Consistency and the Validity of Regulations

Guest contributor Monte Jackel discusses guaranteed payments and how differing regulations inconsistently approach whether such guaranteed payments are indebtedness. While the post highlights substantive technical issues it also flags a procedural issue: the difficulty in challenging tax regulations outside normal tax enforcement procedures. That procedural issue, present in the current teed up Supreme Court case CIC v Commissioner which is now set for oral argument on December 1, as Monte suggests and as I discussed last year in Is It Time To Reconsider When IRS Guidance Is Subject to Court Review?, may call for a legislative fix. Les

How can a guaranteed payment on capital under section 707(c) of the Internal Revenue Code be both an actual item of “indebtedness” if, but only if, there is a tax avoidance motive for purposes of section 163(j)’s limitation on business interest expense but only be “equivalent to” but not actually be indebtedness for purposes of the foreign tax credit? Well, if you are the IRS with the “pen in hand”, anything is possible.

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Section 163(j)(5) defines “business interest” for purposes of section 163(j) as “any interest paid or accrued on indebtedness properly allocable to a trade or business.” Thus, the key term here is “indebtedness”. More on that later. 

Similarly, income equivalent to interest is referenced in section 954(c)(1)(E) and in regulation §§1.861-9(b)(1) and 1.954-2(h)(2) and specifically refers to guaranteed payments on capital as equivalent to interest expense at regulation §1.861-9(b)(8). On the other hand, the very same guaranteed payment on capital is treated as actual interest expense under regulation §§1.469-2(e)(2)(iii) and 1.263A-9(c)(2)(iii). 

It is very hard to either see or to justify treating guaranteed payments on capital under section 707(c) as both actual interest expense or as equivalent to interest expense for purposes of different provisions of the Internal Revenue Code. Either a guaranteed payment represents interest on indebtedness under all provisions of the Internal Revenue Code or it does not, unless a specific provision of the Code expressly treats guaranteed payments on capital a certain way. Merely because a statute or implementing regulation treats a guaranteed payment on capital as equivalent to interest does not mean that it can be both actual indebtedness for some but not all provisions of the Code and as equivalent to but not actual interest on indebtedness for purposes of other provisions of the Code. 

The recently finalized foreign tax credit regulations, T.D. 9922, had this to say about the issue:

The Treasury Department and the IRS have determined that guaranteed payments for the use of capital share many of the characteristics of interest payments that a partnership would make to a lender and, therefore, should be treated as interest equivalents for purposes of allocating and apportioning deductions under §§1.861-8 through 1.861-14 and as income equivalent to interest under section 954(c)(1)(E). This treatment is consistent with other sections of the Code in which guaranteed payments for the use of capital are treated similarly to interest. See, for example, §§1.469-2(e)(2)(ii) and 1.263A-9(c)(2)(iii). In addition, the fact that a guaranteed payment for the use of capital may be treated as a payment attributable to equity under section 707(c), or that a guaranteed payment for the use of capital is not explicitly included in the definition of interest in §1.163(j)-1(b)(22), does not preclude applying the same allocation and apportionment rules that apply to interest expense attributable to debt, nor does it preclude treating such payments as “equivalent” to interest under section 954(c)(1)(E). Instead, the relevant statutory provisions under sections 861 and 864, and section 954(c)(1)(E), are clear that the rules can apply to amounts that are similar to interest.

OK, so the IRS is saying here that a guaranteed payment on capital is not and does not have to “indebtedness” for the item to be treated the same as interest expense under the enumerated statutory provisions. This is so without regard to there being a tax avoidance reason for the taxpayer to have used a guaranteed payment on capital instead of actual indebtedness. Technically true in the case of the enumerated provisions but does it make good policy sense or is it merely “talking out of both sides of your mouth” and, thus ultra vires? 

Take a look at how guaranteed payments on capital recently fared under the final section 163(j) regulations (T.D. 9905). The final regulation preamble had this to say about the issue:

Proposed §1.163(j)-1(b)(20)(iii)(I) provides that any guaranteed payments for the use of capital under section 707(c) are treated as interest. Some commenters stated that a guaranteed payment for the use of capital should not be treated as interest for purposes of section 163(j) unless the guaranteed payment was structured with a principal purpose of circumventing section 163(j). Other commenters stated that section 163(j) never should apply to guaranteed payments for the use of capital….In response to comments, the final regulations do not explicitly include guaranteed payments for the use of capital under section 707(c) in the definition of interest. However, consistent with the recommendations of some commenters, the anti-avoidance rules in §1.163(j)-1(b)(22)(iv)…include an example of a situation in which a guaranteed payment for the use of capital is treated as interest expense and interest income for purposes of section163(j).

Without getting into the merits of the example the IRS added to the anti-avoidance rule, suffice it to say that acting “with a principal purpose” of tax avoidance in preferring a guaranteed payment on capital to actual interest on indebtedness is a very low barrier for the IRS to meet. After all, “a principal purpose”, based on existing authority is merely an important purpose but need not be the predominant purpose and the test can be met even if there is a bona fide business purpose for using the guaranteed payment in lieu of actual indebtedness and even though the transaction has economic substance. 

But what about how the U.S. Supreme Court and the IRS itself treated a short sale for purposes of interest deductibility and the unrelated business income tax, respectively? In Rev. Rul. 95-8, 1995-1 C.B. 107, the issue was whether a short sale of property created “acquisition indebtedness” for purposes of the unrelated business income tax under section 514. The IRS concluded, in a revenue ruling that is still outstanding, that the answer was no:

Income attributable to a short sale can be income derived from debt-financed property only if the short seller incurs acquisition indebtedness within the meaning of section 514 with respect to the property on which the short seller realizes that income. In Deputy v. du Pont, 308 U.S. 488, 497-98 (1940), 1940-1 C.B. 118, 122, the Supreme Court held that although a short sale created an obligation, it did not create indebtedness for purposes of the predecessor of section 163.

In turn, the U.S. Supreme Court had this to say about what is “indebtedness” under the Internal Revenue Code (Deputy v. du Pont, 308 U.S. 488 (1940)): 

There remains respondent’s contention that these payments are deductible under § 23 (b) as “interest paid or accrued . . . on indebtedness.” Clearly [the taxpayer] owed an obligation….But although an indebtedness is an obligation, an obligation is not necessarily an “indebtedness” within the meaning of § 23 (b)…. It is not enough….that “interest” or “indebtedness” in their original classical context may have permitted this broader meaning.  We are dealing with the context of a revenue act and words which have today a well-known meaning. In the business world “interest on indebtedness” means compensation for the use or forbearance of money. In [the] absence of clear evidence to the contrary, we assume that Congress has used these words in that sense. (footnotes omitted). 

And so, the U.S. Supreme Court says that “interest on indebtedness” means “compensation for the use or forbearance of money”. A guaranteed payment on capital is a return on equity and cannot be transformed into interest on indebtedness based on some general regulatory authority under section 7805(a), no matter how abusive the IRS views a transaction. And effectively treating a guaranteed payment on capital as “equivalent to interest” but not actually indebtedness for purposes of certain enumerated provisions (such as section 901) seems to be overreaching given the mandate of the U.S. Supreme Court on an economic equivalent to interest on indebtedness at that time, a short sale. 

Can the IRS write a regulation that circumvents the dictates of the U.S. Supreme Court using a general grant of regulatory authority under section 7805(a)? I would think that the answer is clearly and obviously no. But what is the price that the IRS will ultimately pay if the results enumerated here are overruled by a court several years down the road? Other than spending taxpayer dollars unnecessarily, it does not appear that there is any downside in doing so. 

Note that this bifurcated treatment of a guaranteed payment on capital “infects” other recent regulations because in one case (T.D. 9866, the GILTI final regulations) there is an explicit cross reference to the definition of interest income and expense under section 163(j) (which presumably includes the application of the interest expense anti-abuse rule in those final regulations), and in another case (T.D. 9896, the section 267A final regulations) the substance of the definition of interest expense and the anti-avoidance rule exception were incorporated into those regulations.

