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California Bar Members Say Treasury Regs More Vulnerable After Mayo

JUN. 10, 2011

California Bar Members Say Treasury Regs More Vulnerable After Mayo

DATED JUN. 10, 2011
DOCUMENT ATTRIBUTES
  • Authors
    Horwitz, Robert S.
    Hopley, Courtney A.
  • Institutional Authors
    State Bar of California
    Taxation Section
    Procedure & Litigation Committee
  • Cross-Reference
    For Mayo Foundation for Medical Education and Research v. United

    States, No. 09-837 (U.S. Sup. Ct. Jan. 11, 2011), see Doc

    2011-609 or 2011 TNT 8-10 2011 TNT 8-10: Court Opinions.
  • Code Sections
  • Subject Area/Tax Topics
  • Jurisdictions
  • Language
    English
  • Tax Analysts Document Number
    Doc 2011-12386
  • Tax Analysts Electronic Citation
    2011 TNT 111-31

 

STATE BAR OF CALIFORNIA

 

TAXATION SECTION

 

PROCEDURE & LITIGATION COMMITTEE

 

 

THE ADMINISTRATIVE LAW IMPLICATIONS OF MAYO

 

FOUNDATION FOR MEDICAL EDUCATION AND RESEARCH V.

 

UNITED STATES

 

 

This proposal was prepared by Robert Horwitz and Courtney Hopley, members of the Procedure & Litigation Committee of the State Bar of California's Taxation Section.1 The authors wish to thank Dennis Perez of Hochman, Salkin, Rettig, Toscher & Perez, P.C. and Steven Walker of the Law Office of Steven L. Walker, P.C. for their valuable comments.2

 

Contact Persons:

 

 

Robert Horwitz

 

Law Offices of A. Lavar Taylor

 

6 Hutton Centre Drive, Suite 880

 

Santa Ana, CA 92707

 

Tel: 714-546-0445

 

Email: rhorwitz@taylorlaw.com

 

 

Courtney A. Hopley

 

Greenberg Traurig, LLP

 

153 Townsend Street, 8th Floor

 

San Francisco, CA 94107

 

Tel: 415-655-1314

 

Email: hopleyc@gtlaw.com

 

EXECUTIVE SUMMARY

 

 

In Mayo Foundation for Medical Education and Research v. United States, the Supreme Court held that Treasury Regulations issued pursuant to Treasury's general authority under I.R.C. § 7805(a) are entitled to broad deference under Chevron. It is difficult to predict how courts will apply Mayo, but government officials and tax practitioners predict that the decision will have a widespread impact on the tax system. There is significant concern in the tax practitioner community about how Treasury will exercise its discretion under Mayo. Specifically, practitioners fear that Treasury will use its discretion to: (i) issue retroactive regulations that bolster the IRS's position in pending litigation; or (ii) issue regulations that overturn longstanding judicial precedent that is unfavorable to the IRS.

Before Mayo, there was a significant amount of conflict in the courts over the appropriate level of deference for Treasury Regulations. Mayo has major administrative law implications because it states that it would not "carve out an approach to administrative review that is good for tax law only." Mayo clarifies that Treasury Regulations are subject to the same rules of review that govern regulations issued by other agencies. The issue with applying Chevron deference to Treasury Regulations is that Treasury often fails to comply with the strict requirements of APA § 553. Therefore, in the wake of Mayo, Treasury Regulations may be more vulnerable to challenges on procedural grounds.

This paper suggests that Treasury and the IRS make revisions to the Internal Revenue Manual to ensure that its Treasury Regulations are in compliance with the requirements in APA § 553. Treasury should rethink its position that most of its regulations are "interpretive regulations" and, thus, exempt from the requirements of the APA. Because Treasury Regulations are treated as binding and the failure to comply can result in the imposition of substantial penalties under I.R.C. § 6662, it is a mistake to assume that they are exempt from the APA.

After Mayo, Treasury Regulations may be more vulnerable to challenge on procedural grounds and, therefore, Treasury should take efforts to fully comply with the APA. To this end, Treasury should only issue temporary regulations after following the formal notice and comment procedure in APA § 553. If Treasury determines that immediate guidance is necessary and the notice and comment procedure will be overly burdensome, it can invoke the good cause exception under APA § 553(b), but if it does so, it should articulate a reason constituting good cause. To facilitate judicial review, Treasury should be required to include a concise statement explaining its rationale for adopting a regulation. Finally, revenue rulings, revenue procedures and other IRS guidance should be entitled to a lower level of deference under Skidmore.

