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? 

Conservation Easement Donation and the Validity of Tax Regulations

Monte Jackel returns to discuss the Tax Court’s latest attempt at squaring the APA and the tax regulation process. Les

In Oakbrook Land Holdings LLC (154 T.C. No. 10, May 12, 2020), the Tax Court, in a reviewed opinion, upheld the validity of a Treasury regulation (reg. §1.170A-14(g)(6)) issued under section 170 of the Code relating to conservation easement donations and the perpetuity requirement. A concurrently issued memorandum opinion issued the same day (T.C. Memo 2020-54) had held that if the regulation was valid, the taxpayer was in violation of it. 

At issue in the opinion was the validity of the regulation at issue. This commentary focuses its attention on the requirement of the Administrative Procedure Act (APA) that a “legislative rule” contain a concise statement of the basis and purpose of the proposed rule. The Chevron doctrine, also addressed by the court, is not discussed here. 

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The majority opinion first stated that the regulation at issue was a legislative rule and not an interpretative one because it set forth a substantive requirement (sharing of proceeds if easement terminated) that was not set forth in the statute and which, if violated, would cause loss of the deduction. 

Underlying this conclusion was the majority’s view of a legislative rule:

“Administrative law distinguishes between interpretive and legislative agency rules. “An interpretive rule merely clarifies or explains preexisting substantive law or regulations….A legislative rule, on the other hand, “creates rights, assigns duties, or imposes obligations, the basic tenor of which is not already outlined in the law itself.”…Legislative rules have “the force and effect of law.”….

The majority then turned to the APA that sets forth the notice and comment requirement for legislative rules:

“Legislative rules are subject to APA notice-and-comment rulemaking procedures. See 5 U.S.C. sec. 553(b)…To issue a legislative regulation consistently with the APA an agency must: (1) publish a notice of proposed rulemaking in the Federal Register; (2) provide “interested persons an opportunity to participate…through submission of written data, views, or arguments”; and (3) “[a]fter consideration of the relevant matter presented,…incorporate in the rules adopted a concise general statement of their basis and purpose.” See 5 U.S.C. sec. 553(b) and (c).”

It was the third requirement that was in dispute in the case (the “concise general statement of basis and purpose requirement”). The majority opinion concluded that the concise general statement of basis and purpose requirement was satisfied in this case. 

“The APA provides that a reviewing court shall set aside agency action that is “arbitrary, capricious, an abuse of discretion, or otherwise not in accordance with law.” 5 U.S.C. sec. 706(2)(a). The scope of our review “is a narrow one” because “[t]he court is not empowered to substitute its judgment for that of the agency.”…We consider only whether the agency “articulate[d] a satisfactory explanation for its action.”…. While we cannot provide a reasoned basis for agency action that the agency itself did not supply, we will “uphold a decision of less than ideal clarity if the agency’s path may reasonably be discerned.”….“So long as an agency’s rationale can reasonably be discerned and that rationale coincides with the agency’s authority and obligations under the relevant statute, a reviewing court may not ‘broadly require an agency to consider all policy alternatives in reaching decision.’” …Indeed, “regulations with no statement of basis and purpose have been upheld where the basis and purpose w[ere] considered obvious.”….

The majority concluded that this test had been met even though the final regulation preamble did not specifically address the comment that pertained specifically to the regulation provision at issue. This was so principally because the point raised in the comments was only one comment out of many submitted and that specific comment did not fully address the provision at issue and alternatives to what was proposed. The majority stated:

“[A]n agency cannot reasonably be expected to address every comment it received. The APA “has never been interpreted to require the agency to respond to every comment, or to analyze every issue or alternative raised by the comments, no matter how insubstantial.” …“We do not expect the agency to discuss every item of fact or opinion included in the submissions made to it.” …“An agency need not respond to every comment.”…. In any event, “[t]he administrative record reflects that no substantive alternatives to the final rules were presented for Treasury’s consideration.” …“A comment is * * * more likely to be significant if the commenter suggests a remedy for the purported problem it identifies.”…. The APA requires “consideration of the relevant matter presented” during the rulemaking process. 5 U.S.C. sec. 553(c). 

The majority then laid out the reasons for denying the assertion of an APA violation:

“Our review of the administrative record leaves us with no doubt that Treasury considered the relevant matter presented to it…. And we find equally little merit in petitioner’s assertion that Treasury failed to “incorporate in the rules adopted a concise general statement of their basis and purpose.” See 5 U.S.C. sec. 553(c)…. No court has ever construed the APA to mandate that an agency explain the basis and purpose of each individual component of a regulation separately. “[T]he detail required in a statement of basis and purpose depends on the subject of the regulation and the nature of the comments received.” …This statement need only “contain sufficient information to allow a court to exercise judicial review.”….

