Eleventh Circuit Finds Regulation Invalid Under the APA

January 3, 2022 by 1 Comment

One of the most significant tax cases of 2020 was Oakbrook Land Holdings, a case involving a challenge to regulations in a conservation easement deduction dispute. In Oakbrook, the Tax Court held that the regulation was properly promulgated under the Administrative Procedure Act. In today’s guest post Monte Jackel of Leo Berwick discusses  Hewitt, an important case out of the 11th Circuit, where the appellate court reached a different conclusion. Les

In a prior post on May 15, 2020 “Conservation Easement Donation and the Validity of Tax Regulations”, I wrote about the Oakbrook Land Holdings Tax Court case (154 T.C. 180 (2020), decided a few days earlier.

The Oakbrook court dealt with the same regulation as the Hewitt case (No. 20-13700, 11th Cir. 2021) that is the subject of this follow up commentary.

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The issue presented is whether, as required by the Administrative Procedure Act (APA), the IRS considered and responded in the final regulations to all “significant” comments to the proposed regulations relating to the extinguishment rule under the conservation easement deduction regulation that requires a proportion of the extinguishment proceeds to include donor improvements to the property. The IRS and Treasury in the final regulations did not address comments that addressed this rule in its “concise general statement of its [the regulation’s] basis and purpose”. This concise general statement is supposed to allow one to see the objections made to the proposed rule and why the agency, in this case the IRS, reacted to those comments as it did. The IRS, just like any other federal agencies, is required to give adequate reasons for its decisions and it is required to rebut vital relevant or significant comments. All the IRS is to state in the final regulation preamble that it “considered all comments” but the IRS did not respond specifically to the comment.

The Tax Court in Oakbrook Land Holdings ruled that either the comment not specifically responded to was not significant or, if it was significant, it was adequately responded to by the general statement that it considered all comments and by taking into account the administrative record. The Tax Court in that case gave the IRS the benefit of the doubt. However, the Eleventh Circuit Court of Appeals in Hewitt required a specific response to the comments made on the issue and put the burden on the IRS to show that it had adequately responded. Since the latter court held that the response was not adequate, the court held that the regulation was arbitrary, capricious, and/or an abuse of discretion under APA 706(2)(A) and was thus invalid.

And so, what does this all mean? There appear to be two choices. Either the taxpayer has the burden to establish that the comment made was significant and that it was not adequately addressed and the administrative record can be used to justify the IRS action. That is Oakbrook Land Holdings. The other approach is that the IRS must establish why the comment was not significant and why its response was adequate. That is Hewitt. And the reviewing court has the last word on whether the comments made were or were not significant-a huge dose of second-guessing.

What does this all mean for the future? The Hewitt case was an Eleventh Circuit opinion and so, under the Golsen rule, the Tax Court does not have to follow that case for taxpayers not within that circuit. But given the circuit court opinion, will this opinion effectively require the IRS to respond to almost every comment made and give a reason directed to that comment or otherwise risk invalidation of the regulation? That seems to be the risk the IRS will be taking if it does not act conservatively and respond to everything. The very recent foreign tax credit regulations seem to have taken the respond to everything approach and that does add pages and pages onto the regulation and become repetitive in a number of cases.

To make matters worse, the reviewing court will have the final say on what was significant and whether it was adequately responded to. Trying to avoid this issue by saying that a regulation was not a legislative rule does not seem to be a favored position in the courts. Can the OIRA review process help avoid mis-steps by the IRS in this area? That also remains to be seen but as I understand it that is where the burden of compliance should be in the current regulation process.

Will this process eat up precious IRS resources better spent elsewhere? Yes it will. Is it good for the tax system? That remains to be seen. The door is now wide open for taxpayers to step in and test the waters.

Filed Under: Administrative Procedure Act (APA) Tagged With:

How Tax Regulations Are Made

July 12, 2021 by 2 Comments

Today’s post is by frequent guest poster Monte Jackel, Of Counsel at Leo Berwick. In today’s post, Monte discusses his reactions to an article written by Shu-Yi Oei of Boston College Law School and Leigh Osofsky of the University of North Carolina at Chapel Hill. A few years ago they wrote an insightful article on the process that led to the 199A regs; Keith discussed their article in a 2019 post. In this post Monte draws on his decades both in and out of the government to suggest changes to the process of reg drafting. Les

A relatively recent article (Shu-Yi Dei and Leigh Osofsky, Legislation and Comment: The Making of the §199A Regulations-Article ) provides a useful discussion of how public commentary, both pre and post the issuance of proposed regulations, affects the ultimate content of final Treasury regulations. 

For me, having experienced this process firsthand, the following reforms should be seriously studied and if appropriate instituted:

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1. The most important reform that could be instituted would require the Congress to amend the Freedom of Information (FOIA) part of the Administrative Procedure Act, 5 USC 552 (APA), to require disclosure by the tax agency holding the government record, the IRS and/or Office of Chief Counsel, to proactively disclose those records to the public (either through the Federal Register or the Internal Revenue Bulletin), instead of the current law which requires that the record relating to pre-proposed regulations comments be disclosed to the public  only upon a FOIA request (post-proposed regulations are generally required by law to be disclosed in the Federal Register as part of final regulations). What a reader of, for example, Tax Notes typically sees is that this tax publication was sent a separate copy of the comment letter or other government record so it could publish it in the public interest (which it often does). But the problem with waiting for a FOIA request to disclose government records is that often the requestor would need to know a record exists before requesting it. That is backwards. See references in the Internal Revenue Manual. 

