any penalties. The Court held that this did not alter the fact that by seeking an injunction, the suit sought to restrain assessment or collection, even if not directly from plaintiffs.

Conclusion

Challenges to IRS rules such as in the Notice reveal the obstacles that taxpayers and advisors have in challenging rules outside mainstream tax litigation paths. The issue is somewhat more nuanced than perhaps the brief CIC opinion suggests, as there is considerable uncertainty as to whether Direct Marketing should be read as support for narrowing the reach of the terms assessment and collection when considering challenges to IRS rules that may result in penalties, especially in the reporting context. As the Chamber of Commerce district court opinion that allowed the challenge to the anti-inversion regs typified and discussed a few times in PT, including in excellent guest posts by Bryan Camp and Daniel Hemel, there is just enough of an opening to allow creative judges the opportunity to let challenges seemingly within the reach of the AIA as traditionally understood to get through the cracks.

In the months ahead we will see more cases discussing the AIA and how far if at all Direct Marketing should be read to allow earlier challenges to IRS rules that can have far-reaching impact on taxpayers and advisors.

 

 

More on the Successful Challenge to the Anti-inversion Regulations

Today Professor Bryan Camp shares with us some of his views on the government’s loss in Chamber of Commerce v IRS, the challenge to Treasury’s anti-inversion regs that I discussed here.The case has been generating significant comment. For example, Professor Andy Grewal on the Notice & Comment blog nicely summarized the outcome and gave some additional context.

Below Professor Camp discusses why the court’s approach may be out of sync with traditional views of the Anti-Injunction Act. As Bryan suggests, the AIA battle is likely to be one where the Treasury may be able to circle the wagons and fend off early challenges to its rulemaking procedures. Les

I know everyone is chomping at the bit to get to the cool APA stuff, but I think the Anti-Injunction Act is the big issue here.  Or at least should be.  If I read the decision correctly (a big if), this appears to be a suit by an Association and they get standing only because one of their members believed that the regulation under attack would deny them a tax benefit they believed they would get absent this section 7874 regulation on inversion.

The court took an extremely narrow view of the Anti-Injunction Act, seeming to say that it only applies when a particular taxpayer seeks to contest an already assessed tax.  The court believed that ANY attack on the procedural validity of ANY regulation is permissible under the anti-injunction act.   The court says “Here, Plaintiffs do not seek to restrain assessment or collection of a tax against or from them or one of their members.  Rather, Plaintiffs challenge the validity of the Rule so that a reasoned decision can be made about whether to engage in a potential future transaction that would subject them to taxation under the Rule.”

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That statement reflects a poor understanding of tax administration.  You could say that about ANY substantive tax reg.  Is the court really saying that ANY tax regulation can be attacked by any taxpayer whose taxes are potentially affected by the regulation???  That cuts against loads of precedent going at least as far back at Fleet Equipment Co. v. Simon, 76-2 U.S. Tax Cas. (CCH) P16,231 (D.D.C. 2976).  This is exactly the kind of suit that the Anti-Injunction Act is supposed to stop.

In contrast to substantive regs the courts have allowed suits to restrain implementation of regulations that go to tax administration, such as return preparer regulations or information reporting regulations.  Those cannot be attacked in a refund suit and they do not affect the self-reporting taxpayers of the taxpayers subject to them.  But the time and place to attack a substantive tax regulation is in a refund suit.  Gosh and golly.

If the TP here wanted to attack the regulation, it could do so in a refund suit if it takes a different position, gets audited, and wants to fight.  Sure, the regulation would be in place, but the TP would argue that the regulation gets zero deference because it was (allegedly) invalidly promulgated.  Without the regulation, the IRS would still take the same position on the return item but the court would be faced with the TP’s position and the IRS position, unsupported by the authority of a valid regulation.  Just like an assessment is not valid when not properly done.

 

Important DC Circuit Opinion on Anti-Injunction Act and Offshore Disclosure Regime

We have previously briefly discussed the challenge that a group of noncompliant taxpayers brought against the IRS decision to disallow participation in the so-called Streamlined Procedures of the offshore disclosure program. Last year, a district court held that the Anti Injunction Act (AIA) barred the taxpayers from challenging the IRS decision. Last week the DC Circuit Court of Appeals in Maze v IRS upheld the district court.

Maze is the latest in a series of important Anti Injunction Act decisions and reflects the statute’s ability to insulate IRS decisions from judicial review until a taxpayer fits squarely within deficiency, refund or CDP procedures.

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The main issue that the Maze opinion considers whether the AIA is a bar to preventing the court from considering the taxpayer’s argument that the IRS should have used streamlined disclosure procedures rather than transition streamlined procedures. Streamlined procedures allow for no payment of accuracy related penalties; transition rules required payment of up to eight years of those penalties. (Readers looking to learn more on the offshore disclosure program can look to our colleague Jack Townsend over at Federal Crimes Blog; Jack is also the primary author in the criminal tax penalty chapter in the Saltzman Book treatise, and we discuss the IRS offshore disclosure policies in detail in the treatise).