There was also a concurring opinion and a dissenting opinion in the case. 

The concurring opinion, among other issues, separately addressed the APA procedural point. After concluding that the text of the statute precluded the deduction, the concurring opinion nevertheless set forth its views on both Chevron and the APA. 

On the latter point, which is the focus of this commentary, the concurrence states:

“Treasury might not have found itself in this predicament under Chevron if it had followed more carefully the APA’s procedural requirements, which are designed to help agencies consider exactly this type of issue before a rule becomes final. 

And then came the dissenting opinion. The dissent, as one would expect, disagreed with the majority’s reasoning on the APA procedural point. It states:

“In today’s case, we hold that the Treasury Department gets to ignore basic principles of administrative law that require an agency “to give reasoned responses to all significant comments in a rulemaking proceeding.” ….A court is supposed to ensure that an agency has taken “a ‘hard look’ at all relevant issues and considered reasonable alternatives.”…But if the majority is right, the Treasury Department can get by with the administrative-state equivalent of a quiet shrug, a knowing wink, and a silent fleeting glance from across a crowded room…. [T]he majority, I fear, has missed the main root of [the taxpayer’s] argument–that at the time of the regulation’s promulgation, commenters made significant comments, and Treasury failed to address them in its statement of the regulation’s basis and purpose…. The Final Rule’s statement of basis and purpose shows absolutely no mention of the [regulation provision at issue]–and no reasoned response to any of the public’s comments on those provisions…. 

The dissent then zeroed in on its objections to the conclusions of the majority:

“[W]hile we don’t demand a perfect explanation for Treasury’s decisionmaking, …we should demand some,… And here, there wasn’t any….. [T]he analysis shouldn’t stop there–what is the nature of a comment that triggers an agency’s obligation to respond? The caselaw tells us to look at a comment’s significance. Agencies must “give reasoned responses to all significant comments in a rulemaking proceeding.”….This is because “the opportunity to comment is meaningless unless the agency responds to significant points raised by the public.”….“It is not in keeping with the rational process [of APA section 553(c)] to leave vital questions, raised by comments which are of cogent materiality, completely unanswered”). So, though an agency doesn’t have to respond to all comments, it must respond to all significant comments.

The dissent then cites a series of Treasury decisions that, as a matter of fact, make the same statement that “all comments were considered” or words of similar import. But, as the dissent states, “the APA,…has no provision for agencies to use ritual incantations to ward off judicial review.” 

Where does this take us? This case shows that the Treasury and IRS need to pay more attention as to (1) what is a legislative rule as compared to an interpretative rule, and (2) has it considered all “significant” public comments and fully addressed them in the final rule. 

And for commenters to regulations, this case seems to indicate that a comment letter should state that the issue is material, fully discuss the issue, and propose a practical alternative if one is available.

All of this is clearly an area to watch in the near future.

Invalidating an IRS Notice: Lessons and What’s to Come from Feigh v. C.I.R.

A few weeks ago, the United States Tax Court decided Feigh v. Commissioner, 152 T.C. No. 15 (2019): a precedential opinion on a novel issue involving the Earned Income Tax Credit (EITC) and its interplay with an IRS Notice (Notice 2014-7). The petitioners in the case just so happened to be represented by my clinic, and the case just so happened to be a A Law Student’s Dream: fully stipulated (no pesky issues of fact), and essentially a single (and novel) legal issue. Because the opinion will affect a large number of taxpayers, I commend those working in low-income tax to read it. What I hope to do in this blog post is give a little inside-baseball on the case and, in keeping with the theme of this blog, tie it in a bit with procedural issues.

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Posture of the Case

I frequently sing the praises of Tax Court judges in working with pro se taxpayers. This case provides yet another example. My clinic received a call from the petitioners less than a week before calendar. Apparently, the Tax Court (specifically Judge Goeke) had recognized that this was a novel issue of law and suggested to the low-income, pro se petitioners that they may benefit from contacting a Low-Income Taxpayer Clinic for help with the briefing.

By the time the client contacted me (again, only a few days before calendar) the IRS had moved for the case to be submitted fully stipulated under Rule 122. The Court had not yet ruled on the motion but I mostly found the stipulations unobjectionable (with one minor change, which the IRS graciously did not object to). Rather, what concerned me was the fact that it was designated as an “S-Case.” I wanted this case to be precedential, and I wanted to be able to appeal –neither of which are possible for S-Cases. See IRC § 7463(b). Yes, the Court can remove the designation in its own discretion (see post here), but I didn’t want to leave anything to chance. After consulting with my clients the first order of business was to move to have the S designation removed -which again saw no objection from the IRS. Now the table was set for briefing on the novel issue.

