“Americans have never had much enthusiasm for paying taxes.” CIC Services, LLC v. Internal Revenue Service, 593 U.S. ___, *1 (2021)
On May 17, 2021, the Supreme Court held that the Anti-Injunction Act (AIA), section 7421(a) of the Code, does not preclude a pre-enforcement challenge to an IRS notice enforced through civil and criminal penalties. The AIA generally precludes pre-enforcement challenges to the assessment or collection of any tax so that the flow of tax payments cannot be disrupted by litigation. For this reason, it is significant that the Supreme Court has held that the AIA does not prevent an information reporter/tax advisor from challenging an IRS notice under the Administrative Procedure Act (APA).
Justice Kagan delivered the opinion for a unanimous Court. At its core, the holding in CIC Services, LLC v. Internal Revenue Service, 593 U.S. __ (2021), shifts the focus of AIA cases from determining whether the downstream effects of a lawsuit would include preventing the assessment or collection of tax to evaluating the burden imposed on the information reporter. The Court reversed the district court and Sixth Circuit and remanded the case to the district court to determine whether the IRS ran afoul of the APA when it issued Notice 2016-66 without following the public notice and comment rulemaking procedures.
Although the Court’s decision is broadly applicable to IRS guidance, it is helpful to understand some of the specific context of the challenged IRS notice. CIC Services, LLC (CIC) provided tax advice with respect to the formation and operation of insurance companies taxable under section 831(b)—so-called “micro-captive” insurance companies. CIC was not a taxpayer who engaged in micro-captive transactions. Section 831(b) allows some insurance companies with up to $2.2 million in annual written premiums to elect to be subject to tax only on investment income. Congress amended section 831(b) as part of the Protecting Americans from Tax Hikes Act of 2015 to address perceived abuses of the section 831(b) election. The amendments are effective for all section 831(b) companies, including preexisting arrangements, for tax years beginning after December 31, 2016.
On November 1, 2016, the IRS issued Notice 2016-66, 2016-47 IRB 745, designating transactions in which taxpayers utilize certain section 831(b) companies as “transactions of interest.” Transactions of interest are “reportable transactions,” meaning that participants in the transactions must disclose the transaction on a disclosure statement (IRS Form 8886) attached to their federal income tax return. In addition, “material advisors” to such transactions, such as CIC, are subject to similar disclosure requirements (IRS Form 8918) and must also maintain lists of those taxpayers they have advised about these transactions. The Notice provided for a 10-year retroactive application.
Failure to supply the required information under Notice 2016-66 is punishable both by civil and criminal penalties. See secs. 6707(b), 6707A(b), 6708(a), 6112(a), and 7203. Only the civil penalties are deemed to be a “tax” for purposes of the Internal Revenue Code. Sec. 6671(a).
Before the first reporting deadline in Notice 2016-66, CIC filed a complaint in the United States District Court for the Eastern District of Tennessee, challenging the validity of the notice under the APA. CIC asked the court for injunctive relief—setting the notice aside for failure to follow the notice and comment procedures of the APA.
The district court ruled in favor of the government, holding that the AIA barred the suit because the civil penalty for failure to comply is deemed to be a tax and because the effect of the suit would be to restrain or enjoin a tax. CIC v. Internal Revenue Service, 2017 WL 5015510, (E.D. Tenn. 2017).
The Sixth Circuit agreed with the district court in a divided decision. CIC Servs., LLC v. Internal Revenue Service, 925 F.3d 247 (6th Cir. 2019). Judge Nalbandian’s dissent in the Sixth Circuit, however, previewed the Supreme Court’s decision, stating: “[T]his is not a dispute over taxes.” Id. at 259 (Nalbandian, J., dissenting). And after an unsuccessful request for en banc review by the Sixth Circuit, CIC successfully petitioned for certiorari.
The Supreme Court’s review was limited to the question of whether the AIA barred the lawsuit, i.e., whether the requested injunction targets the “assessment or collection” of federal tax. The Court’s 2015 opinion in Direct Marketing Assn. v. Brohl, 575 U.S. 1 (2015), addressed this question in the case of the Tax Injunction Act, which applies to injunctive relief against assessment or collection of state tax. As in Brohl, the Court in CIC Services held that information gathering did not implicate the assessment or collection of tax regardless of whether the provision of information might improve a government’s ability to assess or collect taxes.