The importance of Maze for our purposes is its consideration of the AIA and in particular Maze’s efforts to get court review of the IRS decision to shoehorn her into the Transition Streamlined procedures rather than the regular Streamlined disclosure procedures.

This takes us into the AIA itself, which is codified at Section 7121. The AIA provides that “no suit for the purpose of restraining the assessment or collection of any tax shall be maintained in any court by any person . . . .”  The key in the case is whether the lawsuit would have the effect of restraining the assessment or collection of any tax. There is a current ambiguity as to whether restrain for these purposes is defined broadly or narrowly. Not surprisingly the government argued for a broad application, urging that the term includes “litigation that completely stops the assessment or collection of a tax but also encompasses a lawsuit that inhibits the same.” Maze urged a more narrow reading, arguing restrain refers “solely to an action that seeks to completely stop the IRS from assessing or collecting a tax.”

The scope of the term “restrain” is a hotly contested issue in AIA litigation; proponents of the narrow reading have pointed to the analogous Supreme Court discussion of the term in the Direct Marketing opinion from a couple of years ago. Earlier this year, the Tenth Court of Appeals in Green Solutions carefully distinguished Direct Marketing and held that the broader reading of restrain is the more appropriate reading in the context of federal AIA litigation.

The DC Circuit in Maze sidestepped this definitional issue; in resolving the opinion in favor of the government the court assumed that the more narrow reading that the taxpayers urged was correct. Using that narrow reading, the DC Circuit still found that the taxpayers came up short.

To get there it first concluded that for these purposes accuracy related penalties are taxes for purposes of the AIA (as the Court discussed not all penalties are taxes for these purposes). After reaching that decision, it was fairly easy to get to the government’s view:

As participants in the 2012 [Offshore Voluntary Disclosure Program], the plaintiffs are required to pay eight years’ worth of accuracy-based penalties. These penalties are treated as taxes under the AIA and any lawsuit that seeks to restrain their assessment or collection is therefore barred…. This lawsuit, in which the plaintiffs seek to qualify to enroll in the Streamlined Procedures, does just that; to repeat, the Streamlined Procedures do not require a participant to pay any accuracy-based penalties for the three years covered by the program. Thus, their lawsuit would have the effect of restraining—fully stopping—the IRS from collecting accuracy-based penalties for which they are currently liable. We believe this fact alone manifests that the AIA bars their suit. See 26 U.S.C. § 7421(a).

To shift the focus away from the lawsuit’s impact on a possible assessment or collection, Maze emphasized that its efforts concerned a desire to apply to Streamlined procedures, which in and of itself alone was not a determination that there were no penalties due. The DC Circuit rejected that view:

They note that their eligibility to enroll alone, viewed in vacuo, has no immediate tax consequence. But we have never applied the AIA without considering the practical impact of our decision. Rather, we have recognized our need to engage in “a careful inquiry into the remedy sought . . . and any implication the remedy may have on assessment and collection.” Cohen, 650 F.3d at 724 (emphasis added). And here, the plaintiffs concede that they will enroll in the Streamlined Procedures if they are deemed eligible, see Oral. Arg. Rec. 3:10-3:15, thereby stopping the IRS from collecting the 2012 OVDP accuracy-based penalties.

The taxpayer noted that the Streamlined procedures would not have resulted in a more favorable treatment if the IRS determined that there was willful noncompliance or a foot fault with the Streamlined procedures. That too was not enough:

But the fact that their attempt to take advantage of the Streamlined Procedures’ more lenient tax treatment might be thwarted by the possibility of an adverse IRS determination does not make their lawsuit one that is not brought “for the purpose of restraining the assessment or collection of any tax.” 26 U.S.C. § 7421(a).

Conclusion

There are still important definitional questions that the courts are wrestling with as the IRS and Treasury get dragged kicking and screaming into the 21st Century post Mayo world. Using its centuries old shield of tax exceptionalism that is the AIA, the IRS still enjoys powerful procedural protections that essentially shoehorn procedural challenges to IRS rulemaking decisions to traditional tax litigation. The DC Circuit in Maze was careful to note (and the DOJ attorney conceded at oral argument) that Maze could have challenged the IRS position in a refund suit. This concession is important because there is an exception to the AIA if there is no other remedy for the alleged wrong. Of course, a traditional tax refund suit generally requires full payment, and that is a considerable bar and practical limit on taxpayers who do not like the rules of the game. Cases like Maze suggest that while the IRS is less special than it used to be the IRS still enjoys a limit on court inquiry into its decisions.

 

The Chamber of Commerce Has an Anti-Injunction Act Problem

Today’s post is by Professor Daniel Hemel the University of Chicago Law School. Daniel discusses the Chamber of Commerce’s lawsuit that challenges the recently promulgated regulations addressing corporate inversions. In an upcoming article in the Cornell Law Review, The President’s Power to Tax, Daniel examines an area that scholars have largely left unaddressed, as he looks at reasons why the Executive Branch has been reluctant to take actions in the tax arena through regulatory power. This post looks at one aspect of executive power, the inversion regulations, and looks at the Anti-Injunction Act’s role in preventing suits to challenge the validity of  those regulations. We have previously discussed the Anti-Injunction Act and state of flux characterizing this nook of tax procedure (a good place to start is Pat Smith’s two part post last year on the apparent inconsistency between the Direct Marketing and Florida Bankers cases). As Daniel describes, despite some chinks in the armor, the Anti-Injunction Act is alive and well and is a powerful tool to combat pre-enforcement challenges to Treasury guidance.

