March 30, 2022
District court relies on Mann in invalidating IRS notice requiring reporting of micro-captive insurance transactions
In CIC Services v. IRS,1 the US District Court for the Eastern District of Tennessee (district court) held that Notice 2016-66, which requires taxpayers to report micro-captive insurance transactions, is invalid because the IRS did not comply with the notice-and-comment procedures under the Administrative Procedures Act (APA) when issuing the notice. The district court separately found that the IRS acted arbitrarily and capriciously in issuing the notice.
The district court based its ruling on Mann Construction, et al. v. US,2 a recent decision by the US Court of Appeals for the Sixth Circuit. The court in Mann held that Notice 2007-83, which identifies a certain type of employee benefit plan that participants must disclose as a "listed transaction," may not be enforced because the IRS failed to satisfy the APA's notice-and-comment procedures.
The owners of Mann Construction established an employee benefit trust that paid premiums on a cash-value life insurance policy benefitting the owners. They did not report the arrangement to the IRS in accordance with IRC Section 6011 and its regulations, which require taxpayers to file disclosure statements with their tax returns if they have participated in a reportable transaction and must file a tax return. Reportable transactions include arrangements that are treated as a "listed transaction" because they are the same as, or substantially similar to, the types of transactions that the IRS has determined to be tax avoidance transactions. Under IRC Section 6707A, the IRS subsequently penalized the owners and the company for violating Notice 2007-83 by failing to disclose their participation in the trust. The taxpayers paid the penalty and sued the government, alleging the notice was invalid. The US District Court for the Eastern District of Michigan held for the government.
The Sixth Circuit subsequently overturned the lower court's decision and held that the government's failure to comply with the APA's notice-and-comment requirement meant Notice 2007-83 was invalid. In so ruling, the Sixth Circuit rejected the IRS's arguments that it did not follow this requirement because (1) Notice 2007-83 is an interpretative rule (which does not require a notice-and-comment period), not a legislative rule (which does) and (2) Congress exempted the IRS from the APA requirements for this notice. Rather, according to the Sixth Circuit, Notice 2007-83 sets forth a legislative rule because it has "the force and effect of law" and defines transactions that must be reported and are not based on a statute or rule. Notice 2007-83 creates new substantive duties that, if violated, expose the taxpayer to financial penalties and criminal sanctions, the Sixth Circuit said. The Sixth Circuit next concluded that Congress did not expressly exempt the IRS from the APA's requirements in promulgating the notice. The Sixth Circuit said the "driving inquiry is whether Congress 'clearly' departed from the APA's baseline rule" and held that Congress did not clearly do so. Accordingly, the IRS's failure to comply with the APA meant the notice was invalid.
CIC Services v. IRS
CIC is a micro-captive insurance company adviser and subject to Notice 2016-66, which requires taxpayers that engage in or advise on micro-captive insurance transactions to report them to the IRS because they are "transactions of interest." Noncompliance with the notice subjects a party to substantial penalties, which are deemed to constitute taxes for purposes of the Code.3
CIC initiated its litigation in 2017 when it asked the district court to preliminarily enjoin the IRS's enforcement of Notice 2016-66 on the grounds that (1) it is a legislative-type rule and the IRS did not comply with the APA's notice-and-comment requirements in promulgating it, and (2) the notice is arbitrary and capricious. The district court initially denied CIC's motion and dismissed the case on the grounds that CIC was unlikely to prevail on the merits because its claims were foreclosed by the Anti-Injunction Act (AIA),4 which provides that "no suit for the purpose of restraining the assessment or collection of any tax shall be maintained in any court by any person." Although the Sixth Circuit affirmed the district court's ruling, the Supreme Court reversed5 and held that the AIA did not apply, as CIC was seeking to invalidate Notice 2016-66, not to enjoin the collection of any penalty that might be owed as a result of noncompliance with the notice.
On remand, the district court agreed to enjoin the IRS's enforcement of Notice 2016-66 against CIC. CIC then asked the court to enjoin IRS enforcement of Notice 2016-66 against all taxpayers subject to it. After the Sixth Circuit opinion in Mann, the district court invited the parties to brief the court on the implications of Mann. The district court subsequently granted CIC summary judgment and invalidated Notice 2016-66 for all taxpayers. In doing so, the district court noted that the Sixth Circuit's opinion in Mann was controlling precedent and applied to the IRS's arguments. Thus, the district court held that Notice 2016-66 "is a legislative rule that is invalid because the IRS failed to observe notice-and-comment procedures required by the APA."
In addition, the district court found that the IRS acted arbitrarily and capriciously in promulgating Notice 2016-66. While the IRS is authorized to seek information from taxpayers about transactions that may have a potential for tax avoidance or evasion, the district court said, the APA requires the court to review the administrative record to see whether the IRS has examined the relevant data and articulated a satisfactory explanation for its decision. "In this case, the administrative record fails to include relevant data and facts supporting the IRS's decision to designate micro-captive arrangements as transactions of interest, and thus, reportable transactions," the district court said. Rather, according to the district court, Notice 2016-66 "simply states" that the IRS is aware of micro-captive transactions and believes they have the potential for tax avoidance or evasion, without identifying any facts or data supporting its belief.
The district court concluded that vacating Notice 2016-66 in its entirety was the appropriate relief because the IRS did not comply with notice-and-comment procedures and acted arbitrarily and capriciously. In addition, the district court ordered the IRS to return all documents and information produced under the notice to the applicable taxpayers and material advisors.
Although Mann and CIC Services could invalidate the enforcement of the relevant notices by the IRS, given the current uncertainty in the law and the penalty risk for non-compliance, EY will continue to recommend disclosure of these transactions. Furthermore, the IRS is expected to continue viewing these types of reportable transactions as having the potential for tax avoidance and evasion, regardless of these decisions.
1 No. 3:17-cv-00110 (E.D. Tenn. March 21, 2022).
2 No. 21-1500 (6th Cir. March 3, 2022).
3 IRC Section 6671(a).
4 IRC Section 7421(a).
5 141 S. Ct. 1582 (2021).