Back in 2021, the IRS was handed a decisive defeat in court. After years of fighting, the IRS was definitively told that it does, in fact, have to follow the law, even when it’s very inconvenient. Now, as the IRS prepares to ramp up tax enforcement efforts, taxpayers are receiving a roadmap for how to rein in an IRS that sees itself as above the law.
At first glance, CIC Services v. IRS is hardly headline news material. Ostensibly a fairly wonky case over reporting requirements imposed by the IRS for certain micro-captive insurance transactions, CIC Services seems like it would only be interesting to the narrow industry affected by it. But a closer look shows that CIC Services was really about whether or not the IRS can simply ignore the law.
Under the Administrative Procedures Act (APA), government agencies are required to offer a notice-and-comment period before finalizing any new regulation. The IRS, however, had begun to find these notice-and-comment periods, which offer taxpayers a chance to weigh in on proposed regulations that would affect them, to be a nuisance. It had therefore frequently been ignoring this requirement, finalizing regulations without bothering to offer any sort of notice-and-comment period.
One example of this trend was Notice 2016-66, under which the IRS imposed significant reporting requirements for insurance companies engaging in micro-captive transactions. One such company, CIC Services LLC, decided to challenge these requirements, arguing that they were imposed in an administratively improper manner because the IRS ignored the APA.
The IRS’s response was not to say anything about the APA, but to argue that CIC Services could not challenge the notice because it hadn’t been punished for failing to comply yet. In other words, the IRS argued that CIC Services first had to suffer the legal penalties for noncompliance, including large fines and potential imprisonment, before it could challenge Notice 2016-66.
If that seems like an absurd position, it is one that the IRS frequently takes. Using a decades-old law intended to prevent taxpayers from avoiding tax obligations by miring them in years of frivolous litigation, the IRS routinely argues that taxpayers can’t challenge anything the IRS does in court until they first fail to comply and suffer the resulting consequences. In essence, it’s the IRS’s “get out of jail free” card to be able to do whatever it wants.
After all, notice-and-comment requirements are important, but no taxpayer is going to go to jail just for the right to challenge a regulation that failed to allow for them. Fortunately, in CIC Services, the Supreme Court agreed. In a unanimous decision, the Supreme Court ruled that the IRS had to follow the APA, and that taxpayers did not have to first violate an IRS regulation in order to challenge it.
That the Supreme Court decision was unanimous was a strict enough rebuke to a government agency used to a great deal of judicial deference, but the same thing happened not even a year later. This time, the IRS tried to argue a taxpayer couldn’t appeal an erroneous fine because the appeal was filed just a single day late — an especially ironic position given the IRS’s consistent failures to process taxpayer returns in a timely manner. Once again, the IRS lost in front of the Supreme Court unanimously.
The succession of defeats is having some effect. Just recently, the IRS announced a notice of new proposed rules on micro-captive transactions, as well as a public hearing. Of course, it’s not so much the notice-and-comment period that is important, but the proof that the IRS can be made to follow the law when taxpayers stand up for their rights and courts uphold them.
That roadmap will prove necessary as the IRS prepares to ramp up enforcement. But with taxpayers’ representatives in Congress failing to put guardrails on an IRS determined to test the boundaries of what it can get away with, taxpayers will need to be more vigilant than ever.