 

DISCUSSION

 

 

I. BACKGROUND.

In Mayo Foundation for Medical Education and Research. v. United States, the Supreme Court held that Chevron deference applies to Treasury Regulations issued pursuant to the Treasury's general authority under I.R.C. § 7805(a).3 It is difficult to predict how Mayo will be applied, but government officials and practitioners alike predict that the decision will have widespread impact on the tax system. There is concern in the tax practitioner community about how Treasury will exercise its discretion under Mayo. Specifically, practitioners fear that Treasury will use its discretion to: (i) issue retroactive regulations that bolster the IRS's position in pending litigation; or (ii) issue regulations that overturn longstanding judicial precedent that is unfavorable to the IRS. This Paper will examine some of the important administrative law issues raised by the Mayo decision and will suggest some potential safeguards that can be put in place to ensure that Treasury properly exercises its discretion.

 

A. Overview of the Administrative Procedure Act Requirements and I.R.C. § 7805(a).

 

The Administrative Procedures Act (APA) governs the rulemaking activities of administrative agencies. Pursuant to APA § 553, when an agency issues a substantive rule, it must: (i) publish a notice in the Federal Register regarding the proposed rulemaking;4 (ii) give persons who may be affected by the proposed rulemaking an opportunity to comment;5 and (iii) provide an effective date that is at least thirty days after the publication in the Federal Register.6 When final regulations are published, the APA requires that the agency include a "concise general statement of their basis and purpose."7 Because the purpose of the statement is to explain the regulations, it is often a valuable tool for courts. The notice and comment procedures do not apply where: (i) the regulations are interpretive, provide general statements of policy or rules of agency organization, procedure or practice; or (ii) the agency, upon the finding of good cause, which is clearly stated in the rules, determines that the notice and comment procedure is "impracticable, unnecessary, or contrary to the public interest."8

The Internal Revenue Code ("I.R.C.")9 authorizes Treasury to issue regulations and other guidance to aid in the interpretation and application of provisions of the I.R.C. I.R.C. § 7805(a) authorizes the Secretary of the Treasury to, "prescribe all needful rules and regulations for the enforcement of [the I.R.C.] including all rules and regulations as may be necessary by reason of any alteration of law in relation to internal revenue." Regulations issued pursuant to I.R.C. § 7805(a) have traditionally been referred to as "interpretive regulations." Interpretive regulations are distinguished from so-called "legislative regulations." Legislative regulations are authorized by specific sections of the I.R.C. that grant authority to the Secretary to issue regulations.10 There is general agreement among Treasury, the courts and tax practitioners that Treasury Regulations are binding on the government and taxpayers regardless of whether they issued pursuant to a specific grant of authority or pursuant to a general grant of authority under I.R.C. § 7805(a).11 In fact, if a taxpayer fails to comply with a Treasury Regulation, she may be liable for substantial penalties under I.R.C. § 6662.

Prior to the 1980's, Treasury's regulatory authority was delegated to the Legislation and Regulation Division ("L&R Division") of the Office of Chief Counsel.12 The L&R Division consisted of a small group of attorneys who were well-versed in administrative law. In the wake of the Economic Recovery Tax Act of 1981 and the Tax Reform Act of 1986, the IRS closed the L&R Division and re-delegated regulatory duties to multiple substantive law groups.13 Although these substantive law groups have particular expertise about certain areas of the I.R.C., they do not have specialized knowledge about administrative law. In many cases, the Internal Revenue Manual ("IRM") is the only source of guidance that drafting attorneys have regarding the application of administrative law to their regulatory activities.14

In the IRM, Treasury has taken the position that most of the regulations it issues are interpretive and, therefore, are exempt from the notice and comment procedure.15 Notwithstanding, Treasury represents that it generally complies with the APA requirements by publishing Notices of Proposed Rulemaking (NPRMs) and requesting public comment.16 The IRM does not identify any authority for this proposition and does not provide any guidelines for determining whether a particular regulatory project satisfies this exception. Neither the APA nor the IRM requires that Treasury explicitly state that it is relying on the interpretive regulation exception. Rather, the IRM suggests that drafters should include the following conclusory language in the preamble to the regulations, "it has been determined that section 553(b) of the Administrative Procedures Act . . . does not apply to this regulation." According to the IRM, the good cause exception in APA § 553(b) may also apply. Specifically, the IRM states that the procedural requirements in APA §§ 553(b) and (c) will not apply where an agency, ". . . finds that publishing an NPRM is impracticable, unnecessary, or contrary to public interest."17 If the agency determines that the good cause exception applies, the IRM provides that the regulations should include language substantially similar to the following,