How can this practice be effectively stopped? Will it require court litigation and years of uncertainty or is there a mechanism for, in effect, penalizing the IRS for taking positions that, if the IRS were a tax advisor to a client other than itself, it could not have concluded the way it does without disclosure on the equivalent of form 8275? 

Could section 7805(a) be amended to curtail this IRS practice? For example, could a sentence or two be added there to say that “the IRS cannot issue regulations or other guidance inconsistent with the literal words of a provision of the Internal Revenue Code unless Congress expressly grants that power”? 

Now, some will say that doing such a thing contravenes the ability of the courts to adjudicate tax disputes and so is perhaps unconstitutional but clearly inadvisable. Others will say that the regulatory guidance process would grind to a halt because of the forceful taking by the Congress of administrative discretion and expertise. 

I don’t think the status quo is acceptable. On the other hand, I do recognize the implementation problems. Is there any solution other than to throw up your hands in disgust and move on to something else? 

Proving Your Client’s Marital Status, Not as Simple as It Appears but Crucial for EITC

Today we welcome back guest blogger Gina Ahn. In today’s post Gina explains the importance of marital status for the EITC, and how the stark difference between the childless EITC and the EITC with qualifying children led one taxpayer to pursue an extremely weak Tax Court case. While that taxpayer’s claim of common law marriage did not succeed, common law marriage may be a legitimate claim for residents of common law states. Ultimately though, Gina argues that a better solution would be to expand the EIC for childless workers. Christine

As is often the case in the low income or nonprofit universe, the reverse of common knowledge often proves to be true. When I was in-house counsel of a private operating foundation, it became second nature for me to always look for ways to proactively document expenditure responsibility grants, charitable contributions of donors, travel expenses, or the use of statutory safe harbors in self-dealing transactions. This likely was a natural self-defense mechanism because the founders of the foundation practiced reverse ‘tithing’ (where they would donate 90% of their earnings and keep 10%). This radical giving philosophy often drew the ire and suspicion of auditors who were convinced the foundation was a front for a nefarious sophisticated tax scheme. The plain vanilla explanation that the founders were simply living out their religious convictions was too far-fetched for the examiner to believe. So, naturally, the first time I saw an Earned Income Tax Credit (“EITC”) audit of a schedule C cash business at our Low Income Taxpayer Clinic (“LITC”), I was perplexed. I thought to myself, “Why in the world is the IRS contesting this person’s earnings? Don’t they want more revenue? Would they prefer the taxpayer to say he did NOT work and thus owed no taxes?” Little did I realize that the EITC’s high improper payment rate of 25% and large influence of unregulated (and often unscrupulous) private third party preparers “not acting in the best interest of taxpayers and tax administration” gave the IRS statistically sound reasons to select such taxpayers for examination. Apparently, it is an ‘industry’ secret I am just now learning from my clinic’s clientele that preparers often urge taxpayers to increase earnings by declaring cash income of a ‘miscellaneous’ business, to raise the taxpayer’s AGI to be just high enough to land in the fortuitous ‘sweet spot’ to get the largest EITC refund. Oddly, whether one is a high-income taxpayer who “donates too much” money to charity, or a low income taxpayer who has “too much cash income”; you are both a prime candidates for audit.

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Marriage leads to benefits, not a penalty, in the LITC universe

Using the counter intuitive logic of the nonprofit sector, if high income taxpayers normally bemoan the marriage tax penalty; then is there some sort of marriage tax benefit in my alternate LITC universe? Actually, there is – sort of. Childless taxpayers with low income who are de facto (but not legal) stepparents see a substantial EITC increase if they legally marry. For the tax year 2018, a childless taxpayer who supports three children in his household can receive $5912 morein EITC if he is legally married to the mother of the three stepchildren in the household. This is because those who support and care for the children of their cohabitating partner (without marrying their partner)– may not claim any tax benefits from the children. If our example taxpayer is not married, the largest possible EITC for him as a low-income worker without qualifying children is only $518 (see diagram below). By marrying his partner, the children become his qualifying children for the EITC. So, to be more precise, it is not quite a marriage benefit per se. But rather, a legally valid marriage opens the door to a much more lucrative EITC benefit (and other tax benefits that come with qualifying children).

NTA Special Report to Congress, “Earned Income Tax Credit: Making the EITC Work for Taxpayers and the Government, Improving Administration and Protecting Taxpayer Rights

Such is the background for Mr. Brzyski’s Tax Court case, T.C. Summary Opinion 2020-25. (James Creech previously wrote about the social media aspects of the case here.) I am saving this opinion to put in our LITC Volunteer Training Manual/Casebook. It is a methodical parsing of a bread and butter issue that comes up often at our clinic: How much EITC is my client entitled to? What do you do if you don’t have any evidence? Whether one is a seasoned tax practitioner or new law school or LLM graduate, I highly doubt a small tax case without precedential value would ever reach any casebook. My tax casebooks tended to be full of partnerships (inside or outside basis?) and NHL hockey players who did not want to file U.S. tax returns.

Unfortunately, this taxpayer did not have the benefit of an LITC to advise him of the futility of pursuing this case. It becomes quite clear by looking at the chronology of events as described in the opinion that he was grasping at straws. It seems that Mr. Brzyski eventually understood that his entire case depended on whether or not he was legally married to the mother of the two children he claimed on his 2016 tax return. As Judge Copeland writes, “Accordingly, the key to whether [the minors] meet the [stepchild] relationship requirement, as defined by section 152, is whether Mr. Brzyski was married to Daniela [the minors’ mother] in 2016.” The judge does not leave us hanging in suspense. The very next sentence gives her terse (perhaps sardonic? I wish I could have heard her voice) findings of fact: “We find he was not.”

A Melting Pot Federalist System of Governance: Many States and Immigrants

Marriage really ought to be a simple fact to prove. You either have a marriage certificate, or not. If you’ve misplaced it, you can even order one online through a lexis service. But what if you left your country in a state of civil unrest when that country did not maintain birth or marriage records? Then, government agencies offer alternative means to prove your married status. For example, my parents left Korea after the Korean War. At the time they emigrated to the U.S., Korea certainly did not have the luxury of a functioning vital statistics office. However, USCIS and Social Security still figured out an acceptable means to document their marital status in the process of granting their citizenship and social security numbers. However, with this taxpayer in this case, civil unrest was not an impediment to proving his married state. Rather, it was the fact that he did not formally marry in the sense of getting a marriage license or certificate from a civil authority.

However, because the United States has a federalist system of governance and a Constitution with a full faith and credit clause; there was still a slim chance that perhaps Mr. Brzyski had entered into a common law marriage in one of the nine states that recognizes common law marriage; and thus the IRS would recognize his marital status even without a marriage certificate. (See Reg. § 301.7701-18.) And in fact, “Mr. Brzyski contends that he and Daniela entered into a common law marriage in 2011 when they visited Kansas for dinner.” (p.8) The taxpayer seems to believe that a common law marriage is an informal event where a couple can simply “declare” the state of marriage – something akin to eloping to Las Vegas; but without an officiant or registration required.

As a side note, when I was a claims representative for the Social Security Administration (prior to law school) I used to interview widows to evaluate applications for survivors benefits. I vividly recall one conversation with my mentor instructor, because it made an impression on my young naïve (first job out of college) mind.

SSA Gina: “Why do we ask for ALL their former dates of marriages, locations, and dates of divorce? It makes the interview so slow and I feel bad making them work so hard to recall everything. I mean, isn’t the most important marriage the most recent one?”

SSA Mentor: “We do it because it’s our job to look for the correct benefit amount, and it’s possible that they could receive higher benefits based on the earnings of a former spouse.”

SSA Gina: “Okay, I could see the logic of that. But, why do we ask what city or state?”

