Courts Threaten to Undercut IRS Efforts to Go After Tax Shelters

The ruling from the Sixth U.S. Circuit Court of Appeals in Cincinnati applies only in a handful of states, but it provides a road map for taxpayers to challenge the IRS in the absence of further action by the Biden administration or Congress.

The court in the case in question found a flaw in a 2007 notice from the IRS. That announcement warned participants in certain transactions involving cash-value life insurance that purported to give tax advantages to business owners and required them to notify the government of the deals on their tax returns. The IRS uses such disclosures to attack a list of transactions or products that it sees taxpayers using and that it deems particularly abusive; they are often deals that can be replicated and promoted by some accountants and financial advisers.

The requirement acts as a deterrent because many tax advisers will steer clients from the listed transactions. The IRS publishes its list to warn taxpayers it is likely to pursue audits and challenge their returns if they engage in the transactions. The repercussions of the audits vary depending on individual circumstances.

The case turned on a federal law about regulatory processes, known as the Administrative Procedure Act, which businesses have used to challenge rules across the government.

The IRS should have sought public comments before imposing the disclosure requirement, according to the unanimous ruling from the three-judge appeals-court panel, which covers Michigan, Ohio, Kentucky and Tennessee. The decision halted nearly $30,000 in penalties that the IRS had assessed against Mann Construction and its owners. A lawyer for Mann Construction said the Michigan company was pleased with the ruling.

The government uses similar tax notices to track hedge funds’ options transactions, businesses’ use of closely held insurance companies and certain donations of land-development rights known as syndicated conservation easements. Other taxpayers could cite the Mann Construction court ruling to challenge those requirements.

“The threat is definitely growing by the week,” said Clinton Wallace, a law professor at the University of South Carolina. If the IRS and Treasury “don’t get their act together quickly, they will have some problems.”

Representatives for the Treasury and Justice departments declined to comment. The IRS generally doesn’t discuss pending litigation.

“Decisions like this one threaten to hobble our government’s ability to administer a tax system that is fair to all Americans,” said Rep. Bill Pascrell (D., N.J.), chairman of the House Ways and Means Committee’s oversight subcommittee. “It is my hope this holding is appealed and overturned.”

Congress could overturn the ruling by declaring that reportable transactions are exempt from government regulatory procedures, but lawmakers have had little discussion on doing so.

Lower courts have been following the Supreme Court’s lead on the expansion of administrative-law requirements into tax law, limiting the long-held view that tax law was different, said Joseph Bishop-Henchman, vice president of policy and litigation at the National Taxpayers Union Foundation, which argues in court for taxpayers’ rights.

“The IRS keeps losing. And so they need to change their position,” Mr. Bishop-Henchman said. “As an advocate for taxpayers, it’s very ironic that the IRS is asserting that they can cut corners and not follow rules, because that’s not certainly the position they take with taxpayers.”

Last year a unanimous Supreme Court decision allowed taxpayers to challenge a similar reporting requirement before the IRS enforced it, paring back a different but related limit on IRS authority. Lily Batchelder, now the top tax-policy official in the Treasury Department, was among those who filed briefs urging the Supreme Court not to do what it ultimately did.

The reportable-transaction rules developed over several decades as the IRS has tried to fight tax shelters promoted by financial advisers and used by people with high incomes. Congress set up the core of the current structure in 2004.

Taxpayers and their advisers must disclose to the IRS when they engage in the government-listed questionable transactions or pay penalties if they don’t disclose them on special forms with their tax returns. Those disclosures speed the path to audits and have helped the IRS manage its enforcement priorities as it has shed employees over the past decade.

IRS Commissioner Charles Rettig has previously indicated that he hoped to expand the list of transactions for the first time in more than five years. The ruling likely hampers that plan.

Courts have been inclined to make various IRS processes move more slowly, citing requirements under the Administrative Procedure Act.

Under that law, the IRS would have to notify the public of its plan, seek comments, respond to those comments and issue a final rule. That can take months or years and consume staff time, rather than quickly publishing an item in the Internal Revenue Bulletin with immediate effect. Such formal rules on new transactions could be enforced during the comment period, and the IRS could attempt to issue new rules to enforce the existing list of transactions. The agency hasn’t specified its plans.

“Any exceptions to the sturdy protections established by the APA’s notice-and-comment requirements must come from Congress, not us and not the IRS,” wrote Jeffrey Sutton, the Sixth Circuit’s chief judge, in the court ruling.

The IRS for now should consider continuing to issue fast notices for questionable transactions, as well as pursuing formal regulations more likely to stand up in court, said Gil Rothenberg, former chief of the appellate section of the Justice Department’s tax division, who now teaches law at American University and the University of Pennsylvania.

This year’s tax deadline for most individuals is April 18. Interested in knowing more before you file your taxes? Register here to read the WSJ Tax Guide 2022.

Write to Richard Rubin at [email protected]