What’s At Issue?

I’m going to try hard not to dwell on the substantive legal issues in this case, important though they are. Nevertheless, an ever-so-brief primer on what was going on is necessary.

Our client (husband and wife) received Medicaid Waiver Payments for the services the wife provided to her disabled (non-foster) child. From conversations with local VITA organizations I already anecdotally knew that some people received these payments, but since taking this case on I have come to appreciate exactly how vast the Medicaid Waiver program is. For our client, the Medicaid Waiver Payments were made in the form of rather meager wages (a little over $7,000) that were subject (rightly or wrongly) to FICA. They were the only wages my clients had. When my clients went to file their income tax return, however, it looked like they were getting a fairly raw deal: namely, missing out on an EITC and Child Tax Credits cumulatively worth almost $4,000. Why? Because in 2014 the IRS decided that these Medicaid Waiver Payments were excluded from income as IRC § 131 “Foster Care” payments.

An exclusion from income sounds to most taxpayers like a good thing: it’s always better to have less taxable income, right? But the tax code is a complicated animal, and for lower-income taxpayers the exclusion of wages was actually a curse: to be considered “earned income” for both the EITC and Child Tax Credit (CTC), wages must be “includible” in income. By the IRS’s logic, this meant that you must exclude your $7,000 Medicaid Waiver Payment (with a tax benefit of $0 in some cases) and couldn’t thereafter “double-benefit” by also getting the EITC/CTC for those excluded wages.

It doesn’t quite seem fair for those who saw little or no tax benefit from the exclusion.

It seems even less fair when you consider that those who would actually phase out of the EITC (say, by receiving a large Medicaid Waiver Payment over $52,000, which has happened) not only would get a larger tax benefit from the exclusion, but could still potentially get the EITC if they had other wages (say, from the other spouse). Theoretically, a couple making $100,000 could get the EITC in this case if the greater portion of the income were Medicaid Waiver Payments. This would be the case because such payments would be disregarded for EITC eligibility calculation altogether. Probably not what Congress (or even the IRS) had in mind.

My clients felt like they should do something about this unfairness. So they did: they took both the exclusion of IRS Notice 2014-7 and the EITC based on the excluded wages. This of course led to a notice of deficiency and culminated in the precedential Feigh decision.

Our Legal Arguments

Because of our client’s novel stance, we had two points we had to make for our client to win: (1) that the wages could be included in income, and (2) basically, that was it. We wanted to make it a simple statutory argument: If the wages could be included, then they were “includible,” and that was all that was required of the EITC under IRC § 32(c)(2)(A)(i).

As to the first point -whether the payments could (maybe, should) be “included” in income- history was on our side. Prior to 2014 courts and the IRS agreed that such payments had to be included in income. Payments for adopted or biological children clearly did not meet the statutory language of excluded “Foster Care Payments” under IRC § 131. The only thing that changed in the intervening years was the IRS issuance of Notice 2014-7: there was no “statutory, regulatory, or judicial authority” that could anchor the change in treatment. As we argued, the IRS essentially transformed “earned income” into “unearned income” on its own. And that sort of change is a massive bridge too far through subregulatory guidance.

We won on that first issue handily. The Court noted that “IRS notices –as mere statements of the Commissioner’s position—lack the force of law.” Then, the Court applied Skidmore deference (see Skidmore v. Swift & Co., 323 U.S. 134 (1944)) to see whether the interpretation set forth by IRS Notice 2014-7 was persuasive.

It was not.

And the IRS could not, through the notice, “remove a statutory benefit provided by Congress” -like, say, eligibility for the EITC. That sort of thing has to be done through statute. For administrative law-hawks, the Tax Court reigning in the IRS’s attempts to rule-make without going through the proper procedures is probably the bigger win. (As an aside, I’m not entirely positive even a full notice-and-comment regulation could do what Notice 2014-7 tries to: I don’t think any amount of deference would allow a reading of IRC § 131 the way Notice 2014-7 does.)

So we cleared the first hurdle: the IRS can’t magically decree that what was once earned income is no more through the issuance of subregulatory guidance. But what of the second hurdle -the fact that our client undeniably did not include the wages in gross income?