SSA Mentor: “Because we have to look for putative marriages or possible marriages in other states that recognize common law marriage.”

SSA Gina: “You mean, they just have to live together in one of those states and they’re magically married, without getting married? Can you accidentally marry someone?”

SSA Mentor: “No Gina. Just living together is not enough. They have to act as if they are married. You know they need show that us things like utility bills with both their names on it. And present themselves to the community as if they were married. Just look it up in the POMS when you get someone who alleges at least ten years in one of those states. Roommates can’t just get magically married, it’s something more.”

This left an impression on me because I thought, “Wow. I work for a very generous government agency that trains its workers to “look for” the highest wage earning husband to base a survivor benefit off of.”

No Marriage Certificate? Did you spend significant time in one of the 9 states that recognizes common law marriage?

The IRS has a similar philosophical approach in that they also want to determine the correct assessment and if a common law marriage will lead to the correct assessment; so be it. However, unlike Social Security, the IRS was not created to function as a federal benefits agency and does not hire “Claims Representatives” to interview taxpayers for EITC refunds (a quasi benefit of sorts). Instead this ‘federal benefit’ application is outsourced to third party paid preparers, who are to submit tax returns including information for the Service to determine and pay out the correct EITC amount. Therein lies the opportunity not only for intentional abuse, but genuinely mistaken under- or overpayments.

A quick read through IRM 5.19.11.7.1.2.2 (12-14-2018), gives succinct instructions for a taxpayer who spends “significant time” in one of the nine common law states: CO, IA, KS, MT, OK, RI, TX, UT and the District of Columbia. A ‘declaratory’ dinner in Kansas will not suffice, as the taxpayer mistakenly believes, “Mr. Brzyski claims that over the Thanksgiving holiday he and Daniela established a common law marriage by driving across the Missouri border to Kansas and declaring their marriage over dinner.” (fn 11).

How NOT to prove your common law marriage

The final flaw in the taxpayer’s argument was his lack of consistency. If we look at the chronology of life events and tax filings; it’s hard to imagine that the judge did not (at least internally) have a skeptical tone. It is difficult to argue, “We’ve been married since 2011” – if the first time you file a joint return is a late filed amendment in June of 2017 for TY2016 (the year in dispute). Below is the chronology of events as described in the opinion:

  • November 2011, taxpayer and mother of stepchildren fly to Missouri to visit taxpayer’s family.
  • November 2011, taxpayer and mother of stepchildren drive to Kansas for dinner to declare their marriage.
  • December 2011 taxpayer’s social media[1] still refers to the mother of stepchildren as his fiancée
  • Sometime on or before April 2013, taxpayer timely filed TY 2012 as Single
  • Sometime on or before April 2014, taxpayer timely filed TY 2013 as Single
  • (No information about 2015)
  • October 2016 taxpayer and mother of stepchildren enter a lease together using taxpayer’s last name (but she signs agreement with her maiden name).
  • February 22, 2017 taxpayer timely filed TY2016 (year in dispute) as Head of Household
  • June 20, 2017 taxpayer sends TY 2016 amendment to change status to Married Filing Joint
  • July 24, 2017 notice of deficiency from IRS for TY2016
  • August 2017 taxpayer files TY 2015 return as Single

What kind of “supporting documentation” would have worked to establish a common law marriage?

Judge Copeland expands on her “we find he is not [married]” conclusion:

Mr. Bryzski has not offered any consistent supporting documentation that he went to Kansas to marry or that he and Daniela held themselves out to be husband and wife following their 2011 Thanksgiving trip. Accordingly, we find that Mr. Brzyski failed to meet his burden of proof to establish that a common law marriage took place in Kansas.

Opinion at 11

Although we will never know the whole story, I cannot help but to wonder what sort of documentation the judge would have accepted (if any), to overcome the taxpayer’s inconsistent filings? We sometimes come across clients at our clinic in the unfortunate situation where a paid preparer had given them wrong advice. E.g. “I was told that as long as we live together for 10 years, it’s recognized in California as being married.” The hapless unmarried couple has a spent significant amount of time together and have been presenting themselves as married to the community. It’s just the wrong community, in that California doesn’t recognize common law marriage. Hypothetically speaking, suppose this unmarried couple had spent some time in CO, IA, KS, MT, OK, RI, TX, UT or DC; what type of documentation would be helpful to establish their common law married status?

IRM 5.19.11.7.1.2.2 (12-14-2018) instructs the IRS compliance employees to “ask the taxpayer to provide at least two of the following types of documentation to substantiate a claim of common law marriage.”

  • Deeds showing title to property held jointly by both parties to the common law marriage
  • Bank statements and voided checks showing joint ownership of the accounts
  • Insurance policies naming the other party as beneficiary
  • Birth certificates naming the taxpayer and the common law spouse as parents of their children
  • Employment records listing the common law spouse as an immediate family member
  • School records listing the names of both common law spouses as parents
  • Joint credit card accounts
  • Loan documents, mortgages, and promissory notes evidencing joint financial obligations
  • Mail addressed to the taxpayer and common law spouse as “Mr. and Mrs.”
  • Any documents showing that one spouse has assumed the surname of the other spouse

It makes me wonder, had Mr. Bryzski opened a bank account in Kansas and some marketing companies had addressed credit card offers to a Kansas address as Mr. & Mrs. Bryzski, could they have persuaded the examiner or the judge?

For unmarried clients with “stepchildren,” now what?

Unless they are willing to get married, there is nothing that can be done. And I’m not sure it’s good advice to begin or end a marriage for solely for an EITC refund. Although this NPR podcast “How Economists Do Valentines” is an entertaining nine minute exchange of two economists who did NOT marry because the (tax) cost benefit analysis of marriage came out negative, I think they are the exception and not the rule. In the midst of the pandemic, where the hardest hit industries include retail, hospitality, food services, and manufacturing, one source of disaster relief to consider is a temporary expansion of the childless EITC refund. This is currently proposed in the HEROES Act. Included in the category of ‘childless’ taxpayers are unmarried stepparents – for whom an additional stimulus check through a revamped EITC would make a substantial impact. The Tax Policy Center explains,

HEROES Act [proposes] changes to the EITC would go to people in the bottom 20 percent of the income distribution, . . . [that] would help people in industries that are being hurt the most by the pandemic.

While not a long-term solution, this could provide a much needed reprieve during difficult times to the working poor, married or not.

The APA: The Other Taxpayer Bill of Rights

The Taxpayer First Act (TFA) provides that the Tax Court apply a de novo standard of review of a section 6015 determination of the IRS based on (1) “the administrative record established at the time of the determination” and (2) “any additional newly discovered or previously unavailable evidence”.  In today’s guest post practitioner Steve Milgrom advances a novel argument, that the TFA’s changes to Section 6015 open the door to the possibility that IRS innocent spouse hearings should be subject to the formal adjudication rules under the APA. Steve’s provocative post raises the soon to be very important problem of ensuring that parties requesting relief from joint and several liability are entitled to present relevant evidence that may be difficult or impossible to present administratively. While I am skeptical of the solution that Steve proposes, it is likely that at a minimum the Tax Court will be wrestling with the terms “newly discovered” or “previously unavailable” in fashioning broad exceptions that will allow the Tax Court to evaluate difficult cases that often implicate circumstances (like abuse) that may not be fully developed via centralized correspondence-based determinations that are the hallmarks of the current regime under Section 6015. Les

Unlike other Federal government agencies that routinely hold trial like hearings on the record, the IRS stopped doing so back in the 1920’s.  In the case of §6015 innocent spouse determinations, this may be about to change. 