Les

 This post originally appeared in the blog Whatever Source Derived.

The Chamber of Commerce filed a lawsuit in federal district court in Texas Thursday seeking to block the Treasury Department’s April 2016 inversion regulations. The Chamber says that the inversion regulations exceed Treasury’s statutory jurisdiction, that the regulations are arbitrary and capricious in violation of the Administrative Procedure Act (APA), and that Treasury failed to follow the APA’s notice-and-comment requirements. The last of these arguments isn’t frivolous: Treasury certainly could have done more to explain why it was implementing the new rules immediately rather than first allowing 30 days for comment. But whatever one thinks of the Chamber’s notice-and-comment argument, it shouldn’t matter: the Chamber’s complaint has a fatal flaw.

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The problem for the Chamber is the pesky Tax Anti-Injunction Act (TAIA), 26 U.S.C. § 7421, which reads (in relevant part):

[N]o suit for the purpose of restraining the assessment or collection of any tax shall be maintained in any court by any person, whether or not such person is the person against whom such tax was assessed.

The statute lists a number of specific exceptions — none of which even arguably applies here. It establishes a general rule that in order to challenge the assessment or collection of a federal tax, a taxpayer must wait until the IRS actually assesses and attempts to collect the tax, at which point the taxpayer may (a) file a petition in Tax Court challenging the notice of deficiency or (b) pay the tax and then sue for a refund in federal district court or the Court of Federal Claims.

On its face, the TAIA plainly applies to the Chamber’s suit. The Chamber is asking the district court to set aside Treasury’s “Multiple Acquisition Rule,” 26 C.F.R. § 1.7874–8T, which was an element of the April regulations. The Multiple Acquisition Rule says that any stock issued by a foreign corporation in prior acquisitions of U.S. entities over the previous three years shouldn’t be counted when calculating whether a pending acquisition of a U.S. entity qualifies as an inversion. Treasury promulgated the rule pursuant to its regulatory authority under 26 U.S.C. § 7874, which imposes a tax on the “inversion gain” of expatriated entities. A foreign corporation’s acquisition of a U.S. corporation is an inversion for purposes of § 7874 if, after the acquisition, at least 60% of the vote or value of the combined entity is held by former shareholders of the U.S. corporation (among other criteria). “Inversion gain” includes income from the sale of the former U.S. corporation’s stock or property to foreign affiliates over the 10 years following the acquisition (among other items).

So in a nutshell, the Chamber is asking the district court to restrain the IRS from assessing and collecting the § 7874 tax on inversion gain with respect to foreign corporations that fall within the statute’s scope by virtue of the Multiple Acquisition Rule. That sure sounds a lot like a “suit for the purpose of restraining the assessment or collection of any tax.” How, then, does the Chamber plan to get around this?

Friend and JREG Notice & Comment co-blogger Andy Grewal suggests that the Chamber’s strategy might involve the Supreme Court’s 2015 decision in Direct Marketing Association v. Brohl. In Direct Marketing Association, the Court held that the Tax Injunction Act, the state tax equivalent of the TAIA, did not bar a challenge to a Colorado law requiring (mostly out-of-state) retailers to notify Colorado customers of their potential use tax liability and requiring the retailers to report tax-related information to Colorado authorities. The Court emphasized that the Colorado law imposed “notice and reporting requirements” — and not any tax liability — on the retailers.

The Chamber’s suit, by contrast, does not attack any notice or reporting requirements. It attacks the requirement that foreign corporations pay tax on inversion gains after they acquire U.S. entities in qualifying transactions.Direct Marketing Association is inapposite. This is a straight-up challenge to a tax.

Perhaps the Chamber will argue that unless a court addresses the validity of the Multiple Acquisition Rule now, no foreign corporation will acquire a U.S. corporation in a transaction that might trigger the § 7874 tax on inversion gain — the stakes are simply too high for anyone to run that risk. And indeed, Allergan (technically an Irish corporation) and Pfizer (U.S.) called off their merger in April precisely for that reason. But as the Supreme Court said in Enochs v. Williams Packing & Navigation Co., 370 U.S. 1, 6 (1962), and reaffirmed in Bob Jones University v. Simon, 416 U.S. 725, 745 (1974), the TAIA “may not be evaded ‘merely because collection would cause an irreparable injury, such as the ruination of the taxpayer’s enterprise.’” That’s harsh — but so it goes.