The court then considered a question not raised by Brohl, whether the potential imposition of a penalty under section 6671(a), which is treated as tax, brings the suit within the ambit of the AIA. The Court held that, because the relief sought in the complaint as drafted was limited to a declaration that Notice 2016-66 was unlawful, rather than relief from the penalty, the AIA was not implicated. The Court rejected the government’s argument that, by necessity, an injunction against enforcement of the Notice would also mean that the penalty would not apply. Three reasons played into the Court’s conclusion.
First, the cost of compliance was unconnected to CIC’s potential tax liability. The notice created affirmative reporting obligations, but because CIC was an adviser, there was no direct connection between the information it reported and its tax obligations. And in the case of CIC, the cost of compliance could have exceeded the civil penalty for noncompliance. These costs for CIC were unrelated to the tax penalty. “Simply stated,” the Court noted, “this suit attempts to get out from under the (non-tax) burdens of a (non-tax) reporting obligation.” CIC Services, LLC, 593 U.S. at __, *10.
Second, the reporting obligations and tax penalty were “several steps removed from each other.” In order for one to flow from the other, the taxpayer would have to withhold information, the IRS would have to determine that a violation of the reporting requirements had occurred, and the IRS would have to decide to impose the discretionary penalty. The Court noted that this “threefold contingency” meant that there was “too attenuated a chain of connection” between the reporting obligation and the downstream tax.
Third, the potential criminal penalties are not “taxes.” The potential criminal liability made it practically necessary to allow the suit pre-enforcement because otherwise a party seemingly would be required to engage in criminal behavior in order to challenge the Notice. The Court focused on this issue during oral argument and continued to highlight the problem of the government requiring a taxpayer to commit a crime, subject itself to the criminal penalty, and only permit a challenge to the law that made such action a crime in the first instance.
The Court rejected the government’s argument that a victory for CIC would “open the floodgates” to a wave of pre-enforcement actions aimed at tax consequences, noting that actions seeking an injunction against the assessment or collection of a tax would continue to be barred by the AIA. Only a stand-alone reporting requirement—separate from any tax—may be contested in a pre-enforcement injunction proceeding.
Justice Sotomayor filed a separate concurrence, noting the distinction between the circumstances in this case, in which CIC was a tax adviser, and the circumstances in a different case involving a taxpayer engaging in a transaction covered by the Notice. The latter could lead to a different result. In this regard, Justice Sotomayor noted that “[w]hether such suits may proceed will depend on a context-specific inquiry into ‘the relief the suit requests’ and the ‘aspects of the regulatory scheme’ at issue.” CIC Services, LLC, 593 U.S. at __, *20 (Sotomayor, J., concurring). The concurrence suggest that the direct connection between the taxpayer and the tax liability related to the reported transaction might tip the scales in the other direction.
CIC Services reaffirms and extends the reasoning in Brohl to information reporting requirements subject to a civil penalty treated as tax and makes clear that pre-enforcement challenges to a federal stand-alone information reporting requirement may be available despite the AIA.
Eversheds Sutherland Observations: The Court’s decision strikes the right balance, allowing information reporters to challenge the validity of IRS guidance, even if a civil tax penalty is a consequence of noncompliance.
Although CIC overcame the AIA procedural hurdle, it must next address the substantive question of whether the Notice is invalid under the APA.
This case goes back on remand to the Eastern District of Tennessee for the district court to evaluate whether the IRS violated the APA either by issuing the Notice without notice-and-comment procedures or because the notice is arbitrary and capricious. The APA is an increasing focus for challenges to IRS rules, and with the Supreme Court’s decision in CIC, this trend seems likely to continue.
CIC’s chances of success on remand may be influenced by a recent decision by the United States District Court for the Eastern District of Michigan—another district court in the Sixth Circuit—which recently held that notices under section 6707A may be issued without notice and comment without violating the APA. Mann Construction, Inc. v. United States, No. 1:20-cv-11307 (May 13, 2021). Although the Mann Construction decision would not be controlling precedent for CIC’s case on remand, it is likely to be considered by the district court. Moreover, if appealed, Mann Construction would likely reach the Sixth Circuit before any district court decision in CIC.