The road to this change in IRS procedure begins with a bill of rights.  No, not that Bill of Rights, the first ten amendments to the US Constitution (although even this Bill of Rights may come to play a critical role).  I’m not even referring to the Taxpayer Bill of Rights, Code §7803(a)(3).  Here I refer to the bill of rights Congress passed in 1946 to protect us against the Federal government:

[A] bill of rights for the hundreds of thousands of Americans whose affairs are controlled or regulated in one way or another by agencies of the Federal Government.  S.Doc. No. 248, at 298.

The 1946 bill of rights is the Administrative Procedure Act (APA), which is found at 5 U.S.C §551-§706. While the Taxpayer Bill of Rights has not gotten much traction in the courts, the APA is a significant restraint on Federal administrative agencies.

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Before I delve into the mysteries of the APA keep in mind that, like all statutes, standing atop the APA is the U.S. Constitution and its Bill of Rights.  Whether or not the APA applies to agency action, compliance with the Due Process Clause of the 5th Amendment to the Constitution is also required.    PBGC v. LTV Corp., 496 U.S. 633, 655 (1990).  See also, Wong Yang Sung v. McGrath, 339 U.S. 33, at 49 (1950) (The constitutional requirement of procedural due process of law derives from the same source as Congress’ power to legislate and, where applicable, permeates every valid enactment of that body.)

Another preliminary matter is APA §559, dealing with the effect of subsequent statutes on the APA.  §559 states that a “[s]ubsequent statute may not be held to modify” the APA “except to the extent that it does so expressly.”  Faced with the prospect of having to comply with the APA’s formal procedural requirements the IRS might argue that the recent amendment to Code §6015 that I discuss below expressly modified the APA.  Arguments that tax law provisions are express modifications of the APA have gotten traction when made in connection with the judicial review of IRS proceedings.  See Kasper v. Commissioner, 150 TC 8 (2018).  However, these cases do not deal with how the agency itself must proceed and the change to §6015 doesn’t modify the APA in any way.  §6015 states that the procedures for the IRS to make a determination are to be prescribed by the Secretary of the Treasury.    Clearly the procedures prescribed by Treasury have to comply with the APA.  Mayo Foundation for Medical Education v. U.S., 131 S.Ct. 704 (2011).  

The APA covers a lot of ground.  It sets forth rules for agency rule making, agency adjudications, and for judicial review of agency proceedings.  To understand the APA one must first study the definitions.  “Rule making” is defined as an agency’s process for formulating, amending, or repealing a rule.  An “adjudication” is any agency process for the formulation of an order.  An “order” is a final disposition of an agency in a matter other than rule making.  APA §§551(5), (6), and (7).  Basically, adjudications are the things that agencies do other than rule making.  

Another important distinction made by the APA is between what are known as formal vs. informal agency proceedings, both in the context of rule making and adjudications.  The formal vs. informal dichotomy determines which set of procedural requirements apply to agency action.  Both rule making and adjudications are allowed to proceed informally unless the statute governing the agency activity requires it to hold a hearing on the record.  In the tax world, the statute governing agency activity is the Internal Revenue Code (Code).  If the statute calls for a hearing on the record, then the formal procedural requirements of the APA must be following by the agency.  Formal rule making is governed by §§556 and 557.  Formal adjudications are covered in §§554, 556, and 557.  Informal rule making and informal adjudications are covered by §553 and §555, respectively.

Agency adjudication can still avoid being subject to the formal procedural requirements of the APA based upon six specific exemptions, one of which is relevant to this discussion.  APA §554(a)(1) provides that any matter “subject to a subsequent trial of the law and the facts de novo in a court” is exempt from the formal procedural requirements of the APA.  Note that this is not an exemption from the APA itself, only from the formal rules. It is this exemption that has historically allowed the IRS to proceed, in APA parlance, informally.

The exception of matters subject to a subsequent trial of the law and facts de novo in any court exempts such matters as the tax functions of the Bureau of Internal Revenue (which are triable de novo in the Tax Court).  S. Comm. On the Judiciary, 79th Cong., 1st Sess., Administrative Procedure Act.  (emphasis in original).

Last year, in the Taxpayer First Act (TFA), Congress rewrote the rules applicable to the Tax Court’s determination of the availability of innocent spouse relief.  See Taxpayer First Act, Pub. L. No. 116-25, §1203, adding Code §6015(e)(7).  While §6015(e)(7) retains the rule that the Court’s review of an IRS determination is de novo, it is now to be based on the administrative record.  No more trial of the facts de novo.  The exemption provided by APA §554(a)(1) no longer applies.  Does this change mean that the IRS must now comply with the formal procedural requirements of the APA when making an innocent spouse determination? Only if the Code requires the adjudication “to be determined on the record after opportunity for an agency hearing …” See APA §554(a) prefatory language.

The Code says nothing about the IRS holding a hearing when it makes an innocent spouse determination. Might we find the hearing requirement elsewhere?  US v. Florida East Coast Railway Company, 410 U.S. 224, 245 (1973), deals with agency rule making.  However, the language of the APA for adjudications is the same.  In both rule making and adjudications the triggering language is identical, for the formal rules to apply the APA states that the operative statute must require agency action “on the record after opportunity for an agency hearing.”   In Florida East Coast Railway Company the Supreme Court had this to say about these key terms:

… the actual words ‘on the record’ and ‘after … hearing’ used in §553 were not words of art, and that other statutory language having the same meaning could trigger the provisions of §§556 and 557 in rulemaking proceedings. Id, at 238.  (emphasis added)

Other courts have confirmed that there are no magic words. 

[W]hether the formal adjudicatory hearing provisions of the APA apply to specific administrative processes does not rest on the presence or absence of the magical phrase “on the record.”  Marathon Oil Co. v. Environmental Protection Agency, 564 F.2d 1253, 1263 (9th Cir. 1977).

Courts often rely upon the Attorney General’s Manual on the Administrative Procedure Act (1947) in interpreting the APA.  See Vermont Yankee Nuclear Power Corp v. Natural Resources Defense Council, Inc., 435 U.S. 519, 546 (1978).  The AG Manual gives examples of statutes that require formal adjudications where the governing statute requires a hearing but says nothing about it being on the record:

[W]hile the … Act does not expressly require orders … to be made “on the record”, such a requirement is clearly implied in the provision for judicial review of these orders … Other statutes authorizing agency action which is clearly adjudicatory in nature … specifically require the agency to hold a hearing but contain no provision expressly requiring decision “on the record”.

The examples in the AG’s Manual deal with statutes that require a hearing but make no reference to its being “on the record.”  Is there any less of an implication when the missing language is reversed, when the statute calls for judicial review of an administrative record but makes no reference to the agency holding a hearing?  

Due process requires every agency adjudication to involve some type of hearing.  Even where there is no “adjudication required by statute,” the APA’s formal procedures have been imposed based upon the hearing requirement of the due process clause.  Wong Yang Sung v. McGrath, 339 US 33 (1950).  The APA provision stating that it is only applicable to hearings “required by statute” exempts agency hearings that are conducted by a lesser authority than a statute, such as by regulation or rule, not hearings that are held out of compulsion, either by statute or constitutional requirement.  Wong Yang Sung, at 50.  So when the Supreme Court referred to “other statutory language having the same meaning” in Florida East Coast Railway Company, to be consistent with Wong Yang Sung it would have been clearer to say “other statutory or constitutional language having the same meaning.”  

Now that §6015(e)(7) requires the Tax Court to perform its review of an IRS innocent spouse determination based upon the administrative record, the IRS must make its determination “on the record.”  While §6015 leaves it to the IRS to establish procedures for making its determinations, as the Attorney General said some 70 years ago, a requirement that an agency act on the record is “clearly implied in the provision for judicial review.”  §6015(e)(7) is just such a provision for judicial review and here you don’t have to search for an “implied” requirement.  The requirement for an administrative record is explicit.

Did Congress intend to force the IRS to hold formal hearings on the record when making a §6015 determination?  While the number of words used to impose the requirement are few, they are unique, this is the only place where the Code uses the phrase “administrative record.”  By adopting a new approach to Tax Court procedure, using a phrase that comes from the world of administrative law, it does seem that this change in judicial review should also change the agency level procedure applicable to innocent spouse determinations.  