Many readers will remember that Chief Justice Roberts danced around a TAIA issue in NFIB v. Sebelius, 132 S. Ct. 2566 (2012), en route to upholding the Affordable Care Act’s individual mandate and limiting the ACA’s Medicaid expansion. The Chief Justice said there that the TAIA didn’t apply because Congress decided to label the individual mandate provision a “penalty” rather than a “tax.” I had qualms about that holding at the time, but in any event it’s of no help to the Chamber here: Congress labeled § 7874 as a “TAX ON INVERSION GAIN OF EXPATRIATED ENTITIES.” Not much ambiguity about that.

In short, the lifespan of the Chamber’s suit should be short: the Chamber’s claims are barred by the TAIA. But while the suit is still alive, let’s revel in the irony. The Chamber is arguing that Treasury promulgated its rule too hastily, without observing the proper procedure. And yet the Chamber is filing its challenge hastily, without . . . (you can finish the sentence).

 

Grab Bag: FBAR and Offshore Cases Worth Highlighting

While Stephen, Keith and I are traveling, important and interesting tax procedure developments keep coming. For those who are missing their tax procedure fix, I point to two cases and other nice write ups that will give some good context.

The first is the Hom case; Mr. Hom has filled a few PT posts with varied and important tax procedure issues. In the development this week, in a nonprecedential and unpublished (but freely available) opinion the Ninth Circuit reversed in part the district court in a case involving whether online gambling sites were accounts that were required to be reported under the FBAR rules.

Jack Townsend at Federal Tax Crimes and Ed Zollars at Current Federal Tax Developments both discuss the case.

The other case that caught my eye and is one that I will be returning too is the Maze v IRS case out of the federal district court in DC. It contains an important discussion of the Anti-Injunction Act. In particular, the opinion considers whether the AIA is a bar to preventing the court from considering the taxpayer’s argument that the IRS should have used streamlined procedures rather than transition streamlined procedures.

Not surprisingly, Jack’s blog, which is the place to turn for developments generally relating to criminal tax but in particular on all offshore issues, hits the opinion hard here.

What caught my eye in the opinion is the extensive discussion of Florida Bankers and other important AIA cases, including Cohen v US, Foodservice and Lodging Inst. v Regan, and Seven-Sky v Holder. We have discussed some of those issues in PT previously. The opinion is careful to limit the openings in the AIA that some cases have revealed.

Bankruptcy and the Anti-Injunction Act

The recent case of Horstemeyer v. United States decided by the Bankruptcy Court for the District of South Carolina addresses the tension between the anti-injunction act (AIA) of the Internal Revenue Code and the injunctive remedies available to bankruptcy judges administering a case. The bankruptcy court determined that its powers did not override the AIA and it declined to enjoin the IRS from levying on the debtor’s retirement account.  Although the court does not specifically discuss monetary remedies available to the debtor, the IRS must use it levy powers with care where a bankruptcy exists because financial remedies for violating the automatic stay or the discharge injunction could be awarded in the right circumstances.

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The case involves a debt the IRS pins on Mr. Horstemeyer as the alter ego of a business. He filed a chapter 7 bankruptcy petition in August of 2014 and disputed the $3.3 million debt the IRS claimed that he owed.  He received a discharge four months later, the usual amount of time for obtaining a discharge in a chapter 7 case, and that is when this case really began.  In January 2015 he filed an adversary proceeding against the IRS seeking a determination that any liability he owed as an alter ego was discharged in the bankruptcy case.  The IRS responded that the liability was excepted from discharge for various reasons.  This proceeding remains unresolved.

While the discharge proceeding was pending, the IRS levied on Mr. Horstemeyer’s retirement account in an effort to collect the taxes. Levying on the retirement account while the discharge complaint was pending signals a strong belief by the IRS that it will prevail in the discharge proceeding since it exposes itself to monetary damages by collecting on a potentially dischargeable liability.  Due to the levy on the retirement account, debtor filed an adversary proceeding in October 2015 seeking a preliminary injunction until resolution of the discharge proceeding.  The bankruptcy court granted a temporary restraining order preventing payment to the IRS of the funds in the retirement account.  The IRS responded that the bankruptcy court lacked authority to bar it from collecting based on the AIA.

Section 7421(a) provides that “no suit for the purpose of restraining the assessment or collection of any tax shall be maintained in any court by any person.”   The Supreme Court in Enochs v. Williams Packing & Navigation Co., stated “the manifest purpose of 7421 is to permit the United States to assess and collect taxes alleged to be due without judicial intervention, and to require that the legal right to the disputed sums be determined in a suit for refund.”  The debtor argued that the discharge injunction of section 524 of the Bankruptcy Code permits bankruptcy courts to enjoin collection despite the broad language of the AIA.

Bankruptcy courts, however, are split on the issue of their power versus the power of the AIA. The minority of bankruptcy courts concluded that the narrower language of the discharge injunction in the bankruptcy code supersedes the more general prohibition of injunctions against the IRS set out in the AIA.  The handful of courts that have ruled this way cite back to the case of Bostwick v. United States decided under the Bankruptcy Act.