2. Under 5 USC 552(f)(2), a “record” and any other term used in reference to information includes—(A) any information that would be an agency record subject to these requirements when maintained by an agency in any format, including an electronic format; and (B) any information described under subparagraph (A) that is maintained for an agency by an entity under Government contract, for the purposes of records management. The term “records” are defined in various statutes, including the Federal Records Act and the Freedom of Information Act.

Although there is a required collection of emails and such (and voice discussions should be documented as well) by the tax agency, all that is done at present, to my understanding, is to send the material (such as an email from an outside party on a substantive issue) to the Procedure and Administration units at IRS Chief Counsel to be available if and when there is a FOIA request. See IRM 30.11.1 FOIA Requests for Chief Counsel Records, and FOIA Guidelines.  This practice should be changed to make the disclosure of such records proactive without request to the agency. Appropriate FOIA protections would continue to apply.

3. There is a practice by some to take oral comments and not document them in writing or to return written materials to the presenter at a private meeting with outside parties and then take the position that FOIA is not required-ever. That practice should be negated via a change to the APA. 

4. Pre-proposed regulatory meetings and commentary should be discouraged unless immediate public disclosure also occurs. That is item 1 above. The argument against this is that no one will comment during that period if it became public but, assuming that is true, the question comes down to whether public disclosure is more important to the process than is feedback from outside technical experts and “those in the know”.  Those comments do add value but at what cost? 

5. The agency should have a duty to search for articles and similar commentary and take those comments and commentary into account in drafting proposed and final regulations. Due diligence is all this would require. Current law would allow articles to be ignored unless they are part of the proposed regulation comment process.

6. Most technical and substantive regulations have a very limited number of readers and there are few in number who will truly read and understand the regulations. In light of that reality, substantive regulations should, generally, be made more general principles oriented as compared to innumerable and detailed rules.

Filed Under: Administrative Procedure Act (APA) Tagged With:

Who Will Complain About Pro-Taxpayer Ultra Vires Guidance?

April 26, 2021 by 6 Comments

In today’s post guest contributor Monte Jackel, Of Counsel, Leo Berwick, discusses IRS guidance that may be too taxpayer friendly. Les

On April 22, 2021, the IRS issued Revenue Procedure 2021-20. This guidance obsoletes Rev. Proc. 2020-51 to reflect the recent change in the law allowing deductions for PPP expenses even though there was a reasonable expectation of reimbursement in the year the expenses were paid or incurred. See Rev. Rul. 2020-27, obsoleted by Rev. Rul. 2021-2. 

In the subject revenue procedure, the IRS provided a safe harbor for taxpayers who, for their 2020 tax year, followed the guidance then applicable under Rev. Rul. 2020-27 and did not claim its PPP expenses as deductions for that year. In lieu of filing an amended return or an AAR (for a partnership), the revenue procedure allows the deductions to be taken in the following tax year (2021). 

Regulation §1.461-1(a)(3), not cited in Rev. Proc. 2021-20, states:

Each year’s return should be complete in itself, and taxpayers shall ascertain the facts necessary to make a correct return. The expenses, liabilities, or loss of one year generally cannot be used to reduce the income of a subsequent year. A taxpayer may not take into account in a return for a subsequent taxable year liabilities that, under the taxpayer’s method of accounting, should have been taken into account in a prior taxable year. If a taxpayer ascertains that a liability should have been taken into account in a prior taxable year, the taxpayer should, if within the period of limitation, file a claim for credit or refund of any overpayment of tax arising therefrom. Similarly, if a taxpayer ascertains that a liability was improperly taken into account in a prior taxable year, the taxpayer should, if within the period of limitation, file an amended return and pay any additional tax due….

This regulation was not cited or discussed or distinguished in the subject revenue procedure. It was ignored. 

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Somewhat similar type relief was provided in the predecessor to this revenue procedure, Rev. Proc. 2020-51, that was obsoleted in Rev. Proc. 2021-20. However, that revenue procedure allowed deductions to be taken in the 2021 tax year if the application for forgiveness of the PPP loan was not allowed and, thus, the expenses paid or incurred in the 2020 tax year would have been allowed. Once again, the purpose was to avoid requiring taxpayers to file an amended return or AAR but, arguably unlike the current revenue procedure, authority has allowed deductions to be taken in a later year (such as a loss sustained in a prior year where the expectation for reimbursement is eliminated in a later year) where the restrictions no longer exist. See, e.g., §1.165-1(d). On the other hand, an argument can be made that the 2020 revenue procedure was also ultra vires. 