Having decided to limit the Tax Court to reviewing the administrative record, maybe Congress was familiar with Wilson v Commissioner, 705 F.3d 980 (9th Cir. 2013).  In Wilson, the 9th Circuit rejected the IRS’s argument that the Tax Court should be restricted to a review of the administrative record in a §6015(f) case.  Wilson rejected what Congress has now made the law.  The rationale of the 9th Circuit explains why it is so important that the IRS be required to follow the formal procedural requirements of the APA in §6015 cases.  The Wilson decision is based in large part on the fact that the pre-TFA process used by the IRS for making a §6015(f) determination did not result in a sufficient record for the Tax Court to review:

There is no formal administrative procedure for a contested case at which the taxpayer may present her case before an administrative law judge.  At no time during the process is the taxpayer afforded the right to conduct discovery, present live testimony under oath, subpoena witnesses for trial, or conduct cross-examination. … [I]t is before the Tax Court that the taxpayer has the vehicle to conduct discovery … subpoena witnesses and documents … and submit evidence at trial.  Wilson, at 990.

The 9th Circuit continued its explanation of the importance of trial like proceedings:

The ability to supplement the administrative record is particularly important in equitable relief cases, which require a fact-intensive inquiry of sensitive issues that may not come to light during the administrate phase of review.  The threshold requirements for innocent spouse relief may present a complicated and contradictory dilemma for the taxpayer.  The innocent spouse must show that he or she is ignorant of the spouse’s tax misdeeds, yet must marshal documentary support to prove it.  The taxpayer often has limited or no access to critical records.  The innocent taxpayer who has been misled by a spouse often may not understand the full extent or scope of the erring spouse’s misdeeds.  Compounding these difficulties is an administrative system where the only opportunity to present a case is through telephonic interviews with an agent in a remote location.  Wilson, at 991.

Since the Tax Court is no longer permitted to decide the facts de novo, the administrative record which the Tax Court reviews must be created by the IRS using the formal procedural requirement of the APA, allowing for discovery, testimony under oath, cross-examination of witnesses, and the many other procedures that are designed to lead to a full and fair determination of the facts.

The last time Congress set up an agency of the Executive branch that conducted the sort of hearings that the APA requires for formal adjudications was 1924.  That agency was named the Board of Tax Appeals (BTA).  In 1969 Congress moved the functions of the BTA out of an administrative agency and placed them in the Judicial branch, in a court known as the United States Tax Court.   Harold Dubroff and Brant J. Hellwig, The United States Tax Court, an Historical Analysis, 49 (2nd ed. 2014).  When the activities of the BTA were moved to the Tax Court, the job of holding formal hearings to determine the facts of a case likewise moved to the judicial branch of our government.  While the 1924 Act that created the BTA did not provide for any direct appellate review of its decisions, the decisions could be collaterally attacked in a suit for a refund where the findings of the BTA were prima facie evidence.  In 1926 the law was amended to permit review of BTA decisions in the Court of Appeals, where review was limited to questions of law.  Why return to a system of agency level factual determinations followed by judicial review of the agency record? The IRS is constantly underfunded.  The Tax Court is fully capable of hearing the facts of §6015 cases de novo.  What can possibly be gained by forcing the IRS to build a whole new infrastructure just for 6015 cases? 

How might the IRS implement this new requirement?  Currently, requests for §6015 relief are handled by a special office in the IRS, known as CCISO.  There is no need for the operations of this office to change.  When Congress changed the §6015 judicial review provisions it also established a new office within the IRS, known as the Internal Revenue Service Independent Office of Appeals.  This office is required to be fair and impartial to both the government and the taxpayer.  While I don’t know what was in the mind of the drafters of the TFA but it seems like this new office was specifically created to, among other things, handle the task of complying with the APA formal procedural hearing requirements. 

The IRS has long argued that the Tax Court’s review of innocent spouse determinations should be restricted to the administrative record.  Since the argument was not based upon a statutory requirement, had the Tax Court agreed with this proposition it would not have triggered the APA’s formal procedural requirements at the agency level.  While the IRS lost in Tax Court, it prevailed in some Courts of Appeal, but not others.  Congress stepped in to resolve the circuit split by adopting the position advocated by the IRS.  There is now a statute that requires judicial review based upon the administrative record, the operative requirement for application of the formal procedural requirements of the APA.  I am reminded of Marty Ginsberg’s maxim of Moses’ rod:

Every stick crafted to beat on the head of a taxpayer will metamorphose sooner or later into a large green snake and bite the commissioner on the hind part.  Ginsburg, Making Tax Law Through the Judicial Process, 70 ABA J. 74, 76 (1984).

IRS Cash Pay Alternatives Impose Unnecessary Burdens and Fees on Taxpayers

We welcome guest blogger Elizabeth Maresca.  Professor Maresca runs the tax clinic at Fordham Law School.  She also serves as a Senior Legal Advisor to the National Consumer Law Center.  When I saw the IRS announcement she discusses, I reached out to the National Consumer Law Center to see if it had thoughts on this decision.  We are fortunate that Professor Maresca has provided a response.  We do not always think of taxpayers as consumers but certainly aspects of the role of taxpayer involves consuming tax services.  In that role the way the IRS handles their cases can have an important impact not only on the taxes themselves but collateral matters.  The discussion here points to a potentially negative collateral consequence of the decision for handling cash tax payments.  Keith

Earlier this summer, the IRS announced that it would allow certain “retail partners,” to accept cash tax payments for IRS.  Most disturbingly, these retail partners include payday lenders, in particular ACE Cash Express.  Payday lenders engage in practices that entrap lower-income individuals in a long-term cycle of exorbitantly-priced debt that often brings serious financial harm.  In addition, the IRS use of retail partners imposes a fee on taxpayers, and is cumbersome in that it requires internet access, takes three steps, and several days to complete.

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The Perils of Payday Lending

Payday lenders typically offer their borrowers high-cost loans, often with short terms such as 14-days. The loans are marketed as a quick fix to household financial emergencies with deceptively low fees that appear be less than credit card or utility late fees or overdraft fees.  Background on the abuses of payday loans is available here and in National Consumer Law Center, Consumer Credit Regulation, 2d ed. 2015, Chapter 9.  The loans are marketed to those with little or no savings, but a steady income.

Fees for payday loans generally translate into APRs of 200% to 400%. The payday loan business model requires the borrower to write a post-dated check to the lender – or authorize an electronic withdrawal equivalent – for the amount of the loan plus the finance charge. On the due date (payday), the borrower can allow the lender to deposit the check or debit the account – or the borrower can pay the initial fee and roll the loan over for another pay period and pay an additional fee. The typical loan amount is $350. The typical annual percentage rate on a storefront payday loan is 391%.  

Rollover of payday loans, or the “churning” of existing borrowers’ loans creates a debt treadmill that is difficult to escape: The Consumer Financial Protection Bureau found that over 75% of payday loan fees were generated by borrowers with more than 10 loans a year. And, according to the Center for Responsible Lending, 76% of all payday loans are taken out within two weeks of a previous payday loan with a typical borrower paying $450 in fees for a $350 loan.

Use of Retail Partners Imposes Burden and Fees on Taxpayers

In addition to using these payday lenders as tax payment agents, the new IRS arrangement poses other problems for taxpayers.  Since as early as 2007, the IRS National Taxpayer Advocate has criticized the IRS for the lack of available Taxpayer Assistance Centers that accept cash payments from taxpayers.  Although taxpayers can still pay in cash at some of these Centers, appointment are required, and can take upwards of 30 to 60 days to schedule. 