The majority of bankruptcy courts addressing the issue acknowledge the power of bankruptcy courts to issue injunctions but find that this authority is insufficient to override the AIA in light of: “(1) its unequivocal language; (2) its oft-amended statutory exceptions that do not include an exception for bankruptcy courts; and (3) the failure of any bankruptcy code provisions explicitly providing for bankruptcy courts to enjoin IRS collection efforts.” Because the bankruptcy court in this case determined that the AIA applied, it must apply the judicially created exceptions to the AIA or irreparable injury and certainty of success on the merits.  Applying those tests to the facts here the bankruptcy court found that the injuries here were monetary and not irreparable.  It also found that the debtor had not come close to showing that the IRS could not prevail on the merits.

The outcome in this case is not remarkable but it shows that in most jurisdictions a debtor will not stop post-discharge collection efforts by the IRS by seeking to use the power of the bankruptcy court. Pre-discharge the automatic stay will stop the IRS from issuing or pursuing collection on a levy.  Post-discharge when the automatic stay has lifted the IRS is free to take collection action without interference from the bankruptcy court; however, if the underlying taxes were discharged in the bankruptcy case, the IRS does so at its financial peril because of the right of the debtor to seek damages.  For this reason, the IRS will only take collection action like a levy where it has a high level of confidence in the discharge case.

Two wrinkles existed here on which the court did not spend much time because of its focus on the AIA issue. One issue is alter ego.  The debtor may not be contesting his liability under the alter ego theory.  That surprises me a little but the court did not lay out the facts supporting that theory.  The second wrinkle involves the pursuit of funds in the retirement plan.  This has two aspects.  First, the IRS does not pursue funds in retirement plans without higher level approval.  Given the amount of uncollected tax and the pursuit of funds in a retirement plan, this account must have received a fair amount of scrutiny at the IRS before it issued the levy.  Second, the retirement account probably did not become an asset of the estate.  I say probably because I do not know enough about the retirement account.  Footnote 4 of opinion states that the IRS argues that it can enforce its lien against the retirement account because it never became property of the estate.  The federal tax lien continues to attach to property exempted, abandoned or excluded from the bankruptcy estate.  The retirement account would almost certainly have been excluded from the bankruptcy estate under section 541(c)(2).  Because of this argument, the IRS may have been more willing to pursue this asset while the dischargeability proceeding was pending since its ability to collect based on its lien does not depend on whether the underlying liability was discharged.

The Management Fee Waiver Regulations May Be Doomed

Today we welcome back a prior contributor to PT, Professor Andy Grewal, Associate Professor at University of Iowa College of Law.  Andy often provides strong commentary on complicated and technical areas of the Code.  Today’s post is no different, and is a combination of prior posts Professor Grewal wrote for Yale’s great regulatory blog Notice and Comment.  In the post, Andy discusses the recent proposed regulations on management fee waiver transactions in private equity funds, and, specifically, provisions he argues are invalid because the timing under the regulations contradicts the clear statutory language.  This is an incredibly hot topic among tax practitioners and the finance industry, and Andy raises interesting concerns that could impact the regulations generally.  Steve.

In response to considerable public outcry, the Treasury and IRS recently issued proposed regulations on management fee waiver transactions (PT comment: for more information on management fee waiver transactions, see Prof. Grewal’s article, Mixing Management Fee Waivers with Mayo).  Practitioner comments have focused heavily on whether the regulation’s various factors properly follow those described in the legislative history of Section 707(a)(2)(A).

This post examines a largely overlooked provision of the regulations that, if finalized, would plainly contradict the governing statute.  It then considers how any challenge to that provision might arise and how any such challenge might lead to a broad invalidation of the Section 707(a)(2)(A) regulations.

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I. The Invalid Fee Waiver Regulation

Under the proposed fee waiver regulations, an allocation to a private equity firm regarding its waiver interest (the additional profits interest received in exchange for waiving a fee) may be treated as a payment to an outsider, generating ordinary income, rather than as an allocation of partnership long-term capital gain.  The IRS’s approach here is generally sound, but a provision in the regulations, Prop. Reg. 1.707-2(b)(i), departs from the statute on an important timing issue.

The relevant statute, Section 707(a)(2)(A), grants the Treasury the authority to issue regulations that subject partner-partnership transactions to outsider treatment under Section 707(a)(1).  That is,

If:

(i) a partner performs services for a partnership or transfers property to a partnership,

(ii) there is a related direct or indirect allocation and distribution to such partner, and

(iii) the performance of such services (or such transfer) and the allocation and distributionwhen viewed together, are properly characterized as a transaction occurring between the partnership and a partner acting other than in his capacity as a member of the partnership,

such allocation and distribution shall be treated as a transaction described in [Section 707(a)(1)].

As the bolded language shows, the statute contemplates regulations that apply outsider treatment when there has been both an “allocation and distribution.”  The statute uses that phrase 3 times, and Section 707(a)(2)(A)(iii) hammers that point home — the allocation and distribution must be “viewed together” to determine if it’s appropriate to take the transaction outside of the partner-partnership framework.

