Courts have been flexing their muscles when it comes to inquiring into the validity of regulations. We have discussed some high profile cases, such as Loving, Florida Bankers and Altera, (e.g., see Pat Smith’s guest post last month discussing Altera v Comm’r and the Tax Court’s striking down regulations under section 482 dealing with cost-sharing agreements for the development of intangibles).
Last month the Tax Court in McDonald v Commissioner again considered a challenge to regulations; this time involving regs that have been around a while that mandate the time when taxpayers can elect to exclude foreign earned income under Section 911. The case applies the Chevron two-step inquiry in finding that the regulations are valid and reminds us that challenges to regulations face a pretty tough standard. At the same time, the Tax Court’s Chevron Step Two inquiry in McDonald does show that the courts are willing to look carefully at Treasury’s reasoning in promulgating regulations, including whether in issuing final regs Treasury was responsive to comments.
I’ll briefly summarize the facts and explore the court’s Chevron inquiry.
read more...Background and Main Taxpayer Argument
Ms. McDonald lived and worked abroad for part of 2009 and failed to timely file a return. The IRS prepared a substitute for return and then issued notice of deficiency in April 2012. Not petitioning Tax Court, she filed a Form 1040 in May 2012 attaching a Form 2555, “Foreign Earned Income”, claiming a Foreign Earned Income Exclusion of about $23,000. With the return McDonald filed she also sent in about $3,000 which was the balance due taking into account the exclusion. The IRS then issued another notice of deficiency disallowing the exclusion because she failed to file the Form 2555 in accordance with the regulatory deadlines I discuss below. Ms. McDonald filed a petition challenging the disallowance as well as the IRS’s imposition of civil penalties. The case came up on a partial summary judgment motion addressing the exclusion.
At issue in the motion was whether the IRS should allow McDonald’s late filed Form 2555 and thus permit her to elect the exclusion to which she would have been entitled to take had she filed it earlier.
While Section 911 is silent on when taxpayers must file a 2555 or comparable form electing the exclusion, Treasury promulgated regs addressing the issue. Reg. Section 1.911-7(a)(2)(i)(A)-(C) provides three main deadlines: 1) with the original return, 2) at a time that would be timely under Section 6511(a) for filing refund claims, or 3) within one year of the due date of the original return (without regard to extensions).
1.911-7(a)(2)(i)(D) also allows for a taxpayer to elect the exclusion if the taxpayer does not satisfy any of the three options above and either of the following applies:
(1) The taxpayer owes no federal income tax after taking into account the exclusion and files Form 1040 with Form 2555 or a comparable form attached either before or after the Internal Revenue Service discovers that the taxpayer failed to elect the exclusion; or
(2) The taxpayer owes federal income tax after taking into account the exclusion and files Form 1040 with Form 2555 or a comparable form attached before the Internal Revenue Service discovers that the taxpayer failed to elect the exclusion.
The Chevron Inquiry
Ms. McDonald could not satisfy any of the above requirements when it came to timely filing her election, which she filed about three years after the original due date, after the IRS discovered the lack of an election and with a return reflecting a tax liability, even with the exclusion. Her principal argument she made in Tax Court was that the regulation’s timing requirements were not valid:
Ms. McDonald challenges the validity of the regulation on two bases: she argues that the regulation is an invalid interpretation of the statute because the statute creates the only legal standard that she needs to satisfy and the additional timing requirement that the regulation imposes is absent from the statute. Next, she argues that the 12-month deadline in [1.911-7(a)(2)(i)(C)] is arbitrary and “is neither necessary or appropriate to carry out the purposes of Section 911.”
To determine the regulation’s validity the Tax Court looked to the Chevron two-step inquiry, a standard becoming well-known for tax practitioners:
Determining whether a regulation merits deference under Chevron involves a two-step process: We first determine whether Congress has directly spoken to the precise question at issue. Chevron, 467 U.S. at 842. If the answer is yes, we must give effect to congressional intent. Id. at 842-843. In order to determine whether Congress has directly spoken, we “employ[] traditional tools of statutory construction”. United States v. Home Concrete & Supply, LLC, 566 U.S. __, __, 132 S. Ct. 1836, 1844 (2012) (quoting Chevron, 467 U.S. at 843 n.9). If, employing those tools, we determine that Congress has not directly spoken to the precise question at issue, we proceed to the second Chevron step and determine whether the agency’s chosen interpretation is a “reasonable interpretation” of the enacted statutory text. Chevron, 467 U.S. at 843- 844. If it is a reasonable interpretation, the regulation will stand. It will be ruled invalid only if it is found to be “‘arbitrary or capricious in substance, or manifestly contrary to the statute.’” Mayo Found. 562 U.S. at 53 (quoting Household Credit Servs., Inc. v. Pfennig, 541 U.S. 232, 242 (2004)).