While the IRS solution of using retail partners reduces costs for the agency, it adds significant costs and burdens on taxpayers.  There is a fee of $3.99 per payment, and each payment is limited to $1,000.  Before using a “retail partner,” the taxpayer must visit the “Official Payments” website, which effectively excludes any taxpayers who are not comfortable with using the Internet.  Emails are then sent from both Official Payments and PayNearMe.  The PayNearMe email includes a payment code that the taxpayer must print or display on a smartphone at the retail partner.  The entire process takes five to seven business days and must be completed before the payment due date.

The IRS should exclude Payday Lenders from Retail Partner Program

Unfortunately, the new IRS arrangement will almost certainly bring new customers into payday lending stores and leave them susceptible to high-cost loan products and the debt treadmill. Indeed, the individuals most likely to pay their tax liability at a retail partner have some of the characteristics – low-income, BIPOC, female, elderly – that make them prime targets for payday lenders.

The IRS should recognize that using payday lenders as tax payment agents poses a threat to low-income taxpayers. Their services can trap them in debt, and jeopardize their ability to pay their tax debts, and other necessary expenses, such as food and rent.  The IRS should stop allowing payday lenders to accept cash payments for federal taxes, but instead should provide taxpayers with safe and convenient alternatives.

Pfizer Again – On to the Substantive Issue

We welcome back guest blogger Bob Probasco with an update on the Pfizer case and its, seemingly, never ending quest for interest on a large refund.  Pfizer has moved past the procedural hurdles and onto the merits of its claim for interest.  As Bob describes below, we have not yet seen the end of the case and our continuing lessons on the payment of interest.  Keith

I’ve discussed a particular jurisdictional issue in the Pfizer case, and others, several times on Procedurally Taxing over the last two years.  That issue was whether taxpayers can file standalone suits for additional overpayment interest, in excess of $10,000, in the Court of Federal Claims as well as District Court.  (If you’re interested in this issue, the PT posts are here, here, here, here, here, here, here, and here.)  Over that period, Pfizer has moved from the Southern District of New York to the Second Circuit to the Court of Federal Claims.  The jurisdictional issue was resolved long ago, at least for this case, and the parties can proceed to the substantive issue. 

When we last visited the status, Pfizer had filed a motion for summary judgment; the government opposed that motion and sought additional discovery.  The CFC issued an opinion and order on September 14, 2020. 

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The substantive issue – overpayment interest when a refund check is re-issued

The case resolves around a refund of $499,528,449.05, resulting from an overpayment on Pfizer’s tax return for 2008, which was timely filed on September 11, 2009.  The government contends that it processed six separate checks – five for $99 million each and the sixth for $4,528,449.05 – and mailed them on October 20, 2009, by first-class mail.  Pfizer contends that its tax department in New York never received the checks.  The government then cancelled the checks and executed an electronic funds transfer for the entire $499,528,449.05 on March 18, 2010, which was deposited into Pfizer’s account on the following day.

The government did not pay overpayment interest on the refund; Pfizer contends it should have. During that period, the overpayment interest rate on large balances (so-called “GATT interest”) was 1.5%.  Even at that low rate, interest on half a billion dollars would have added up; Pfizer’s complaint asked for more than $8 million, “plus statutory interest” which continues to compound. 

The legal dispute comes down to two words, italicized below.  Section 6611(b), which defines the period for which overpayment interest is paid, states in relevant part:

(b) Period  Such interest shall be allowed and paid as follows: . . .

(2) Refunds

In the case of a refund, from the date of the overpayment to a date (to be determined by the Secretary) preceding the date of the refund check by not more than 30 days, whether or not such refund check is accepted by the taxpayer after tender of such check to the taxpayer. The acceptance of such check shall be without prejudice to any right of the taxpayer to claim any additional overpayment and interest thereon.

Meanwhile, Section 6611(e)(1), which is an exception under which overpayment interest will not be paid, states:

Refunds within 45 days after return is filed

If any overpayment of tax imposed by this title is refunded within 45 days after the last day prescribed for filing the return of such tax (determined without regard to any extension of time for filing the return) or, in the case of a return filed after such last date, is refunded within 45 days after the date the return is filed, no interest shall be allowed under subsection (a) on such overpayment.

The conference report for the 1993 amendment to Section 6611(e) describes the provision as:

No interest is paid by the Government on a refund arising from an original income tax return if the return is issued by the 45th day after the later of the due date of the return . . . or the date the return is filed.

The government focuses on the word “issued” in the legislative history for Section 6611(e) and concludes that mailing the refund within 45 days avoids interest, regardless of whether the refund is delivered to the taxpayer.  Pfizer focuses on the word “tender” in Section 6611(b)(2) and concludes that it requires “that a taxpayer has some knowledge of [the refund check] and an opportunity to accept, or decline to accept, the check.”  That quote is from Doolin v. United States, 918 F.2d 15, 18 (2d Cir. 1990).  The Seventh Circuit adopted that analysis in Godfrey v. United States, 997 F.2d 335, 337 (7th Cir. 1993).  The Doolin precedent is why Pfizer originally brought the case in the Southern District of New York instead of the Court of Federal Claims.

This issue appears to have been litigated infrequently, with Pfizer only the third case to address it.  Although he didn’t seem very impressed with the government’s proffered legislative history, Judge Lettow didn’t decide the legal issue.  Material disputes of fact remained.

The Fact Issues

The government offered evidence of the Treasury’s processing and mailing procedures and that Pfizer’s checks were processed accordingly.  But an email from an IRS employee stated that “the checks weren’t sent & stopped the request.”  Further, problems with the Post Office or Pfizer’s mail handling practices might have resulted in one or two missing checks, but there were six missing checks.  That raised questions about whether Treasury’s procedures were really followed.  Pfizer also argued that the usual presumption of delivery should not apply when there is evidence that the mail was not received.

On the other side, the government wanted additional discovery concerning Pfizer’s mail practices, to challenge Pfizer’s assertion that the checks were never delivered.  A third-party contractor picked up all of Pfizer’s mail from the Post Office and took it to Pfizer’s central mailroom, to be sorted and delivered to various offices and departments.  Pfizer’s Tax Department didn’t receive the refund checks but that didn’t necessarily mean Pfizer hadn’t.  During an earlier deposition, an Operations Manager for Pfizer testified that he wasn’t aware of any complaints regarding lost, non-received, or misplaced mail.  But he hadn’t inquired into incidents of lost mail in preparation for the deposition.  The government had asked to examine a Pfizer witness concerning “all incidents in which Pfizer lost or allegedly failed to receive mail addressed to Pfizer” at that address and considered the deposition testimony insufficient.

Conclusion

The judge declined to resolve the statutory interpretation issue on a motion for summary judgment because neither party would have been entitled to summary judgment at this point.  The government could not win because there were genuine disputes of act concerning whether Treasury issued and mailed the checks.  Pfizer could not win because there were genuine disputes of fact concerning whether the checks were appropriately delivered to Pfizer.

As a result, the judge denied Pfizer’s motion for summary judgment and granted the government’s motion to reopen discovery.  The judge ordered the parties to file a proposed schedule for discovery and further proceedings by the end of September.  It may be a while longer before we get a ruling on the legal issue.

The Barrier of the Anti-Injunction Act for Low Income Taxpayers

Today we welcome back guest blogger Omeed Firouzi, who discusses a recent case involving a dispute over employees’ tax withholding. Omeed notes that withholding disputes may become more frequent as the payroll tax deferral plays out. Christine

The Tax Anti-Injunction Act has been the subject of several posts on this site over the years. The law garnered national political attention in the summer of 2012 in the aftermath of the U.S. Supreme Court’s NFIB v. Sebelius decision. In NFIB, the Supreme Court upheld the Affordable Care Act’s individual mandate on the basis that the shared responsibility payment was within Congress’ taxing authority. The Tax Anti-Injunction Act (26 U.S.C. Section 7421) reads, in relevant part:

No 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.

