When agencies take controversial regulatory actions, it can be anticipated that those actions will be challenged in federal district courts as soon as they become operative, if not before. In other instances, a challenge to agency action will be unexpected, as was a challenge to a 2007 action of the Internal Revenue Service designating a welfare plan structure as a listed transaction, in Mann Construction, Inc. v. United States, a March 2022 decision by the Court of Appeals for the Sixth Circuit.
A listed transaction is a type of transaction that the IRS presumes will be designed to abuse the tax laws, so the IRS wants to be notified when the transaction occurs so that it can assess whether to challenge it. Heavy penalties are provided by statute for failure to file Form 8886 to notify the IRS that the transaction, or a transaction similar to a specifically listed transaction, has occurred.
The challenged agency action in the Mann Construction case was Notice 2007-83, entitled “Abusive Trust Arrangements Utilizing Cash Value Life Insurance Policies.” Notice 2007-83 (the “Notice”) was issued in October 2007, concurrently with Revenue Ruling 2007-65, which was issued to limit deductions for employer contributions to purchase cash value life insurance policies. The Notice designated certain employee benefit plans funded with cash value life insurance policies as listed transactions.
A cash value life insurance policy combines life insurance coverage with a cash value investment account. Under Section 264 of the Internal Revenue Code (the “Code”), an employer normally cannot take a tax deduction for the premiums paid for cash value life insurance, and there are limits as well under Code Section 419. By wrapping the cash value policies in a purported employee benefit plan, an employer might try to claim a deduction for the contributions to the program on the theory that the contributions were for employee benefits, and the fact that the funding was through the policies was incidental. In addition, the Notice, which was directed at small businesses, also expressed concern that taxpayers were taking the position that the distribution of the policies on termination of the trust was not taxable because the employees had purchased the policies, even though the IRS asserted that the amount paid for a policy was significantly less than the value of the policy. The IRS position was that these transactions ran the risk of enabling small business owners to impermissibly receive cash and other property from the business on a tax-favored basis. The IRS discussed in the Notice the various theories that it might employ to challenge these transactions, including treating the arrangement as a deferred compensation plan under Code Section 409A, characterizing it as a split dollar life insurance arrangement, treating the contributions on behalf of shareholder employees as dividend income, and violating Revenue Ruling 2007-65.
The plaintiffs in the Mann Construction case were penalized for failure to file Form 8886 to report this listed transaction on their tax return. They paid the penalty, then sued for a refund, which the IRS denied. Plaintiffs then proceeded to federal court, where they challenged the IRS action on several grounds, but the issue on which the Sixth Circuit decided the case was the failure of the IRS, in issuing Notice 2007-83, to comply with the notice and comment period requirements of the Administrative Procedure Act (the “APA”). The APA normally requires any government agency to give notice of a planned regulatory action, and to afford the public an opportunity to comment on the proposed guidance.
Congress has, for a long period of time, delegated to the Internal Revenue Service the authority to require taxpayers to submit information that the IRS determines is needed to assess and collect taxes. The purpose of this delegation has been to permit the government to ensure compliance with tax code provisions and to ferret out improper tax avoidance. To assist the IRS in identifying tax avoidance schemes, Congress in 2004 enacted Code Section 6707A, which permitted the IRS to penalize taxpayers for the failure to provide information (on Form 8886) regarding both reportable and listed transactions. A reportable transaction is one that has the potential for tax avoidance or evasion, and a listed transaction is one that is “the same as, or substantially similar to a transaction” that the IRS has identified as “a tax avoidance transaction.” Notice 2007-83, which was issued pursuant to an IRS regulation permitting listed transactions to be identified in IRS notices, was issued under Code Section 6707A, but without the notice and comment period required under the APA.
The IRS, not surprisingly, disagreed with plaintiff’s assertion that a notice and comment period was required. It argued that Notice 2007-83 was an interpretive rule, which does not require notice and comment, as opposed to a legislative rule, which does require notice and comment. Second, even if the Court found that Notice 2007-83 was legislative rather than interpretive, Congress had explicitly exempted it from the APA, as it may permissibly do, based in part on statements in the legislative history of Code Section 6707A indicating the importance of early detection of tax avoidance transactions. The Sixth Circuit rejected both arguments, and told the IRS that if it disagreed with the result, it should take the matter up with Congress.
Shortly after the Sixth Circuit issued its decision, another case, CIC Services, Inc. v Commissioner, was decided by a District Court in Tennessee that is located within the Sixth Circuit. The CIC Services case invalidated Notice 2016-66, which dealt with micro captive insurance transactions. In addition to invalidating the Notice on the same basis as Mann Construction, the District Court also found that notice to be arbitrary and capricious, an issue not addressed by the Sixth Circuit in Mann Construction.
The IRS takes a broad view of interpretive regulations, and no doubt will look for an opportunity to have another circuit address the issue, in order to create a conflict between appellate courts that it could take to the Supreme Court. The potential application of the decision is unclear, but some taxpayers may take the position that the Sixth Circuit decision provides them with a basis for not reporting listed transactions. That is, if the notice is the means by which the IRS identifies a listed transaction, and the notice is invalid under the APA, then there is no listed transaction for taxpayers to report. However, taxpayers not residing in the Sixth Circuit may wish to act with caution before taking that tax position.
This client alert is intended for general informational purposes only. Any accounting or tax advice contained in this communication is not intended as a thorough, specific in-depth analysis of specific issues, nor a substitute for a formal tax opinion, nor is it sufficient to avoid tax-related penalties.