Recent Supreme Court Case Provides Possible Pre-Assessment Judicial Review for Onerous Penalties

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The Supreme Court’s recent decision in CIC Services, LLC v. Internal Revenue Service may have significantly expanded taxpayers’ ability to obtain immediate injunctive relief against onerous tax reporting requirement.

The Anti-Injunction Act bars any “suit for the purpose of restraining the assessment or collection of any tax.” Civil penalties are usually considered to be “taxes” for purposes of the Anti-Injunction Act. But in CIC Services, the Supreme Court sustained a suit to enjoin the enforcement of IRS Notice 2016–66 which provides that micro-captive insurance arrangements are “listed transactions” which must be disclosed (regardless of the ultimate validity of the transaction) upon pain of a civil monetary penalty under IRC § 6707A – as well as potential criminal sanctions under § 7203 for the willful failure to make a return or supply information required by law or regulation.  The IRS’ problem in CIC Services was that in issuing Notice 2016-66, it had failed to comply with the Administrative Procedures Act (APA) which requires that a rule with the force and effect of law may be issued only after an opportunity for public notice and comment. No public notice, no enforceable rule, the Court held.  The Anti-Injunction Act did not deprive the courts of jurisdiction.

Although CIC Services only deals with the requirements for reporting micro-captive insurance arrangements, the IRS has become lax in its compliance with the APA, preferring to issue “subregulatory advice” instead.  There are similar non-APA compliant notices requiring the reporting of other arrangements that the IRS has determined to be “suspicious” and subject to reporting under pain of § 6707A penalties.  For example, IRC § 6048(c) requires the annual reporting of distributions from a foreign trust; and § 643(i) adds that any direct or indirect loan from a foreign trust to a beneficiary shall be treated as a distribution.  Section 643(i)(1) (which was enacted in 1996) specifically expected that its scope would be explained by regulations. Unfortunately, as of the present – 25 years after the enactment of Section 643(i) – no regulations have been issued.

The legislative history of section 643(i) expresses the expectation that Treasury regulations will provide an exception to the reporting requirement for loans with arms’-length terms where there is a reasonable expectation of repayment. Although no regulations have been issued, the IRS continues to rely upon non-regulatory advice in the form of a Notice, which states that any loan to related U.S. beneficiaries will be treated as a distribution under Section 643(i) unless the loan is a “qualified obligation”. A loan is only “qualified” (according to the Notice) only if (among other things) “the U.S. person reports the status of the obligation . . . on Form 3520 for each year that the obligation is outstanding.” Instructions that accompany IRS Form 3520 contain the same non-regulatory interpretation.

To state it more plainly: A loan from a foreign trust doesn’t have to be reported if it is a “qualified transaction”; but it can only be a “qualified transaction” if it is reported.  Go figure!

If the IRS Notice and instructions have the force and effect of law (as duly-promulgated Treasury regulations would) then the failure to report any loans from a foreign trust would result in significant civil penalties under IRC § 6707A as well as potential criminal sanctions under § 7203.

It should be further noted that the civil penalties imposed under 6707A do not depend upon a related tax deficiency and could be assessed even if there is an overpayment of tax.  Furthermore, penalties under sec. 6707A are not subject to deficiency proceedings. Therefore, a person subject to sec. 6707A penalties is not entitled to any pre-assessment judicial review.

But change may be in the wind.  The CIC Services case (which had previously been dismissed by both lower courts on jurisdictional grounds under the Anti-injunction Act) was remanded back to the district court for factual findings.  On September 22, 2021, the U.S. District Court for the Eastern District of Tennessee granted CIC Services’ application for a preliminary injunction against the IRS’ enforcement of Notice 2016-66.  “CIC has demonstrated that it is likely to succeed on its claim that Notice 2016-66 constitutes a legislative rule and that it is invalid because the Secretary failed to comply with required notice-and-comment procedures under the APA,” Judge Travis R. McDonough said in granting the injunction.  The IRS is not likely to take this decision lying down.  This is only a preliminary ruling, and additional proceedings and further appeals are likely.

Stay tuned!

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DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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