Even if the revenue procedure is ultra vires, how, if at all, can it be challenged? If the revenue procedure was anti-taxpayer, then the taxpayer could either not pay the tax and challenge it in court or pay the tax and sue for a refund. There would be no pre-enforcement challenge in those cases under current law due to the Anti-Injunction Act absent a favorable opinion by SCOTUS in the pending  CIC Services case or a new statute allowing such challenges. This is all quite difficult to do. If, on the other hand, the guidance is pro-taxpayer, who will have standing to challenge the guidance? The answer under the law as of this writing is that no one will have standing to challenge the guidance. See a letter to the editor of Tax Notes by Michael Schler where he states:

“The problem, as I have pointed out previously, is that anti taxpayer regulations can be freely challenged by taxpayers, but pro-taxpayer regulations are invulnerable to challenge because of the lack of anyone with standing. I do not believe this makes for a balanced tax system.”

It would appear that Rev. Proc. 2021-20 is inconsistent with Reg.§1.461-1(a)(3) and cannot stand. And yet, who will challenge the revenue procedure? Most likely no one. But, in the words of some, “this is not anyway to run a railroad”. 

Filed Under: standing Tagged With:

What Is A Preamble Worth?

January 18, 2021 by 4 Comments

We welcome back guest blogger Monte Jackel, Of Counsel at Leo Berwick, who discusses the legal significance of preambles to regulations. Les

Introduction

Regulation preambles are a part of the reading cycle of a tax professional. If I can be taken as a typical or average tax regulation reader, the first thing I do when reviewing a regulation package as a reader is to look carefully through the regulation preamble before I review the text of a regulation. This is because the regulation preamble, much like legislative history to a statute, provides meaning and context to the regulation text.

Regulation preambles add one additional feature that is more difficult to discern as to its legal significance. Often, or at least not infrequently, a regulation preamble contains a substantive rule that is not in the regulation text itself. (A recent example is the final section 163(j) regulations issued within the past week or so that contains a rule only in the preamble that items omitted from the final regulation but that are contained in the proposed regulations can be relied on until new final rules are issued for the omitted items. There are more.)

At that point it would be appropriate to ask the question: What legal import, if any, does this “special preamble rule”, if I may call it that, have?

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It Is Just Not Clear

Unfortunately, it is not clear that a taxpayer can rely on statements in a preamble that are not in the text of the regulation as “authority” for purposes of avoiding accuracy related penalties under section 6662 of the Internal Revenue Code. Regulation §1.6662-4(d)(3)(iii), which determines the types of authority that can be relied on to avoid the substantial understatement penalty, states that “[P]roposed, temporary and final regulations construing [the Internal Revenue Code]” is an authority.

However, the next question to ask is: Whether the regulation preamble is considered part of “the regulation” construing the statute for this purpose as the quoted language from section 1.6662-4(d)(3)(iii) does not say anything on this question one way or the other. (A search for the regulatory history on this particular regulation has not turned up anything relevant to this discussion. The ability to rely on regulations for this purpose is derived from section 6661, the predecessor to section 6662, which references only “Treasury regulations”. JCS-38-82, Dec. 31, 1982, p.217.).

So Can We Rely On Preambles Then?

As much as logic dictates that the preamble should be considered part of “the regulation” for this purpose, where does it expressly say that in the regulation text or even in a regulation preamble dealing with the subject? I can find nothing.

It is not subject to doubt that a regulation preamble can be used as background and context much like legislative history in interpreting a regulation. But the key question at issue here is what if the preamble contains a substantive rule of law that is not contained in the text of the regulation itself as sometimes occurs? Is that naked (non-textual) statement in the preamble an “authority” that can be relied on?

The Office of the Federal Register Document Drafting Handbook, chapter 2.2, requires a preamble, for whatever it is worth, to be part of the submission to the Federal Register. However, the preamble is not published in the Code of Federal Regulations as it is not regulation text. (1 CFR sec. 18.12 also requires a preamble to be part of a regulation in order to be published in the Federal Register). The Administrative Procedure Act (APA) at 5 USC sec. 552 requires federal agencies to publish their regulations in the Federal Register in order to be legally effective, and 5 USC 553(c) sets forth the requirement for a regulation to contain the basis and purpose of or for the rule.

The reg. §1.6662-4 rules were issued in December 1991 (T.D. 8381) but 1 CFR sec. 18.12 was issued in 1976 and thereafter amended in 1989. Thus, there can be no doubt that the requirement to have a regulation preamble existed before reg. §1.6662-4 was finalized or even proposed.

Does this mean that the reference to the term “regulation” in §1.6662-4 must mean it includes a preamble because regulations had to have one to be published in the Federal Register? Or, since the CFR does not include regulation preambles when they are published there (IRS regulations are in title 26 of the CFR), does it mean that the term “regulation” does not include preambles because they are not expressly included when published there? Which inference should you draw here?

This needs regulatory text clarification, more urgently now than ever as there is an increasing trend to include substantive or applicability date rules and reliance rules in only the regulation preamble.