This law was at the center of a recent case decided in the U.S. District Court for the District of Oregon in July 2020. The plaintiff in this case, Alex Wright, alleged in a class action suit that his employer, Atech Logistics, Inc., wrongly withheld more taxes than they should have. Wright alleged unpaid wages and unpaid overtime as well.

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With regard to the federal tax component of his case, Wright specifically alleged that Atech improperly rounded up his Federal Insurance Contributions Act (FICA) withholding on his paychecks to the next penny “instead of down as required by 26 C.F.R. Section 31.3102-1(d).” Consequently, Wright “on behalf of a proposed class of all current and former Atech employees…[sought] a $200 statutory penalty, a declaratory judgment that Atech violated the law, and attorney’s fees and costs.”

The magistrate judge agreed with Atech’s claim that the Anti-Injunction Act and the Declaratory Judgment Act “bar Wright’s claims relating to Atech’s alleged FICA tax miscalculation.” Virtually all of the court’s analysis relies on controlling precedent in the Ninth Circuit courtesy of the very similar case Fredrickson v. Starbucks Corp., 840 F.3d 1119, 1124 (9th Cir. 2016). In Fredrickson, the Ninth Circuit ruled that the Anti-Injunction Act barred Starbucks employees’ claims of improper federal and state tax withholding that the employees alleged was “based on an improper estimate of tips received.” The Fredrickson court cited U.S. Supreme Court precedent to justify its ruling, specifically United States v. Am. Friends Serv. Comm., 419 U.S. 7, 10 (1974), a case that found an employer’s withholding of taxes to be a kind of collection that can’t be enjoined under the Anti-Injunction Act. The Wright magistrate here, in turn, cited these precedents to recommend that the district court “grant Atech’s motion to dismiss.” The magistrate states plainly that Wright and his fellow employees could not challenge their employer’s tax withholding because the employees were attempting to restrain a collection of tax in direct contravention of the Anti-Injunction Act.

The court’s ruling here presents a frustrating predicament for taxpayers like Mr. Wright. When employers actively withhold more taxes than they should, workers are seemingly left with little recourse because of courts’ sweepingly broad interpretation of a decades-old statute. Such rulings mean that taxpayers like Mr. Wright are forced to pursue other options. One such option might be a refund suit, as suggested by the court in a footnote (“he can seek a refund of any amount Atech improperly withheld.”)

This route would lead Mr. Wright down a path of paying, through withholding, taxes that he should not have to pay, in violation of the “right to pay no more than the correct amount of tax,” per the Taxpayer Bill of Rights. He would then need to file a return or make a claim on which he would somehow seek a refund of the improperly withheld taxes. If that fails, he would then possibly have to file a refund suit (six months after filing the return or within two years from a notice of disallowance) – something he could of course only do after having paid all the taxes in full thanks to the Flora rule much discussed on this blog. During this entire process, it is unclear, per that very same Am. Friends case, whether he could seek injunctive relief against his employer, because of the Anti-Injunction Act, if he continues to work for him and the employer continues to withhold improperly.

What to make of the fact that this timeline may not yield success and could be cumbersome? The Supreme Court made clear in Am. Friends that the “frustrat[ing]” or “inadequate” nature of a refund suit does not change the fact the Anti-Injunction Act bars such suits. There are at least a couple of perplexing questions that come to mind here. First, if a worker can sue their employer under the Fair Labor Standards Act (FLSA) for failure to pay them proper wages or overtime pay, why can’t a worker sue their employer for failure to pay them enough in net take-home pay after tax deductions? The same principle of adequate, proper pay under federal law would seem to apply in the case of FICA deductions as would apply in FLSA cases (and of course both FICA and FLSA are products of the same New Deal progeny of the Depression-era federal social safety net overhaul).

Second, a worker can challenge their active misclassification, for example, as an independent contractor. If the worker succeeds, and their employer is ineligible for Section 530 safe harbor protections, the employer would have to abide by the IRS SS-8 determination and start withholding income and employment taxes. The tax withholding would change in real time as a result of the worker’s action to challenge their status; no separate proceeding is required. In addition to filing form SS-8, workers can also file a Form 3949-A to report “failure to pay tax” or “failure to withhold,” among other tax violations. If workers are permitted, even with the Anti-Injunction Act on the books, to take these actions related to their employers’ withholding, why should Mr. Wright’s claims be barred?

If these results seem inconsistent, consider the vexing nature of the Anti-Injunction Act that was articulated in the Supreme Court’s aforementioned NFIB decision. In NFIB, the Court famously saved the Affordable Care Act and its individual mandate partly on the grounds that the penalty for lack of health insurance (“the shared responsibility payment”) functionally amounted to a tax that Congress had the power to create.

But the Court interestingly held that the Anti-Injunction Act was not applicable to the shared responsibility payment because Congress specifically structured it as a “penalty” rather than as a “tax” that would be couched in the language of the Anti-Injunction Act. Therefore, while the individual mandate was upheld, the tax that enforces it was considered a “penalty” that was constitutionally a tax but notably not a tax for purposes of the Anti-Injunction Act – so suits against it could be maintained and the court could rule on its merits.

If Congress decided to recategorize FICA taxes in a way that did not explicitly tie them to the language of the Anti-Injunction Act, then Mr. Wright may have gotten past the initial barrier here. However, even with the Anti-Injunction Act firmly in place, we likely have not heard the final say on this matter.

Consider that currently some employers are following through on President Trump’s recent executive order on suspension of the employee share of FICA taxes. Absent congressional action, these taxes will have to be repaid. That could lead to large amounts of FICA withholding on some paychecks right before the deadline for repayment. That could mean miscalculations and inaccuracies, whether intentional or not, that produce improper withholding on paychecks. In turn, frustrated taxpayers might turn to the courts to recoup unauthorized deductions as workers try to make ends meet during an economic crisis. It remains to be seen how all of these developments will unfold considering courts’ generally broad reading of the Anti-Injunction Act.

Why a Win for CIC Services Would Be a Win for Tax Shelters

We welcome a group of guest bloggers who filed an amicus brief in CIC Services earlier this week.  Professors Susie Morse, Clint Wallace and Daniel Hemel and attorneys at Gupta Wessler filed a brief on behalf of former government officials Lily Batchelder, Mark Mazur, Eileen O’Connor, Leslie Samuels, Stephen Shay and George Yin.  Today, they provide us with an explanation of why the Supreme Court should uphold the decision of the 6th Circuit, which held that the Anti-Injunction Act bars CIC Services’ suit.  The Supreme Court has now scheduled this argument for December 1, 2020.  Keith

This week, a group of former government officials filed an amicus brief in support of the government in CIC Services v. IRS, the Anti-Injunction Act case before the Supreme Court this term. The case involves a tax shelter promoter that seeks to prevent the IRS from imposing penalties on the promoter and its clients if they fail to comply with tax-shelter reporting requirements. A ruling for CIC Services would, as the Solicitor General emphasizes in its brief, go a long way toward gutting the 153-year-old Anti-Injunction Act. It would also—as our brief demonstrates—deal a serious blow to the IRS in the agency’s decades-long battle to combat abusive tax shelters.

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Ever since the first wave of abusive tax shelters gathered momentum in the 1960s, Congress has taken a series of actions to give the IRS tools to fight back. Those include the at-risk rules in the Tax Reform Act of 1976, the passive activity loss limitations in the Tax Reform Act of 1986 and, at issue here, the reportable transaction disclosure regime in the American Jobs Creation Act of 2004. Specifically, in the 2004 law, Congress required tax shelter promoters and their clients to disclose certain large-dollar shelter transactions to the IRS, and it enacted new penalties so that those disclosure requirements had teeth. Of particular importance to this case, Congress placed those penalties in Subchapter 68B of the Code, which means that they qualify as “taxes” for purposes of the AIA.