Step One Analysis
Ms. McDonald’s main challenge seemed to fit with Step One, essentially arguing that the statute’s lack of addressing the timing meant that the inquiry should end there and not push the court into the second step:
It appears that Ms. McDonald disagrees and would, in effect, halt the analysis at step 1. Her argument questions whether, in section 911, the “silence” about any deadline really creates a gap that can be legitimately filled by regulation. Ms. McDonald seems to suggest that the statute, by including no deadline, reflects a congressional intention that there be no deadline.
To buttress her position, Ms. McDonald noted that the specific statutory hook in Section 911 authorizing the Secretary to promulgate regs does not address timing.
Unlike in cases like Loving, where the DC Circuit found that the IRS lost at Step One because its regulatory efforts were “foreclosed by the statute”, here the court had little trouble dispensing with that argument, looking to Section 7805(d), which provides the IRS with wide latitude in setting deadlines:
“Except to the extent otherwise provided by this title, any election under this title shall be made at such time and in such manner as the Secretary shall prescribe. [Emphasis in original opinion.]
That Section 911 itself did not address the timing in the court’s view just opened the door into the reasonableness of the timing requirements that the regulations imposed.
Step Two: Like a Good Neighbor State Farm is There Too
After pointing the Code’s statutory authority giving the IRS discretion to set deadlines for elections, the opinion moved to Step Two. Ms. McDonald argued that setting deadlines was unreasonable and thus the reg was invalid. The Tax Court noted that it had previously considered in Faltesek v Commissioner 92 T.C. 1204 (1989) a challenge to the first three regulatory deadlines under Section 911 and found that those regs were valid. Given that Treasury promulgated the fourth option in 1.911-7(a)(2)(i)(D) after Faltesek, the taxpayer attempted to distinguish that case, but the Tax Court dismissed that distinction:
[W]e find the rationale and holding of Faltesek equally applicable here, because the amended regulation with new subdivision (i)(D) is even more permissive than the former version. The amended regulation provides a taxpayer with an additional method for making the election if the taxpayer does not otherwise meet the requirements of subdivision (i)(A) through (C). Thus, if the pre-amendment version of the regulation was reasonable, as we held in Faltesek, then the more permissive amended version must also be reasonable.
In setting the table in discussing the Step Two arbitrary and capricious analysis, the Tax Court notes the similarity in a Step Two analysis to the inquiry that courts undertake pursuant to State Farm, i.e., that the agency satisfies a hard look reasoned decision making standard. In rewriting and updating Chapter 3 of Saltzman and Book IRS Practice and Procedure we have discussed extensively the manner in which courts have undertaken Step Two analyses in the context of tax cases. As we state in Chapter 3.02[4][c] in Step Two, “[u]nder State Farm hard look, the agency not only needs to engage in reasoned decision making, but must also provide contemporaneous explanations of its reasoning.”
The Tax Court early in the McDonald opinion notes the confluence of the Step Two and State Farm inquiries. In McDonald, Judge Gustafson, who did not join the Tax Court in the Altera opinion, could have found for the IRS by stating that the precedent of Faltesek (a pre-Mayo case but still a regular Tax Court opinion) foreclosed the inquiry. Instead, he also emphasized how in Faltesek the Tax Court affirmed the regulations in part because in the regulatory process the IRS “responded favorably to public comment and criticism that the originally proposed periods were too narrow and did not account for the difficulties of communicating with overseas taxpayers” and eventually promulgated regulations that were more liberal than originally proposed.
In assessing the validity of regulations, courts will inquire into the IRS’s acknowledging and responding to comments, and the McDonald opinion reminds us that while it is not easy for taxpayers to successfully challenge regulations, courts will be looking carefully at the give and take of the notice and comment process. While the McDonald opinion is an important government victory, it also stands to remind that Step Two is not meant to be a rubber stamp allowing any regulation to stand.