A Closing Comment On Avoiding the 60-Day CRA Rule For Regulations

The Congressional Review Act (CRA) contains a requirement that absent “good cause”, regulations shall not take effect for 60 days after they are published in the Federal Register (or when submitted to Congress if later). 5 USC 801(a)(3), 808. In a recent slate of regulations scheduled for publication in the Federal Register on January 19, the day before inauguration day (and the assumed date of a Biden regulatory freeze order for regulations not published by then), the IRS asserted that there was “good cause” for the waiving of the 60-day CRA period. This was done so the regulations could be both effective and published before the new administration assumes power on January 20.

The statute provides that “good cause” means that the 60-day delay is impractical, unnecessary or contrary to the public interest. 5 USC 808(2). (The good cause language also appears in the APA at 5 USC 553(b)(3)(B)). The justifications used by the IRS in these waiver cases is principally that the rules at issue explain or clarify the law and therefore should be effective immediately. Well, if that is the case, then a vast number of regulations could avoid the 60-day period because most rules explain or clarify the law-that is their principal purpose.

If either the new administration (or a court) finds that the CRA was violated, that should mean that the regulations were not legally effective when filed with the Federal Register, and therefore not lawfully published there and can, as a result, be subject to any regulatory freeze order of the Biden administration when it comes into power. Can taxpayers safely assume that the CRA 60-day delay rule was effectively waived for reliance purposes? Could a court years later make the determination that the waiver was invalid and the regulation is and always was void?

Comments and insight to this blog are clearly welcome.

Filed Under: Administrative Procedure Act (APA), Regulations Tagged With:

A Brief Look At Section 7805(b)

January 11, 2021 by 3 Comments

We welcome back Monte Jackel, Of Counsel at Leo Berwick, who returns to discuss regulations that are made public but that are not published in the federal register prior to the end of a presidential administration. Les

Section 7805 was amended as part of the second Taxpayer Bill of Rights in 1996, P.L. 104-68, JCS-12-96, p. 44. Subsection (b), headed “Retroactivity of regulations”, describes the circumstances where retroactivity, that is where a “taxable period”, an undefined term, cannot be subject to a regulation filed or issued before certain dates, is permitted. Section 7805(b)(1)(A) references the date the regulation is filed with the Federal Register. The date of filing is a clearly known term given that the Office of the Federal Register uses that term as the date the document is available for public inspection before it is published there. Section 7805(b)(1)(B) also uses the filing date with the Federal Register to set the retroactivity that is permitted. However, section 7805(b)(1)(C) uses the term “issued” to the public when referencing the permitted retroactivity. That term is not defined although 5 USC 552(a)(1) (the APA) requires federal agencies to publish their regulations in the Federal Register. The term “issued” is not used there. Section 7805(b)(2), relating to promptly issued regulations, references the term “filed or issued” but defines neither. The legislative history does not add anything to this either. However, it is probably safe to assume that “issued” means “published”. 

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There has been some commentary recently about the upcoming change in administrations and what happens to regulations that are made available to the public before they are filed with the Federal Register but are not published there by the time a new incoming administration orders that all regulations not yet published (and maybe even those that are) be returned to the issuing agency. Attached at the end of this post is the text of a letter to the editor that I recently published in Tax Notes describing some of these issues. 

The practice of the IRS and Treasury releasing to the public a copy of a regulation with a disclaimer at the top of the first page saying that only the copy published in the Federal Register is the legal copy, should be discouraged. I can find no provision in either the Internal Revenue Code or the APA that authorizes this practice or gives any legal significance to it. And while this is not the first time in our history that presidential orders of a new administration put a “freeze” on the publication of regulations to evaluate them first, this practice only adds to the natural confusion created when a new administration takes power. The situation is exasperated when the text of the regulations are made available to the public but those regulations do not apply to any taxable period beginning before the regulations are published. What positions do taxpayers take in the interim. 

I think there should be a new federal statute that prohibits the issuance of regulations within 60 to 90 days before a new administration comes on board absent “extreme need” or other such standard, which is subject to review later. Alternatively, a new statute could describe the legal impact of these regulatory freezes. I much prefer the former. What do others think?

Text of Letter to the Editor, “Potential Danger of Making Public Pre-Release Versions of Regulations”
170 Tax Notes Federal 299, Jan. 11, 2021

To the Editor:

The Office of Information and Regulatory Affairs website says that the final section 163(j) regulations were released from OIRA on December 30, 2020. These regulations were, based on past IRS practice, posted on IRS.gov on January 5, 2021. Under the Congressional Review Act, the final regulations state that they will be effective on the date filed with the Federal Register. That date was either yesterday or today or will be shortly thereafter. But those regulations may not make it to be published in the Federal Register by January 20. That day, or the next day or so by the latest, a presidential executive order will be issued by the new administration ordering the Federal Register to return regulations not yet published there.
Emily L. Foster addressed the issue in her story last week [in Tax Notes] titled “Final Interest Regs Provide Clarifications for Taxpayers” but the story is a bit misleading when it discusses what happens if the regulations are pulled back by a new administration before they’re published in the Federal Register. It’s true that the regulations are effective on the date filed with the Federal Register under the CRA (assuming that the explanation given for the expedited effective date by the IRS stands up to challenge if it comes to it). That date was either January 5 or 6, or will be shortly thereafter.