For the IRS, this apparently creates administrative problems, because a partnership might allocate income to a partner in one year, but any related distribution may take place in a later taxable year.  Citing these administrative problems, the proposed regulations nix the statute’s distribution requirement. Under Prop. Reg. 1.707-2(b)(i), the transaction is tested “at the time the arrangement is entered into.”  So, under the regulation, an income allocation may be recharacterized without regard to any related distribution.

As a pure textual matter, the regulation does not comply with the statute.  The statutory language requires an “allocation and distribution” that are “viewed together.”  If the IRS focuses on only the allocation and attempts to alter its tax consequences, without considering the related distribution, it has exceeded the regulatory authority granted by Section 707(a)(2)(A).  The IRS cannot “view[] together” two parts of a transaction, as required by the statute, if it looks at only one part.  Under Step One of the familiar Chevron framework, Prop. Reg. 1.707-2(b)(i), if finalized, will fail.

The IRS might offer rejoinders to this conclusion.  For example, it might make a policy-based argument and say it’s unfair to delay the determination of tax consequences until a distribution is made, especially in light of the apparent administrative problems associated with a wait-and-see approach.

However, it’s just as easy to imagine that Congress wanted to limit the IRS’s authority to circumstances where a distribution occurs soon after any partnership allocation is made.  After all, if a partner and partnership are using the distributive share regime as a mere funnel for payments, with the intention of avoiding capitalization requirements or of converting the character of a payment, one would expect that a distribution will occur soon after the related allocation.  If instead a distribution occurs, say, 10 years after an allocation, that would be a fairly strong sign that the allocation/distribution were not used as a device to funnel payments.  In other words, it’s quite easy to see why the temporal relationship between the allocation and distribution are relevant to whether a transaction should be moved to the Section 707(a)(1) framework.  Congress, in fact, was principally concerned with relatively simple transactions when it enacted Section 707(a)(2)(A), not complex fee waiver transactions.

This is not to say that Congress’s policy in enacting Section 707(a)(2)(A) was the best one.  Maybe the statute should be amended such that it extends regulatory authority when “an allocation and a reasonably anticipated distribution, viewed together” show that the parties acted as strangers.  However, those are not the words that Congress has chosen.  And any pure policy arguments supporting the negation of the distribution requirement can just as easily be matched with a policy argument emphasizing the insights yielded by viewing an allocation and distribution together.

To find some statutory support for its approach, the IRS refers to the underlying policies of Section 704(b).  Under that statute, an allocation generally must have “substantial economic effect” to be respected.  The relevant regulations contemplate that an allocation to a partner will enjoy “economic effect” when the partner essentially enjoys the benefit or bears the burden associated with an allocation of income or loss.  See Treas. Reg. 1.704-1(b)(2)(ii)(a).  Thus, it’s not enough to nominally allocate income to the partner — the partnership must increase his capital account as a result of the allocation and must make distributions consistent with the balance in that account.  See Treas. Reg. 1.704-1(b)(2)(ii)(b)(2).  In other words, an income allocation comes with some “distribution rights,” via the capital account maintenance rules.

The proposed regulations seize on these distribution rights to negate the statute’s distribution requirement.  That is, “the Treasury Department and the IRS believe that a premise of section 704(b) is that an income allocation correlates with an increased distribution right, justifying the assumption that an arrangement that provides for an income allocation should be treated as also providing for an associated distribution for purposes of applying section 707(a)(2)(A).”   80 Fed. Reg. 43652, 43654 (July 23, 2015).

The IRS’s assumption that a distribution will usually follow an allocation may very well be justified, but it does not square with the statute.  Again, Congress plainly required an “allocation and a distribution” that are “viewed together.”  The statute does not refer to distributions that are “anticipated” or “reasonably assumed.”

Nor does the statutory text allow for any equation between a “distribution right” and a “distribution.”  When Congress passed Section 707(a)(2)(A), Section 704(b) and its substantial economic effect requirements were already in place.  That is, Congress already knew that an “allocation” contemplated distribution rights, because Congress itself had passed the law under which the capital account maintenance regulations had been issued.  So, by including in Section 707(a)(2)(A) the words “allocation and distribution” and “view[ing] together,” Congress must have meant something beyond an allocation that enjoys substantial economic effect.  Otherwise it would have referred only to an “allocation.”

The IRS might nonetheless argue that when Congress referred to an “allocation” in Section 707(a)(2)(A), it was speaking of sham allocations, and not those that enjoy substantial economic effect.  But that wouldn’t make much sense.  If an allocation lacks substantial economic effect, it will not be respected under Section 704(b) in the first instance, and the parties’ attempt to manipulate the allocation rules would already be defeated, without regard to Section 707(a)(2)(A).  Thus, the statute’s references to a “distribution” and to viewing the transactions “together” add further elements to the statute which the IRS must honor.