Courts have (rightly) treated the terms “allowable” and “allowed” differently, as well as “excludible” vs. “excluded” in previous cases. The breakdown is that the suffix “able” means “capable of” whereas the suffix “ed” means “actually occurred.” See Lenz v. C.I.R., 101 T.C. 260 (1993). Coming into this case I was keenly aware of this distinction because of a law review article I read while writing a chapter on the EITC for Effectively Representing Your Client Before the IRS. Indeed, it was that aspect of the EITC statutory language (and not my familiarity with Notice 2014-7 or Medicaid Waiver Payments) which made me want to take this case from the beginning. I feel compelled to raise the value of that law review article (James Maule, “No Thanks, Uncle Sam, You Can Keep Your Tax Break,”) because so many law professors joke that no one reads law review articles, or that most articles are impractical (no comment on the latter).

Consistently with the distinction of “allowed” vs. “allowable,” the Court has previously ruled on the nuance of “included” vs. “includible.” See Venture Funding, Ltd. v. C.I.R., 110 T.C. No. 19 (1998). “Included” means it was reported as income, “includible” means that it could/should be reported in income. Since the Tax Court already found that we met the first hurdle (our client could include the payments in income and Notice 2014-7 can’t take that away), we were in the clear: it was “includible.”

And so our client has excluded income and the earned income credit derived from it… Impermissible double-benefit, you (and the IRS brief) say?

I disagree. Not only does treating excluded payments as earned income apply the statutory language correctly, and more in line with what Congress would want, I contend that it is the better way to protect the integrity of the EITC. To see why this is you have to look again at how the EITC is calculated, and how the phase-out applies. In so doing we see that the real problem would be in disregarding excluded income altogether.

The Integrity of the EITC

The EITC is means tested, but it calculates the taxpayers means through two separate numbers: (1) “earned income” and (2) “adjusted gross income (AGI).” See IRC § 32(a)(2) and (f).  Excluded income isn’t reflected in AGI, so people with high amounts of excluded income might escape the AGI means testing prong of the EITC -unless the excluded income is specifically caught through other IRC 32 provisions like limits on investment income or foreign income exclusions. (Note that excluded alimony payments post TCJA would not be incorporated in the means testing.)

However, if excluded income like Medicaid waiver payments is considered “earned income” (that is, if we don’t require that earned income be “included”) then people with large amounts of excluded earned income do begin to phase out under the “earned income” means testing prong. In other words, it more appropriately reserves the credit only for those who working and are (truly) of limited means, while denying it to those who (truly) are not. I think Congress would approve. I’d also note that the exclusion is necessarily worth more to higher income earners than to lower-income earners -and frequently worthless to EITC recipients, many of whom may not actually have a tax liability at all (thus providing a $0 benefit to the exclusion).

Finally, I’d note (and did in the brief) that Congress has essentially addressed this problem of excluded earned income before -only with non-taxable Combat Pay. A little history is helpful on that point.

For the majority of the EITC’s existence (from 1978 to 2001), earned income actually didn’t have to be “includible” in gross income. Then, in an effort to make the credit easier to compute (not an effort to limit eligibility), Congress added the includible requirement as part of the Economic Growth and Tax Relief Reconciliation Act of 2001. Mostly, Congress made this change because it wanted information returns to give taxpayers (and the IRS) all the information needed for calculating the EITC.

Unfortunately, this meant that active duty soldiers receiving combat pay (which is a mandatory statutory exclusion, and thus not “includible” under IRC § 112) could not treat that pay as qualifying for the EITC. A GAO report noted that this was likely an unintended consequence (see page 2), that accrued the bulk of the benefits to those that made the most money. The Congressional fix was IRC § 32(c)(2)(B)(vi), which allows taxpayers to “elect” to treat excluded combat pay as earned income (it still isn’t taxed). Congress had to make this change to fix an unintended consequence of their own (statutory) making. However, it would be absurd (we argued) to require Congress to fix an unintended consequence wholly created by the IRS through Notice 2014-7.

What Happens Next?

I’ve been in contact with the local VITA providers in my community that see Medicaid Waiver Payments on the front lines -apparently fairly frequently. Their main question is a practical one: what do we tell taxpayers now? The IRS VITA guidance before had been “you can’t get credit for those payments towards the EITC.” In the aftermath of Feigh, can they both exclude and get credit now (as my client did)?

That is an excellent question, which brings up some excellent procedural issues (finally: I promised I’d get to them). The main issue is whether the IRS may now consider Notice 2014-7 completely moribund, such that there is no exclusion period and the Medicaid Waiver Payments must be included. The Court noted that the IRS did not raise the argument that the payments should be includible in income for my client, so it was conceded. But is the IRS stuck with that position now? Can the IRS take a position that is contrary to its own published guidance? What if that guidance is essentially invalidated?

