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For taxpayers challenging IRS notices and regulations designating transactions as “reportable transactions” or “listed transactions,” the Mann Construction case keeps getting better.
In 2022, the U.S. Court of Appeals for the Sixth Circuit in Mann Construction held that IRS Notice 2007-83, which labeled a certain type of transactions as a “listed transaction,” was invalid due to the IRS’ violation of the Administrative Procedure Act in promulgating the notice. Last week, on remand, the district court amplified the IRS’ loss by vacating the IRS notice not only for purposes of Mann Construction’s case or for taxpayers with cases appealable to the Sixth Circuit, but for all taxpayers nationwide.
As background, Congress has given the IRS a panoply of potent weapons to combat tax shelters. Among these is the authority to promulgate rules under which taxpayers who engage in specific transactions or types of transactions with the “potential” to evade taxes must disclose the transactions to the IRS. Such transactions come in two flavors: “reportable” transactions and “listed” transactions. A “reportable transaction” is one that has the potential for illegal tax avoidance or evasion. 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.
A transaction’s status as reportable or listed does not carry any weight in determining whether the transaction which the IRS has identified as having the “potential” for tax evasion has actually been used by the taxpayer to illegally avoid taxes. But being categorized as a reportable or listed transaction is still significant. The initial import of being designated a reportable or listed transaction is that their disclosure is required. But there’s more. Congress further enacted a draconian set of penalties that may apply to taxpayers who fail to disclose either reportable or listed transactions.
In 2007, the IRS added a “listed transaction” that taxpayers must disclose or be subject to the aforementioned penalty regime. It issued IRS Notice 2007-83, entitled “Abusive Trust Arrangements Utilizing Cash Value Life Insurance Policies Purportedly to Provide Welfare Benefits.” The Notice designates certain employee-benefit plans featuring cash-value life insurance policies as listed transactions. The IRS had concern that these transactions may enable small business owners to receive cash and other property from their business on a tax-favored basis.
In 2020, Mann Construction challenged in U.S. district court the imposition of penalties for its failure to disclose participation in a transaction the IRS alleged constituted a Notice 2007-83 transaction. Mann Construction argued, among other things, that the IRS’ issuance of Notice 2007-83 had violated the notice-and-comment requirement in the Administrative Procedure Act. After the district court rejected the taxpayer’s argument, on appeal the U.S. Court of Appeals for the Sixth Circuit agreed with the taxpayer that the IRS should have but failed to validate Notice 2007-83 through the APA’s notice-and-comment process.
In its decision, the Sixth Circuit emphasized the importance of the APA’s notice-and-comment rulemaking process: “The process serves regulated parties and the agency alike. Notice and comment gives affected parties fair warning of potential changes in the law and an opportunity to be heard on those changes—and it affords the agency a chance to avoid errors and make a more informed decision. The process also shines a light on delegations of authority from Congress to an executive-branch agency to ensure they remain subject to public scrutiny. Courts must set aside agency actions that fail to follow these requirements.”
On remand, the district court then considered whether the Sixth Circuit meant what it said: that an agency action that violates the APA, in this case Notice 2007-83, must be “set aside.” The impact of “setting aside” the agency action could be more profound that a typical ruling against the IRS in a tax refund action. Ordinarily, a circuit court’s ruling on an issue of law is binding only for disputes brought in courts appealable to that circuit. And ordinarily a district court’s ruling has very limited, if any, binding effect on anyone other than the parties to the litigation. See Lowy, Legal Authorities in U.S. Federal Tax Matters – Research & Interpretation, 3rd Ed., TAX MANAGEMENT PORTFOLIO SERIES (2016).
However, under the Administrative Procedure Act, specifically 5 U.S.C. § 706(2), a reviewing court in a successful challenge under the APA must “set aside” the agency action. According to the district court in Mann Construction, this means that if the agency action that is challenged is an illegal or procedurally defective rule (in this case, in the form of an IRS notice), it is the rule itself that must be set aside. The effect may be a nationwide vacatur of the IRS notice. Thus, rather than impacting only Mann Construction or taxpayers with cases appealable to the Sixth Circuit, the consequences of setting aside an IRS action under the APA could have a nationwide impact.
The district court in Mann Construction acknowledged the broad ramification. On remand, it applied 5 U.S.C. § 706(2), and held that it required the court to vacate and set aside Notice 2007-83, with the effect that the notice is no longer in force for any taxpayer anywhere in the country. If the district court’s decision becomes final, it would promote uniformity of treatment so that taxpayers in the Sixth Circuit do not have a different – and more favorable – version of federal income tax disclosures and related penalties than taxpayers elsewhere in the country.
But the decision greatly expands the IRS’ loss in the Mann Construction case, and it would not be surprising if the IRS challenges the vacatur. The IRS is currently considering its response to, and actions to take in the wake of, the Mann Construction decision. So stay tuned.
Peter A. Lowy, a shareholder in Chamberlain Hrdlicka’s Houston office, is best known for his tax controversy work and deep experience in the energy sector. He also advises corporations and other taxpayers in a broad spectrum of ...