But that only means that the regulations are legal documents upon filing with the Federal Register. However, the applicability date of the regulations is for tax years beginning on or after 60 days from the date of publication in the Federal Register. If the regulations are never published or publication is delayed for months, the regulations will not be mandatorily applicable to taxpayers and neither will the proposed regulations.

However, the final regulations state that taxpayers can elect to apply the final regulations to periods before they are applicable. Also, the final regulation preamble (but not the text of the regulation) says that prior to the applicability date, taxpayers can apply the proposed regulations instead. In addition, the final regulation preamble (but not the text of the regulation) states that if there is a rule from the proposed regulations that is not in the final regulations, taxpayers can nevertheless apply the proposed regulation rule until final regulations are published at a later date that deal with the omitted items. It is unclear what happens if the final regulations are never published in the Federal Register. In other words, can taxpayers rely on the proposed omitted items forever like they have for the proposed section 465 regulations (since the late 1970s)?

Eric Yauch wrote about the omitted items and other partnership rules in the final regulations in a story titled “Trading Partnership Approach Remains in Final Interest Regs”. The omitted rules from the proposed regulations were, principally, the creation of inside tax basis “out of thin air” upon a complete redemption of a partner and the application of section 734(b), and all the tiered partnership rules.
The latter rules were incoherent and difficult to follow and apply, even for partnership experts. But the final regulation preamble (but not the regulation text) says if a rule is omitted from the final regulations that was in the proposed regulations, a taxpayer can apply the proposed rules anyway.

That action could end up with the omitted rules being like the proposed section 465 regulations, which, as noted, have been proposed and not finalized since the late 1970s. This “can rely on the omitted rules” rule will literally be the case even if the final regulations are never published in the Federal Register or are published months from now. In the interim period before the omitted rules are addressed and finalized in one form or another, taxpayers are not obligated to apply the missing omitted rules from the proposed regulations, but they will have to apply a reasonable approach based on the statute and its legislative history.

Since the IRS does not explain why the omitted rules were not finalized, what other approach would be considered reasonable? Would a pure aggregate approach to tiered partnerships suffice? Can there be a situation when the “create basis out of thin air rule” applies without relying on how the proposed regulations handle that rule? How long will it be until these issues are resolved, if ever? The final regulation preamble states only that the partnership rules continue to be studied. Although that explanation sounds good, it’s probably truer to say that the omitted rules had technical and other issues and that the IRS could not figure out what changes should be made. They then ran out of time because the IRS powers that be wanted the final regulations pushed out the door before the new administration comes into power.

Is this course of behavior by the current IRS and Treasury advisable? The other regulations now pending at OIRA may also get posted to IRS.gov by January 20, but it is unlikely that those regulations will make it out as published in the Federal Register by that date. The section 1061 carried interest regulations come to mind. [Those regulations ended up being released to the public after this letter was submitted to Tax Notes]. That means that all those pre-publication regulations will most likely not be mandatorily applicable to taxpayers for months, if ever. Taxpayers can elect to apply those unpublished rules in the interim, but they don’t have to. Why do this?

In other words, if the OIRA-reviewed regulations have already been returned to the IRS, they may end up being a set of pre-publication regulations posted on IRS.gov which has, as a matter of law, absolutely no legal effect unless taxpayers elect that they apply. But what if they don’t so elect?

Such is the case with the section 163(j) final regulations. And it will be a race for other federal agencies to get their regulations filed and then published in the Federal Register by no later than the close of business on January 19, the day before inauguration day. If not, the same mess as with section 163(j) applies.

If pre-publication regulations that have been publicly released don’t make the January 19 Federal Register publication date, there will, as noted, be an executive order by the new administration shortly thereafter sending all unfiled and/or unpublished regulations back to the agency issuing them. At this point, it will likely be months before activity occurs on those regulations.

In the interim, how many taxpayers will gamble on the “new rules” that would apply to them once the regulations are resubmitted to the Federal Register by the new administration, and how many taxpayers will just apply the proposed regulations? Is it even safe to assume that the statements made by the current administration in the final section 163(j) regulations (that taxpayers can rely on those rules today) will not be changed by the new administration?
That latter action would be the height of unfairness but what stops a new administration from doing so? At that point, the Administrative Procedure Act would come into play in terms of how to render uneffective those regulations deemed effective by the good cause exception under the CRA? Would it be revocation and reissuance, or would it just be revocation under the CRA?
Is this good or bad tax policy for the current administration? To me, the answer is that it is resoundingly bad. What do others think?