The best case on point for this sort of situation may be Rauenhorst v. Commissioner, 119 T.C. 157 (2002). In that case, the IRS essentially said it wasn’t bound by its own guidance (in that instance in the form of a Revenue Ruling) when the Commissioner took a litigating position directly contrary to it. After receiving something of a slap-down from the Tax Court, the IRS issued Chief Counsel Notice CC-2003-014 (sorry, I couldn’t find any free links), which provided that “Chief Counsel attorneys may not argue contrary to final guidance.” Final guidance includes “IRB notices” (i.e. notices that are published in the Internal Revenue Bulletin), which Notice 2014-7 was.

Further, it does not appear to matter that Feigh essentially invalidated Notice 2014-7. The Chief Counsel Notice specifically includes a section headed “Case law invalidating or disagreeing with the Service’s published guidance does not alter” the rule that Chief Counsel shouldn’t take a contrary position that is unfriendly to taxpayers. In other words, so long as IRS Counsel follows the CC Notice, they should continue to let taxpayers exclude the Medicaid Waiver Payments… And since they’ve already lost on whether those excluded payments are earned income, it is perhaps best of both worlds for taxpayers moving forwards.


Perhaps. But I’m not sure I’d bet the farm on the IRS following the Chief Counsel’s Notice in all cases (and especially for taxpayers working with IRS agents or appeals, rather than Counsel).

But the final procedural point I want to make takes the long-view of things: which is that this never should have happened in the first place, because the IRS never should have overstepped its powers by issuing Notice 2014-7 masquerading as substantive law without, at the very least, following the rigorous notice and comment procedures required of substantive regulations. Had the IRS done so the tax community could well have seen this before the regulation was finalized and it could have been addressed. This may echo from my soapbox, but Notice 2014-7 undoubtedly caused real harm to some of the most vulnerable taxpayers. I know from conversations in the tax community that many low-income earners lost out on a credit they rightfully deserved. I don’t think for a second that was the intention of the IRS when they issued Notice 2014-7. Nor does Judge Goeke in the opinion (see footnote 7).

But, again, tax is a complicated animal: legislating new rules should not be done lightly. Procedure, in other words, matters.

Ninth Circuit Reconsideration in Altera v. Commissioner

We welcome back guest blogger Stu Bassin. Stu has blogged with us on several occasions. He is a practitioner based in DC with an extensive controversy practice and provided a discussion of the Altera case earlier here. Les

Last week bought the latest twist in the saga of a challenge to a critical transfer pricing regulation—a rehearing by the Ninth Circuit of a since-vacated ruling upholding the regulation. The original unanimous reviewed decision by the Tax Court in Altera Corp. v. Commissioner, 145 T.C., No. 3 (2015), invalidated the regulation. A divided panel in the Ninth Circuit reversed, upholding the validity of the regulation over a strong dissent. The majority opinion was soon vacated and the case was reargued on October 16, 2018. Given the importance of the specific regulation at issue in transfer pricing cases, as well as the continuing discussion regarding questions concerning Administrative Procedure Act challenges to IRS regulations, the reargument has generated substantial attention in the tax community.

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The underlying dispute involves a cost-sharing agreement governing allocation of stock-based compensation costs between entities related to the taxpayer and invocation by the IRS of Section 482 to recharacterize the terms of that agreement. Section 482 provides:

In any case of two or more organizations . . . owned or controlled directly or indirectly by the same interests, the Secretary may distribute, apportion, or allocate gross income, deductions, credits, or allowances between or among such organizations, trades, or businesses, if he determines that such distribution, apportionment, or allocation is necessary in order to prevent evasion of taxes or clearly to reflect the income of any of such organizations, trades, or businesses. In the case of any transfer (or license) of intangible property (within the meaning of section 936(h)(3)(B)), the income with respect to such transfer or license shall be commensurate with the income attributable to the intangible.

The taxpayer relied upon the undisputed fact that the terms of its cost-sharing agreement were consistent with the prices which unrelated parties would employ in comparable arms-length agreements, thereby satisfying the legal standard historically applied in evaluating cost-sharing agreements under Section 482. The IRS recharacterized the terms of the agreement, relying upon a regulation which specifically required affiliates to share stock-based compensation costs in a manner “commensurate with the income attributable to the intangible.” The taxpayer disagreed, contending that the regulation was invalid under the APA because it deviated from the comparable arms-length transaction test.