About Leslie Book
The quote I would like to focus on is:
If, employing those tools, we determine that Congress has not directly spoken to the precise question at issue, we proceed to the second Chevron step and determine whether the agency’s chosen interpretation is a “reasonable interpretation” of the enacted statutory text. Chevron, 467 U.S. at 843- 844. If it is a reasonable interpretation, the regulation will stand. It will be ruled invalid only if it is found to be “‘arbitrary or capricious in substance, or manifestly contrary to the statute.’” Mayo Found. 562 U.S. at 53 (quoting Household Credit Servs., Inc. v. Pfennig, 541 U.S. 232, 242 (2004)).
This seems to posit a binary choice. If “reasonable” – then valid; If “arbitrary or capricious in substance or manifestly contrary to the statute;” then invalid. I wonder, however, if there is some interpretive space between those choices. What if one could not conclude that the interpretation is affirmatively reasonable but could not affirmatively say that the interpretation is “”arbitrary or capricious in substance or manifestly contrary to the statute?” Or, if the conclusion cannot be made that the interpretation is reasonable, then the interpretation is deemed to be “arbitrary or capricious in substance or manifestly contrary to the statute.”
Perhaps I misinterpreted it, but in my Tax Procedure text book, I stated the test as follows: “That inquiry in Step Two is whether the administrative agency interpretation is unreasonable.” The question is the same one. Is there only a binary choice between reasonable and unreasonable or is there some space for saying that the interpretation is neither reasonable nor unreasonable and therefore the interpretation is valid?
Would appreciate comments on this so that, as appropriate, I can correct the error of my ways.
Jack Townsend
Jack,
As I understand it, you are not the first to notice the difference between APA “arbitrary and capricious” review and Chevron “reasonable” review. It is my understanding that the D.C. Cir. came to the conclusion that there is no space between the two and that the tests are flip sides of each other. That seems to have been accepted in the Supreme Court in the case of Judulang v. Holder, 132 S. Ct. 476 (2011), where the Court used APA review of the Board of Immigration Appeals’ precedents and wrote the following at footnote 7:
The Government urges us instead to analyze this case under the second step of the test we announced in Chevron U.S.A. Inc. v. NRDC, 467 U. S. 837, 104 S. Ct. 2778, 81 L. Ed. 2d 694 (1984), to govern judicial review of an agency’s statutory interpretations. See Brief for Respondent 19. Were we to do so, our analysis would be the same, because under Chevron step two, we ask whether an agency interpretation is “ ‘arbitrary or capricious in substance.’ Mayo Found. for Med. Educ. & Research v. United States, 562 U. S. ___, ___, 131 S. Ct. 704, 178 L. Ed. 2d 588 (2011) (quoting Household Credit Services, Inc. v. Pfennig, 541 U. S. 232, 242, 124 S. Ct. 1741, 158 L. Ed. 2d 450 (2004)). But we think the more apt analytic framework in this case is standard “arbitrary [or] capricious” review under the APA. The BIA’s comparable-grounds policy, as articulated in In re Blake, 23 I. & N. Dec. 722 (2005) and In re Brieva-Perez, 23 I. & N. Dec. 766 (2005), is not an interpretation of any statutory language–nor could it be, given that § 212(c) does not mention deportation cases, see infra, at ___ – ___, 181 L. Ed. 2d, at 464-465, and n. 11.
Carl, thanks for your response. I am not sure I understand. So let me digress. I was not speaking to any space between the APA review and the Chevron review. They may or may not be the same. What I was talking about was only Chevron Step 2 as it is articulated in the opinion. If “reasonable,” then valid. If “arbitrary or capricious in substance, or manifestly contrary to the statute,” then invalid. Are you saying that there is no space between those alternatives?
If there is no space between the alternatives, it seems that the court the test would be better and more accurately stated as follows: If “reasonable,” then valid. If “not reasonable,” then invalid. In this formulation “not reasonable” means just that — i.e., the Court cannot conclude that the interpretation is affirmatively reasonable and with the conclusion nothing further is required (i.e., the Court would not have to conclude that the interpretation is ”arbitrary or capricious in substance or manifestly contrary to the statute.” Perhaps this is semantics, because if you then define “not reasonable” as ”arbitrary or capricious in substance or manifestly contrary to the statute” that solves the problem.
Jack Townsennd
Jack,
I agree with you that Chevron’s own language contains the contradiction you point out — i.e., leading one to question whether the two tests are exact flip sides of each other. I have never been able to figure out the answer to your question, so just pointed you to Judulang.
But, frankly, I think the whole Chevron opinion should get the heave ho and we should go back to non-deferential review of regulations. I am glad to see some Justices like Thomas beginning to regret Chevron.