Filed Under: Administrative Procedure Act (APA) Tagged With:

Disguised Sales to Partnerships, BBA Centralized Audits and Due Process

June 3, 2020 by 1 Comment

Returning to look at the BBA regime, Monte Jackel examines final BBA regulations and issues relating to a partner’s gain on a disguised sale with a partnership. Les

The final BBA regulations reflect that “partnership-related items” are the items that are subject to the uniform centralized partnership audit regime. (T.D. 9844; Reg.§301.6241-1(a)(6)(ii)-vi)). These “partnership-related items” are those shown or reflected, or required to be shown or reflected, on a partnership income tax return (form 1065), or is otherwise required to be maintained in the partnership’s books and records. On the other hand, an item shown or required to be shown on an income tax return of a person other than the partnership that results from the application of the Internal Revenue Code to a partnership-related item based upon the other person’s specific facts and circumstances, including an incorrect application of the Code or taking into account erroneous facts and circumstances of that person, is not a partnership-related item.

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On the surface, the distinction between non-partnership related items and partnership- related items seems clear in most cases. Examples 1 and 2 under reg. §301.6241-1(a)(6)(vi) are the most helpful in this regard. Example 1 stands for the proposition that even though an income producing event occurs between a non-partner person and the partnership, only the deduction or expense relating to the transaction, and not the income of the other person from the very same transaction, is a partnership-related item. Similarly, example 2 involves a purported loan to the partnership by a non-partner person whereby it is stated that although the treatment of the purported loan on the partnership’s return, which presumably includes whether it is debt or equity and related interest expense, is a partnership-related item, the treatment of the purported loan in the hands of the other person, which also presumably includes a debt versus equity determination, is not a partnership-related item. Further, that appears to be the case if the persons in examples 1 and 2 were instead partners of the transferee partnership. For example, if there was a disguised sale under reg. §1.707-3, the tax effects of a purchase must clearly be reported on the partnership return but the sales gain would apparently only be reported on the partner’s separate form 1040. 

Even though the very same transaction with the same parties is involved on both sides of the transaction, the final regulations push strongly in the direction noted immediately above, although it would have been very useful if alternative facts under examples 1 and 2 had tested the results if the other person had been a partner instead. 

In both examples 1 and 2, the other person is clearly not identified as a partner in the partnership at issue. If that were otherwise the case, section 6222 would generally require the partner to follow the partnership’s treatment of the item. The most pertinent example of the case where the other person is in fact a partner, for purposes of this commentary, is a disguised sale by the partner to the partnership under section 707(a)(2)(B) and reg. §1.707-3. (It should be noted as an aside that the only significant set of BBA audit regulations that are still in proposed form are those relating to attribute adjustments under sections 704, 705, 706, 6225, and 6226, REG-118067-17, Feb. 2, 2018). 

The regulations are also unclear, and this relates to the main point at issue in this commentary, as to whether the computation of the imputed underpayment (IU) includes the sales gain that the partner will incur if it is determined in a partnership proceeding that a sale and purchase occurred under section 707(a)(2)(B) and its underlying regulations. 

As a technical matter, in computing an IU, there is first a determination of whether there is a “partnership adjustment” which is any adjustment to a partnership-related item. (Reg. §§301.6241-1(a)(6)(i), 301.6225-1(a)(1), 301.6225-1(b)). Thus, unless the item is a “partnership-related item”, it will not enter into the computation of an IU. 

Similarly, if an election is made under section 6226 to push out a partnership adjustment that is part of an IU, there first needs to be a determination of whether the item is a partnership-related item. 

For these reasons, it is critical to understand whether, in the case of partner-partnership transactions, the item attributable to the partner side of the transaction is a partnership-related item and a partnership adjustment. Given the fact that the proposed regulations specifically listed disguised sales and related items as partnership-related items (prop. reg. §301.6241-6(b)(5)) and the final regulations do not include that language but contain instead the “reportable on the partnership return” or “reportable on the other person’s return” standard, the apparent answer is that the partner sale gain on a disguised sale with a partnership will not be part of the computation of an IU.  

The preamble to T.D. 9844 is confusing and circular in how it describes what is a partnership-related item in these types of cases, particularly when there is a transaction between a partner and the partnership. It states, in pertinent part:

“[The proposed regulations] provided as an example of an “item of income, gain, loss, deduction, or credit” any items related to transactions between a partnership and any person including disguised sales, guaranteed payments, section 704(c) allocations, and transactions to which section 707 applies….One comment suggested that this provision inappropriately included partner items such as a disguised fee under section 707(a)(2)(A) and the gain or loss a partner may realize from a disguised sale under section 707(a)(2)(B). … Similarly, another comment expressed concern about situations where a partner was not acting in the partner’s capacity as a partner, but rather as a counterparty to a transaction with the partnership. …. These comments are addressed by the final regulations …regarding the definition of partnership-related item. …[T]he final regulations clarify that items or amounts relating to transactions of the partnership are items or amounts with respect to the partnership only if those items or amounts are shown, or required to be shown, on the partnership return or are required to be maintained in the partnership’s books and records. The final regulations further clarify that items or amounts shown, or required to be shown, on a return of a person other than the partnership (or in that person’s books and records) that result after application of the Code to a partnership-related item and that take into account the facts and circumstances specific to that person are not partnership-related items and, therefore, are not determined at the partnership level under the centralized partnership audit regime. ….”