The Tax Court unanimously ruled in favor of the taxpayer, invalidating the regulation and rejecting the proposed Section 482 adjustment, focusing upon the second stage of the regulation validity inquiry mandated by Mayo Foundation v. United States, 562 U.S. 44 (2011) — whether the determinations reflected in the regulation were arbitrary and capricious. The opinion concluded that the regulation was invalid because the IRS failed to engage in actual fact-finding, failed to provide factual support for its determination that unrelated parties would share compensation costs in their cost-sharing agreements, failed to respond to significant comments, and acted contrary to the factual evidence before Treasury.

The IRS appeal to the Ninth Circuit was initially heard by a panel consisting of Chief Judge Thomas, Senior Judge Reinhardt, and Judge O’Malley of the Federal Circuit. Judge Thomas, joined by Judge Reinhardt, wrote the opinion for the court reversing the Tax Court opinion and upholding the validity of the regulation. He reasoned that the 1986 amendment of Section 482 (which added the language containing the “commensurate with income” standard) mandated that the IRS adopt regulations employing the commensurate with income standard in addition to the comparable arms-length transaction standard. Judge O’Malley dissented, urging invalidation of the regulation because it deviated from the arms-length standard.

Because the decisive vote was cast by Judge Reinhardt, who died after the argument and roughly 100 days before the opinion was issued. A footnote to the opinion states that “Judge Reinhardt fully participated in this case and formally concurred in the majority opinion prior to his death.” A procedural issue arose when Altera petitioned for rehearing. The remaining members of the panel were deadlocked, so the court withdrew the original opinion, assigned Circuit Judge Susan Graber (a Clinton appointee) to replace Judge Reinhardt on the panel, and scheduled the case for reargument last week.

At the argument, Judge Thomas was silent and Judge O’Malley appeared to reiterate the position stated in her dissent. So, all eyes focused upon Judge Graber, who was new to the panel and the likely decisive vote on the merits. She focused her inquiry upon statutory construction issues and the relationship between the historic standard of “comparable arms-length transactions” embodied in the first sentence of Section 482 and the “commensurate with income” standard embodied in the second sentence of Section 482. Noting that the statutory language of the second sentence applies only to “the income with respect to such transfer or license [of intangible property],” she questioned whether the cost sharing agreement was a “transfer or license” within the meaning of the statute. The taxpayer argued that its cost-sharing agreement was not a narrow “transfer or license” and that the second sentence’s “commensurate with income” standard was therefore inapplicable. In contrast, the government contended that the indirect role of the cost-sharing agreement in establishing the pricing on the arrangement between the two subsidiaries was sufficient to render the “commensurate with income” standard applicable and controlling.

Judge Graber also asked a series of questions focused upon reconciling the commensurate with income standard with the general requirement under Section 482 that the IRS must allocate costs in a manner consistent with the arms- length standard. The government argued that the legislative history reflects a congressional policy judgment and determination that, in those cases involving transfers of intangible property, only an allocation based upon the “commensurate with income” standard would satisfy the arms-length standard. The taxpayer countered by stating that the legislative history did not support such a construction and observed that, if the government’s construction were adopted, relatively few transactions would remain governed by the traditional arms-length standard.

Finally, Judge Graber inquired whether there was a factual basis or economic theory which supported the regulation’s finding that stock-based compensation costs must be allocated in a manner   commensurate with income to satisfy the arms-length standard. The taxpayer noted the absence of a factual record or economic theory supporting the IRS findings, arguing that the only evidence before the agency supported a finding that comparable arms-length transactions did not allocate stock-based compensation costs in the manner required by the IRS. In contrast, the government stated that such evidentiary support was not required to support the IRS determination.

Interestingly, the argument gave relatively little attention to the second stage of the Mayo analysis—the arbitrariness of the IRS determination. The degree of deference accorded regulations under Chevron was hardly discussed. Both sides and the court focused upon the statutory authority for the regulation. They all seemed to agree that, if the statute authorized the IRS to deviate from the arms-length standard, the regulation would survive.   Otherwise, the regulation was invalid.

The panel gave no indication of when it would render its decision. Full opinions on appeals to the Ninth Circuit tend to take a long time and the initial panel decision was not released until nine months after the argument. So, it seems likely that a decision will not be issued until early 2019.

 

Challenges to Regulations Update: Government Withdraws Appeal in Chamber of Commerce and New Oral Argument Set for Altera

One of the more interesting cases from last year was Chamber of Commerce v IRS, where a federal district court in Texas invalidated temporary regulations that addressed inversion transactions. The case raised a number of interesting procedural issues, including the reach of the Anti-Injunction Act and the relationship between Section 7805(e) and the APA.