The disclosure regime was, by most accounts, a resounding success. Prior to the disclosure rules, the IRS often found itself “looking for the tax shelter needle in the haystack of a complicated business tax return.” By requiring parties who arrange and participate in specific potentially abusive transactions to identify themselves to the IRS or face stiff penalties, Congress made it possible for the IRS to find the needle. To be sure, taxpayers still have the opportunity to argue that their transactions claim legal tax benefits. What they can’t do any more is keep their transactions outside the IRS’s view.

The reportable transaction scheme is designed to be agile. Congress wanted the IRS, upon learning of a new shelter, to require disclosure from promoters of the shelter and their clients. Congress specifically blessed the IRS’s practice of issuing reportable-transaction designations under already-existing authority (section 6011). That regime provides for issuance of designations by the IRS via notice in the Internal Revenue Bulletin—backed by penalties under the AJCA for failure to comply. Indeed, the IRS has designated dozens of transactions in this way, starting before Congress enacted the penalties for failure to report in the AJCA and continuing in recent years. CIC Services’ substantive argument is that the IRS should promulgate these notices through Administrative Procedure Act rulemaking rather than relying on the section 6011 framework. We think the AJCA endorsed the IRS’s approach. But in any event, the only issue here is whether CIC Services can obtain a pre-enforcement injunction that would block the IRS from imposing penalties for nondisclosure.

Allowing pre-enforcement challenges to these penalties—i.e., allowing taxpayers to challenge reportable transaction designations and to delay revealing to the IRS their participation in such transactions—would have severe consequences for the effort to fight abusive tax shelters. As we detail in our brief, injunctions of the sort that CIC Services seeks would yield three specific effects. First, they would prevent the IRS from detecting many abusive transactions. Second, when injunctions delayed detection, it would be likelier that the statute of limitations would lapse before the IRS could assess taxes that are rightfully owned. Third, in cases where the IRS is able to assess taxes before the statute of limitations runs out, delaying assessments would increase the risk of non-collection. The longer the delay, the likelier it is that taxpayers will have spent down their assets or moved their wealth beyond the IRS’s reach.

The petitioner wants to cast its effort in a different light. By its telling, the case has nothing to do with tax shelters at all. Petitioner tells the Court in its brief that its micro-captive products allow for “customized” risk management and a “more seamless claims process,” though it advertises itself to clients as a provider of a “legal tax shelter” that “can often double a business owner’s wealth.”

As readers of Procedurally Taxing know, petitioner’s argument received support from Professors Fogg and Book, who joined with the Center for Taxpayer Rights in an amicus brief opposing the Sixth Circuit’s interpretation of the AIA. Their brief argues that low-income taxpayers are especially disadvantaged when forced to rely on the AIA’s required remedy of post-enforcement judicial review. As Professor Fogg has written, under the Flora full-payment rule, in practice this can mean that post-payment judicial review for low-income taxpayers who face failure-to-report penalties is out of reach. And as Professor Book has written, the government’s approach to enforcing the tax law applicable to low-income taxpayers may excessively target taxpayers who make unintentional mistakes and lack access to constructive government guidance about how to comply.

Like Professors Fogg and Book, the authors of this blog post are concerned about the interaction between tax law enforcement and the situations faced by low-income taxpayers. But we think the remedy is to relax the full-payment rule in cases where it forces hardship for low-income individuals, and not to exempt CIC Services from the Anti-Injunction Act’s plain text.

The immediate result of a ruling for CIC Services would be to make it easier for tax-shelter promoters and their predominantly high-income clients to avoid paying the taxes they owe. That would result in less revenue overall, and more of the federal tax burden would be borne by lower-income taxpayers. The distributive result would be regressive.

Also, a ruling for petitioner is unlikely to provide relief for low-income taxpayers fighting the IRS. Petitioner’s theory is that it is challenging a “regulatory mandate” unrelated to its own tax liability. “Win or lose,” petitioner says in its brief, “the IRS will collect no additional revenue from CIC.” Petitioner accepts that taxpayers litigating about their own liabilities are covered by the Anti-Injunction Act but asks the Court to distinguish tax shelter promoters like CIC Services who are litigating about penalties for failure to disclose other taxpayers’ transactions. 

We agree with the government that the distinction that CIC Services draws is not a valid one. (Whether CIC Services wins or loses will affect the ability of the IRS to collect penalties from CIC Services itself under §§ 6707 and 6708—penalties that Congress has deemed to be taxes.) But let’s imagine that the Court disagrees and accepts CIC Services’ argument. That helps tax shelter promoters, but what does it accomplish for low-income taxpayers seeking to claim the earned income tax credit or the child tax credit? They are arguing about their own taxes and tax credits. 

In addition, a ruling for the government in CIC Services would leave undisturbed any equitable exceptions to the Anti-Injunction Act, which would allow low-income taxpayers to seek prepayment remedies in a case of clear government overreach. In the Bob Jones case, the Court said that such an equitable exception could be available where a plaintiff can show both a “certainty of success on the merits” and “irreparable injury.”  CIC Services has not sought that exception, and as our brief argues, it would not be eligible anyway. But Bob Jones may provide relief for low-income taxpayers in situations like the ones that Professors Fogg and Book highlight.  

The AIA lies at the foundation of federal tax administration and the modern tax shelter disclosure regime. That regime relies on a nimble IRS, backed by the threat of penalties for failure to disclose. Permitting tax shelter promoters to resist disclosure requirements with strategic lawsuits and pre-enforcement injunctions would mean trouble for tax collection.

IRS Expands Digital Signature COVID Response

Today guest blogger James Creech returns with an update to his previous post on IRS acceptance of digital signatures. As James notes, there continues to be confusion over which forms may be accepted with a digital signature, and for what purpose. Christine

The IRS recently made two announcements dated August 28, 2020 and September 10, 2020 expanding the list of documents that are temporary eligible to be filed using electronic signature due to the ongoing pandemic.  These two announcements add 16 forms to the list of documents that can be submitted with electronic signatures. 

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What is notable about these forms, is that they are forms that were previously barred from using an electronic signature because they were subject to standard filing procedures.  Since these forms had standard filing procedures, they were outside of the scope of the March 27, 2020 (and superseded with minor changes on June 12th) internal IRS memo that originally permitted electronic signatures on a number of forms used by the IRS to resolved cases at the exam or collection stages.  A full list of the forms can be found here.

The expanded use of electronic signatures for more routine forms is a welcome development even if, as the memo notes, it does not “represent the full universe of forms filed or retainer on paper that taxpayers and their representatives would like to see covered”.   Some of the forms such as the 706 family of tax returns are particularly useful because they allow an executor who may be at high risk from COVID to sign the return without having to come into contact either with other people by having to travel to the return preparer’s office or without having to physically go into the post office.  

The expanded use of electronic signatures does not change any of the other filing requirements.  Generally speaking most of the document on the expanded electronic signatures list still require that they be physically mailed to the IRS although some of the forms such as Form 3115 are also subject to temporary acceptance by fax.  The current expiration for electronic signature acceptance on both the listed forms as well as for documents provided for exam and collection is December 31, 2020.  In the case of a form filed though normal channels an electronic signature is valid as long as the form is signed and postmarked prior to January 1, 2021. 

These announcements by the IRS are a recognition that while life is returning to normal it is not the normal that existed in January.  Overall the IRS has done a good job of adjusting to our shared existence of social distancing.  The agency’s flexibility with electronic signatures, accepting documents via email, expanding e-filing for forms such as the 1040x are all recognition that the tools for remote work exist and have value. 

While the rollout of the prior electronic signatures has not gone without its hitches, such as continued CAF rejections of 2848’s due to electronic signatures despite the form being specifically identified as eligible for electronic signature is in the March 27th memo, and there are some tradeoffs with security and identity verification, these changes are a net positive.  Hopefully the IRS spends some of the next few months working out ways to reduce these risks to acceptable levels so that when taxpayers and their representatives can safely meet again they will not have to return to signing paper forms.