Prop. Reg. 1.707-2(b)(i) may reflect a good policy (a debatable point), but it does not square with the law.  In recharacterizing any income allocated to a private equity firm’s waiver interest, the regulation should be re-drafted such that it follows the statutory requirements and views together the allocation and the related distribution.  The IRS will continue to enjoy the authority to recharacterize allocations and distributions on waiver interests — the issue here relates to when to make the relevant determinations, not whether to do so.  And if, as expected, private equity firms quickly receive distributions on their waiver interests, then the administrative problems might be negligible.  If distributions are severely delayed and the IRS still wishes to act under Section 707(a)(2)(A), it should request authority from Congress.  Its current regulation, if made final, reflects an invalid interpretation of the existing statute.

II.  Challenging the Regulation

Any allegation of a regulation’s invalidity usually comes with some uncertainty, given the generally deferential framework employed by courts in examining agency rulemaking.  But here, the IRS has taken an eraser to statutory language.  Perhaps some on the Tax Court would uphold the regulation under a strong purposive approach, but that tribunal has gone through somewhat of a renaissance in the administrative law area, as evidenced by the Altera decision.  Thus, the Tax Court may very well view Prop. Reg. 1.707-2(b)(i) through the same lens that the Supreme Court and the circuit courts would view it.  Under their approach to statutory interpretation, they do not bless an agency’s rewrite of a statute especially where, as here, following the plain language is consistent with the statutory structure and is supported by plausible policy concerns.

The regulations thus seem poised for a challenge.  The Preamble to the proposed regulations acknowledges that some “distributions may be subject to independent risk,” and taxpayers who face risky distributions may scoff at the premature re-characterization of their income allocations.  Additionally, two comment letters raise concerns with Prop. Reg. 1.707-2(b)(i), so presumably some taxpayers will be adversely affected.  See Comments of the Tax Section of the Connecticut Bar Association (Oct. 8, 2015)Comments of the Tax Section of the New York State Bar Association (Nov. 13, 2015).

Although the invalidation of a regulation always raises a significant issue, the stakes could be far higher if the private equity industry mounts a pre-enforcement challenge to the regulations.  The IRS apparently believes it must eliminate the statute’s “distribution” and “view[ing] together” requirements to make the regulations administratively workable.  Consequently, Prop. Treas. Reg. 1.707-2(b)(i) might not be severable from the remainder of the regulations.  If that is so, a successful challenge to the final version of Prop. Treas. Reg. 1.707-2(b)(i) could lead to the invalidation of all the Section 707(a)(2)(A) regulations.

To address this issue, the IRS might include a severability provision in its fee waiver regulations, stating that if a court invalidates Prop. Treas. Reg. 1.707-2(b)(i), it should not bring down the rest of the regulations.  But the effect of such provisions remains uncertain, as detailed in a new article by recent Yale Law School graduate Charles Tyler and by former Yale Law School Professor Donald Elliott found here.

Of course, taxpayers usually very wisely avoid pre-enforcement challenges to Treasury regulations, especially given the difficulties associated with standing.  Thus, a deficiency or refund action reflects the most natural and likely forum through which to invalidate Prop. Treas. 1.707-2(b)(i).

Nonetheless, the private equity industry seems unusually well-coordinated, even aggressive, when it comes to preserving their tax benefits.  Additionally, the legal fees associated with a pre-enforcement challenge reflect an exceptionally tiny fraction of the industry’s income, and the benefits of a victory would be considerable.   Consequently, the possibility of a pre-enforcement challenge might be explored.  See generally, Patrick J. Smith, Challenges to Tax Regulations: The APA and the Anti-Injunction Act, 147 Tax Notes 915 (2015).  Any related litigation would involve procedural and severability issues that are as uncertain as they are fascinating.

D.C. Circuit Majority Opinion in Florida Bankers Not Consistent with Supreme Court’s Direct Marketing Decision (Part 2)

Pat Smith continues his discussion of the DC Circuit’s Florida Bankers decision. Les

In yesterday’s post I discussed the state of the law in Anti-Injunction Act cases as well as the Supreme Court’s Direct Marketing opinion. I described how the majority opinion is out of step with the law and is inconsistent with the narrow reading of the AIA as expressed in recent important developments. In today’s post, I will discuss Judge Henderson’s dissenting opinion in Florida Bankers, and describe why I think the dissent is the better reasoned opinion. Judge Henderson began by noting that while the bankers associations’ “challenge raises several difficult questions, the Anti-Injunction Act (AIA) is not one of them.” She correctly relied on the Direct Marketing decision as providing the applicable Supreme Court guidance for resolving the Anti-Injunction Act issue in Florida Bankers. As was the case in Direct Marketing, a challenge to an information reporting requirement does not relate to the assessment or collection of taxes under the Direct Marketing analysis because information reporting is a step in the overall revenue raising process that precedes the narrowly defined assessment and collection steps. Moreover, as she correctly notes, the information reporting requirement at issue in Florida Bankers is even farther removed from any assessment or collection of taxes than the reporting requirement in Direct Marketing because the interest income that is the subject of the Florida Bankers reporting requirement is not even subject to taxation by the U.S.