Not surprisingly, the government appealed Chamber of Commerce. Over the summer, Treasury issued final regs that were substantively similar to the temporary regs that the district court struck down, and then the government filed a motion with the Fifth Circuit to dismiss its appeal with prejudice.

Last month the Fifth Circuit granted the motion.

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The outcome in Chamber of Commerce illustrates the difficulty that taxpayers face when challenging regulations for process violations (i.e., failing to subject guidance to notice and comment) and in particular challenges to temporary regulations. After all, Treasury can (and did in this case) issue final regs, and Section 7805(b) provides that those regs take effect retroactively upon the earlier of the “date on which any proposed or temporary regulation to which such final regulation relates was filed with the Federal Register” or “the date on which any notice substantially describing the expected contents of any temporary, proposed, or final regulation is issued to the public.”

Chamber of Commerce is to be contrasted with challenges to regs that focus on the substantive way that the regulations interpret a statute; for example, earlier this summer the DC Circuit reversed the Tax Court in Good Fortune Shipping.There, the DC Circuit applied Chevron Step Two and held that Treasury regulations that categorically restricted an exemption to foreign owners of bearer shares unreasonably interpreted the Internal Revenue Code. The taxpayer in Good Fortune challenged the reg the old fashioned way– in a deficiency case as contrasted with the pre-enforcement challenge in Chamber of Commerce.

Probably the most watched procedural case of the year, Altera v Commissioner, also tees up a procedural challenge to regs, and like Good Fortune is also situated in a deficiency case. One of the main arguments that the taxpayer is raising in Altera is a cousin to the challenge in Chamber of Commerce; that is the taxpayer is challenging the way that the reg was promulgated (and the case also involves a Chevron Step Two challenge). In particular, the issue turns on whether the agency action [the regulation] is “arbitrary, capricious, an abuse of discretion, or otherwise not in accordance with law.” 5 USC 706(2)(A). Altera involves Treasury’s compliance with § 706 of the APA as expanded on in the 1983 Supreme Court State Farm’s “reasoned decisionmaking” understanding of the clause prohibiting “arbitrary” or “capricious” agency action.

As Keith flagged a few weeks ago, after the Ninth Circuit reversed the Tax Court and found that Treasury did enough in its rulemaking and held that the cost-sharing regulation was valid, the Ninth Circuit withdrew the opinion. The Ninth Circuit has now scheduled a new oral argument in Altera for October 16.

Stay tuned.

White House Oversight of Tax Regulations

One of the more significant tax procedure developments of the past year is the new centralized OMB review  that applies to some tax regulations. In this post, Professor Clint Wallace from the University of South Carolina School of Law describes the new framework and notes the many areas that await further clarification. Clint discusses this in greater detail in Centralized Review of Tax Regulations, forthcoming in the Alabama Law Review. Clint is an important voice in the academy on tax administration and tax procedure. His article Congressional Control of Tax Rulemaking appeared this past year in the Tax Law Review. In that piece Clint discussed the special institutional capacity that the Joint Committee on Taxation plays in tax legislation, situating the JCT in the context of administrative law and principles of statutory interpretation. Les

Earlier this month, the Treasury Department and the Office of Management and Budget announced a “new framework” that appears likely require many more tax regulations to undergo OMB review.  In other contexts—for example, environmental or workplace rules—this sort of consultation between agency regulation-writers and OMB is commonplace.  Dating back to the Reagan administration, centralized review has been mandated for many regulations.  (The fountainhead of OMB’s authority to impose this review is Executive Order 12,866, which has been modified in some minor respects by subsequent EOs, but remains in effect).  When OMB reviews a “significant” regulation, it requires the drafting agency to quantify the costs and benefits of the rule, and it facilitates a process whereby other departments can weigh in on the proposals.  But OMB has never before required tax regulations to be subjected to this sort of review.

Some political commentators saw the framework as OMB winning a turf war against Treasury, and some tax professionals reacted with dismay that additional layers of analysis will delay new regulations.  Delays are a particular concern in the tax community right now because Treasury is scrambling to produce reams of important regulations to fill in the many blanks that Congress left when it hastily enacted the Tax Cuts and Jobs Act at the end of 2017.

But treating this as either an issue of shifting political power or simply a matter of stretching out a bureaucratic process both undersells and oversells the potential import of this move.  As of now, no one really knows what it means for the implementation of the Tax Cuts and Jobs Act, nor for the development of regulatory tax policy more generally.