There are a number of issues with how this particular provision (partnership-related item) is defined and the explanation given for it in the final regulation preamble as it relates to transactions between a partner and a partnership where the partner is acting in a partner capacity and, thus, the transaction is not governed by section 707(a)(1) (partner acting in non-partner capacity). In that latter case, the final regulation is worded properly because unless either res judicata or collateral estoppel apply to the other non-partner person, the determination at the partnership level has nothing to do with how the other person reports the transaction, which can be inconsistent with how the partnership treats it because that other person is not a partner.  An assessment of tax at the partnership level will have absolutely no effect on the assessment of tax of that other person in that case.

A transaction between a partner and the partnership invokes, first, section 6222 which generally requires the partner to report the transaction consistently with how the partnership reports it. Thus, if the partnership treats a contribution of built-in gain property to it as a purchase because it is determined to be a disguised sale under reg.§1.707-3, then the partner must also treat the transaction as a purchase by the partnership absent timely notice of inconsistent treatment by the partner. 

This would seem to mean that since the same factors are taken into account in determining whether there is a sale and a purchase under reg. §1.707-3(b)(1) and 1.707-3(b)(2), it would be difficult for a partner who files an inconsistent treatment statement under section 6222(c) to sustain a position that there is no sale by him even though the partnership either reports or is required to report that a purchase occurred as part of a partnership level proceeding. 

If the issue of whether the partner sold property to a partnership is determined first before the partnership level proceeding, section 6222(d) states that if the partnership was not a party to the partner proceeding then the partner determination is not binding on the partnership. Although such a determination is not technically binding on the partnership, it is difficult to see how a later separate partnership level proceeding based on the same facts with the same parties could lead to a different result but that is not discussed or explained in any set of BBA audit regulations. 

However, the reverse is not true. Thus, section 6222 does not prohibit a proceeding at the partnership level from binding the partner in a partner level proceeding relating to the same transaction with the same facts. It would seem that any partnership level proceeding as to whether there was a sale would bind the partner as well under common law rules given that the same prime legal issue (whether there was a sale) and the same facts as well as the same parties are involved. Section 6223(b) says as much by stating that “A partnership and all partners of such partnership shall be bound (1) by actions taken …by the partnership, and (2) by any final decision in a proceeding …with respect to the partnership.” See, also, reg. §301.6223-2(a). 

Now, for the “due process of law” question left unaddressed in the regulations. Assume, as it appears is most likely the case as discussed above, that the gain portion of the disguised sale is not a partnership-related item but only the purchase side of the transaction is a partnership related item. (If the sales gain was part of the computation of the IU, the liability for tax under section 6225 would then be shared by all adjustment year partners and would not be limited to the selling partner only. If, on the other hand, the push-out election is made under section 6226 in that case, then the partners with whom the partnership-related adjustment “is associated” will be required to include the amount in income. That push-out may allocate all of the sales gain to the seller although the regulations do not address that issue either). 

Left unresolved by the regulations, and here I think lies the due process question in a nutshell, is whether the selling partner may still contest in a separate proceeding whether he owes tax on the now determined (by the partnership) disguised sale to the partnership. It seems that the legal issue involved (sale versus contribution) will be resolved by how the partnership treats the transaction or is required to treat the transaction in a partnership level proceeding. And section 6222(b) seems to allow for immediate assessment as a mathematical error the inconsistent treatment by the partner as a non-sale if the partnership treats the transaction as a purchase and the partner does not file a notice of inconsistent treatment. And even if the partner does file a notice of inconsistent treatment, it is not clear whether the doctrines of collateral estoppel or res judicata or other common law doctrine will apply to prevent the selling partner from relitigating the question in a separate court proceeding.

But this is not all there is to the question. Only the partnership representative can represent the partnership in a proceeding with the IRS regardless of the limitations on the representative’s power in the partnership agreement. This seems to mean that the selling partner, if he is not the partnership representative, can be forced solely to pay tax on a transaction, the sale, without the partner’s participation in the IRS proceeding with the partnership. If the partnership proceeding occurs first, can inconsistent treatment by the partner result in an immediate math error assessment? If a notice of inconsistent treatment is given, is the prior partnership proceeding legally binding so that no challenge to the merits can occur anyway in the separate partnership proceeding? And, is this a violation of due process by the government taking property from the partner without any rights by the partner to contest or challenge the partnership proceeding?

The answer to this question is not clear. On the one hand, the partner has agreed to enter into the partnership and will be charged with the knowledge that the partnership representative is the sole party representing the partnership with the IRS. Thus, it may be argued, the partner has given his consent to the consequences of not being able to participate in his own audit in this kind of case. On the other hand, are the terms of the statute and regulations sufficient to override fundamental notions of no taking of property by either the federal government or the states “without due process of law” as set forth by the Fifth and Fourteenth amendments to the U.S. Constitution? 

It should be noted that the regulations could most likely have eliminated this issue by stating that the seller partner side of the transaction is also a partnership-related item along with the partnership purchase side of the transaction. In that case, the tax liability would be shared by all adjustment year partners under section 6225 and there would be no meaningful due process question. (Otherwise, the entire BBA audit regime would be unconstitutional). But the regulations seem to say just the opposite, as this commentary has explained. 