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She then addressed the issue of whether the fact that the penalty for violation of the reporting requirement is treated as a tax for purposes of the Anti-Injunction Act has the consequence that the Florida Bankers challenge is barred by the Anti-Injunction Act. She concluded that this issue had already been decided by the D.C. Circuit in Seven-Sky. That case held that when a plaintiff challenges a regulatory requirement that is enforced by a penalty that is treated as a tax for purposes of the Anti-Injunction Act, such a challenge is not barred by the Anti-Injunction Act, because the challenge relates to the regulatory requirement rather than the penalty. Putting this in the terms of the Direct Marketing analysis, the challenge could not possibly relate to the assessment or collection of a tax because the act that would give rise to liability to pay the penalty, namely a violation of the reporting requirement, has not occurred.

Judge Henderson also concluded that Bob Jones and Americans United were factually distinguishable from Florida Bankers because there was a much closer connection in those cases between the challenge to the revocation of tax-exempt status and the effect a successful challenge would have on the tax liability of the contributors to the organizations than any connection between the challenge in Florida Bankers and actual tax liability. Thus, contrary to the argument made by the government in its footnote in its reply brief in Z Street, it is not necessary to conclude that Direct Marketing has implicitly overruled those cases in order to apply the reasoning in Direct Marketing in interpreting the Anti-Injunction Act.

Judge Henderson also concluded that the 1987 D.C. Circuit decision in Foodservice, which was cited in the district court opinion, is directly on point and supports the conclusion that the Anti-Injunction Act does not apply to the Florida Bankers challenge. Finally, she noted that it would be particularly inappropriate to hold that the only way to challenge the information reporting requirement at issue in Florida Bankers is for a bank to violate the requirement, pay the resulting penalty, and sue for a refund of the penalty, in light of the fact that section 7203 of the Code makes willful violation of reporting requirements such as this one a misdemeanor.

With respect to Judge Kavanaugh’s majority opinion in Florida Bankers holding that the Anti-Injunction Act does apply to bar the Florida Bankers challenge, I could have understood how a judge might have agreed with the position taken by the government in the footnote in it Z Street reply brief, namely, that since the Direct Marketing decision did not say anything explicit about what effect the decision might have on the Bob Jones and Americans United holdings, as a consequence, the more prudent course of action for a lower court judge would be to wait until the Supreme Court has explicitly addressed the issue. While I do not agree with that position, since the reasoning in Direct Marketing is so clear and so obviously applicable under the Anti-Injunction Act as well as under the Tax Injunction Act, nevertheless, I can at least understand how a reasonable judge might hold that position.

However, that is not the approach Judge Kavanaugh took in his majority opinion. He did not attempt to engage with the reasoning in Direct Marketing at all. Instead, he distinguished Direct Marketing based on a point that had played no role at all in either the briefing of the case or in the Supreme Court’s opinion, namely, the contention that the penalty for violation of the reporting requirement in Direct Marketing was not a tax for purposes of the Tax Injunction Act, whereas the penalty for violation of the reporting requirement in Florida Bankers clearly is a tax for purposes of the Anti-Injunction Act.

While it might at first seem very surprising that the same judge who wrote such a strong opinion invalidating a regulation issued by the IRS and Treasury in Loving v. IRS 742 F.3d 1013 (D.C. Cir. 2014).could write as weak and misguided an opinion as the majority opinion in Florida Bankers. This result seems somewhat less surprising, however, when viewed in the context provided by Judge Kavanaugh’s opinions in other cases involving the Anti-Injunction Act. He wrote dissenting opinions addressing the Anti-Injunction Act issues in both the panel and en banc decisions in Cohen as well as in Seven-Sky.

One final collateral issue that was addressed briefly by both Judge Kavanaugh and Judge Henderson is the issue of whether the restriction imposed by the Anti-Injunction Act is jurisdictional. As both judges note, prior D.C. Circuit opinions characterize the restriction as jurisdictional, but as Judge Henderson points out, a line of Supreme Court decisions in recent years has called into question the loose analysis that has traditionally been applied in deciding whether particular statutory requirements for bringing suit are or are not jurisdictional, and this line of authority would often result in characterizing as non-jurisdictional certain requirements that may traditionally have been viewed as jurisdictional.

While the Tax Injunction Act is clearly jurisdictional, the reason for that conclusion rests on one point on which the Tax Injunction Act and the Anti-Injunction Act differ, namely, the fact that the Tax Injunction Act explicitly restricts the ability of district courts to hear the type of cases the Act covers, whereas the Anti-Injunction restricts only the ability of parties to maintain such suits. This difference should lead to the conclusion that the Anti-Injunction Act is not jurisdictional. I developed this position at length in a Tax Notes article written in the context of the issue that was subsequently resolved by the Supreme Court in NFIB v. Sebelius.

As noted at the outset, in light of the weakness of Judge Kavanaugh’s majority opinion, the strength of Judge Henderson’s dissenting opinion, the clear conflict between the analysis and conclusion in the majority opinion and the Supreme Court’s Direct Marketing decision, and the conflict between the majority opinion and numerous prior D.C. Circuit decisions, such as Z Street, Cohen, Foodservice, and Seven-Sky, the Florida Bankers decision is a very strong candidate for en banc review.