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The framework has three major components.  First, it requires Treasury to keep the Office of Information and Regulatory Affairs (the office within OMB charged with central authority to review regulations)abreast of its agenda by submitting quarterly “notices” of all “planned tax regulatory actions.”  This, of course, does not mark a significant change from current Treasury and IRS practices: Treasury and the IRS already produce an annual “Priority Guidance Plan,” with quarterly updates.  Further, these documents are already robust and useful versions of the sort of regulatory agenda-setting prescribed under Executive Order 12,866: Treasury does a good job of soliciting public input on agenda items, makes fairly accurate predictions of its capacity, and follows through on the items it places on the agenda. It looks like the new framework does not change anything about this agenda-setting process, but rather simply mandates that Treasury should provide the (already publicly available) agenda and updates directly to OIRA.  The framework specifies that “[a]t the election of the OIRA administrator, Treasury will engage in substantive consultation with OIRA regarding any” regulatory action that appears on the agenda.  It is not clear from the memorandum what such engagement might consist of; regardless, such engagement was not prohibited previously.

The second component of the framework is that it provides that OIRA will review any regulatory actions that “create a serious inconsistency or otherwise interfere with an action taken or planned by another agency,” or that “raise novel legal or policy issues, such as by prescribing a rule of conduct backed by an assessable payment.”  The treatment of this category of tax regulatory actions corresponds with the treatment of “significant” rules under E.O. 12,866.  Along similar lines, the third element of the framework requires that regulatory actions that have “an annual non-revenue effect on the economy of $100 million or more,” be subject to the comprehensive review that is required for “economically significant” regulations under E.O. 12,866.  This review calls for the drafting agency (i.e., Treasury) to produce quantified cost-benefit analysis of the proposed regulation and alternatives.   The framework provides OIRA with 45 days to review each rule, with additional time provided as necessary, and allows Treasury to request an “expedited” 10-business-day review—this is notably shorter than the standard 90-day review period provided for regulations from other agencies, which suggests Treasury and OIRA were mindful of timing concerns expressed from the tax community.

These changes potentially mark a sea-change in the process for producing tax regulations.  However, many important details—which could impact the effectiveness and significance of this new world of centralized review—remain to be determined.  Most prominently, the categories of tax regulatory actions subject to review are ill-defined:

  • The first category of tax regulations that OIRA plans to review—i.e., the category that aligns with “significant” regulations under Executive Order 12,866—applies if a proposed regulation presents a “serious inconsistency” with action taken by another agency. But it is unclear how OIRA will distinguish between serious and minor potential inconsistencies.  The other definitional prong is similarly vague: a “novel legal or policy issue” appears straightforward, but is then exemplified as a “rule of conduct backed by an assessable payment.”  In tax administration, such a rule is not novel; it is a tax or a penalty.  It is unclear whether OIRA intends to (or believes it is authorized to require) review of any rule that can affect the amount of tax or penalty owed, or if this is more limited.
  • The second category of tax regulations includes no explanation of how the “non-revenue effect on the economy of $100 million or more” will be calculated. The first descriptor, “non-revenue effect” makes clear that revenue estimates are not relevant.  Presumably this means that Treasury will be focused on the costs and benefits of compliance and behavioral changes.  If Treasury relies on its existing compliance cost estimates, this requirement will simply weight review towards regulations that affect more taxpayers.
  • Further, the $100 million amount is measured again a “no action” baseline, but it is unclear what sort of action that refers to—Does that mean a state of the world where Congress has not enacted a provision that requires regulatory action?Or where Congress has acted but Treasury provides no further guidance?  If it is the latter, then the baseline will often be defined by partial compliance with a law as enacted.

Additionally, a central feature of centralized review is quantified cost-benefit analysis.  But for most tax regulations, current CBA practices will not yield any benefits—a tax creates deadweight loss, and imposes compliance and administrative costs, and CBA does not account for benefits flowing from transfers to the government.  So how will CBA be used in the tax regulatory process?

The way that OMB and Treasury construe these provisions could be the difference between almost all regulations proposed this year and next being subject to centralized review, or almost none, so these are significant questions.

The framework allows OIRA to defer the “economically significant” style of review for up to a year (until April 2019), in order for Treasury and OIRA to hire necessary personnel. And shortly after the framework was released, OIRA announced that Kristin Hickman is acting as an advisor, presumably sorting through these sorts of issues.  I address many of these challenges in my forthcoming piece Centralized Review of Tax Regulations(this linked version is newly updated – the previous version was written prior to the release of Trump administration framework).