I know that both sides of this argument have been taken by a number of practitioners. I have previously taken the position that there is a clear violation of due process in this case and the BBA statutory regime is invalid to that extent. I still think so. What do others think?  

Filed Under: BBA, BBA Partnership Regime Tagged With:

Executive Order on Regulatory Relief to Support Economic Recovery

May 21, 2020 by 1 Comment

Monte Jackel returns to discuss an executive order issued this week by the President. Keith

On May 19, 2020, the President signed an executive order (Order) relating to regulatory relief to support economic recovery from the coronavirus crisis. Section 1 of the Order states:

“Agencies should address this [crisis] by rescinding, modifying, waiving, or providing exemptions from regulations and other requirements that may inhibit economic recovery, consistent with applicable law and with protection of the public health and safety, with national and homeland security, and with budgetary priorities and operational feasibility. They should also give businesses, especially small businesses, the confidence they need to re-open by providing guidance on what the law requires; by recognizing the efforts of businesses to comply with often-complex regulations in complicated and swiftly changing circumstances; and by committing to fairness in administrative enforcement and adjudication.”

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The reference to “regulations” is to EO 13892, section 2(g), which states that the term means a legislative rule under section 553 of 5 USC, the Administrative Procedure Act (APA). This means that the executive order would only apply to tax regulations to the extent they are legislative rules and not interpretative rules. The IRS view is that most tax regulations are interpretative and not legislative but the courts have recently deviated from following the IRS view. [see this prior post here on PT for further discussion].

The Order then states:

“The heads of all agencies are directed to use, to the fullest extent possible and consistent with applicable law, any emergency authorities that I have previously invoked in response to the COVID-19 outbreak or that are otherwise available to them to support the economic response to the COVID-19 outbreak. The heads of all agencies are also encouraged to promote economic recovery through non-regulatory actions.”

This provision of the Order, as it could apply to federal tax matters, seems to authorize continued and expanded use of the tax related provisions of sections 7508 and 7508A. See below.

The Order then states:

“The heads of all agencies shall identify regulatory standards that may inhibit economic recovery and shall consider taking appropriate action, consistent with applicable law, including by issuing proposed rules as necessary, to temporarily or permanently rescind, modify, waive, or exempt persons or entities from those requirements, and to consider exercising appropriate temporary enforcement discretion or appropriate temporary extensions of time as provided for in enforceable agreements with respect to those requirements, for the purpose of promoting job creation and economic growth, insofar as doing so is consistent with the law and with the policy considerations identified in… this order.”

Does the Order apply to tax regulations and, if so, how? In cases outside of tax, it is relatively easy to determine what is and is not a legislative rule. Outside of FAQs not being legislative rules because they are not “authority” under section 6662 in the first place, the determination of what is a legislative rule in the tax realm at present is being determined by the courts on a case-by-case basis. Essentially, from where we stand right now, legislative rules are those that impose substantive rights and duties not directly dealt with in the applicable statute.

Assuming that there is some uniform approach taken by the Treasury Secretary to implement the Order on the issue of tax legislative rules, the next question is what action can the Treasury Secretary take with tax regulations and other items considered legislative rules for this purpose?

The following are possibilities:

  1. Tax regulations that raise revenue because of the substance of the rule would seem to impede economic growth and recovery because the taxpayer has less net after-tax cash than if the rule provided otherwise. Does this mean that all tax regulations, if deemed legislative rules, should be rescinded or suspended if such action would reduce the taxpayer’s net after-tax economic position? That is not likely to be how the IRS views the situation but guidance may be needed to flush this out.
  2. As briefly noted earlier above, the Order seems to lean in favor of the IRS issuing more extensions of applicable due dates pursuant to the authority of section 7508A due to the March 1, 2020 emergency presidential declaration on the coronavirus. This would mean that the IRS’s announced position that tax due dates will not be extended beyond July 15, 2020 may need to be re-examined by that agency. How else could the Order be interpreted in this area of law?
  3. There was a prior regulatory effort under executive orders previously issued by the president relating to withdrawing regulations deemed too burdensome or perhaps lacking legal authority and limiting the use of new regulations generally, among other matters.  A limited list of regulations was produced by the IRS and Treasury a few years back and action was taken on a number of those items. Does the subject Order mean that this process will need to be repeated by Treasury and the IRS, perhaps more thoroughly than previously? Guidance should perhaps be issued on that as well.

As Professor Hickman and others have espoused over the years, due to the long period where tax regulations were, more or less, given a free pass under the APA, it is often not clear today how regulatory edicts generally, such as the subject Order, are to be applied to tax regulations given that the process of how and to what extent tax regulations are subject to the APA continues to be a developing area of law. Now would appear to be a good time to push this process along.

Filed Under: Administrative Procedure Act (APA) Tagged With:

Conservation Easement Donation and the Validity of Tax Regulations

May 15, 2020 by 1 Comment

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.

Filed Under: Administrative Procedure Act (APA), Regulations Tagged With:
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