 

These regulations are necessary to provide taxpayers with immediate guidance. Accordingly, good cause is found for dispensing with notice and comment pursuant to 5 U.S.C. 553(b) and (c) and with the delayed effective date pursuant to 5 U.S.C. 553(d).18

 

Treasury often issues temporary regulations. I.R.C. § 7805(e)(1) requires that temporary regulations also be issued as proposed regulations. If not otherwise made final, temporary regulations expire within three-years following their issuance.19 Temporary regulations are distinguished from proposed regulations because they are often treated as having binding effect on taxpayers and the government. This is true even though temporary regulations are rarely issued pursuant to the formal notice and comment procedure in the APA. A number of commentators, including Professor Kristin E. Hickman, have identified Treasury's practice with respect to temporary regulations as diverging most significantly from the APA requirements.20 As a general proposition, courts will not uphold temporary regulations that do not conform to the APA requirements unless an exception in APA § 553(b) or (c) applies.21 In the context of temporary Treasury Regulations, Treasury rarely identifies the exception under which it is operating; however, given the language in the IRM,22 it is reasonable to conclude that, in most cases, Treasury is relying upon the exception for interpretive regulations. Nevertheless, Treasury and the IRS still take the position that temporary regulations are binding on both the government and taxpayers.

 

B. Conflict Regarding the Appropriate Level of Judicial Deference for Treasury Regulations.

 

The courts have taken an active role in interpreting and applying Treasury Regulations. There has been a significant amount of conflict in the courts over the appropriate level of deference for Treasury Regulations. Historically, the courts differentiated legislative regulations from interpretive regulations. In Rowan Cos. v. United States, the Supreme Court held that, "where the Commissioner acts under specific authority, our primary inquiry is whether the interpretation or method is within the delegation of authority."23 In other words, under the Rowan standard, it would be impermissible for a court to substitute its judgment for that of the Treasury because Congress had specifically delegated the authority to the Secretary. A legislative regulation would only be invalid under this standard where the court finds that Treasury had exceeded the bounds of the authority delegated by Congress24 or it was inconsistent with the applicable statute.

In contrast, interpretive regulations issued pursuant to the general grant of authority under I.R.C. § 7805(a) were accorded less deference by the courts. The prevailing view was that interpretive regulations were not binding on the courts. In Skidmore et al. v. Swift & Co., the Supreme Court considered regulations issued under the Fair Labor Standards Act and stated,

 

There is no statutory provision as to what, if any deference courts should pay to the Administrator's conclusions. And, while we have given them notice, we have had no occasion to prescribe their influence . . . This court has long given considerable weight and in some cases decisive weight to Treasury Decisions and to interpretive regulations of the Treasury and other bodies that were not of adversary origin. We consider that the rulings, interpretations and opinions of the Administrator under this Act, while not controlling upon the courts by reason of their authority do constitute a body of experience and informed judgment to which courts and litigants may properly resort for guidance. The weight of such a judgment in a particular case will depend upon the thoroughness evident in its consideration, the validity of its reasoning, its consistency with earlier and later pronouncements, and all those factors which give it power to persuade, if lacking power to control.25

 

In National Muffler Dealers Association v. United States, the Supreme Court specifically revisited the issue of judicial deference in the context of Treasury Regulations.26 The Supreme Court considered whether the association constituted an exempt "business league" within the meaning of I.R.C. § 501(c)(6). The regulation at issue was promulgated under the Treasury's general authority to prescribe regulations under I.R.C. § 7805(a). The court determined that "business league" was a term of art that had no common usage outside of the context of I.R.C. § 501(c)(6) and, therefore, an interpretive regulation was appropriate. The Supreme Court stated,

 

In determining whether a particular regulation carries out the Congressional mandate in a proper manner, we look to see whether the regulation harmonizes with the plain language of the statute, its origin, and its purpose. A regulation may have particular force if it is a substantially contemporaneous construction of the the statute by those presumed to have been aware of congressional intent. If the regulation dates from a later period, the manner in which it evolved merits inquiry. Other relevant considerations are the length of time the regulation has been in effect, the reliance placed on it, the consistency of the Commissioner's interpretation, and the degree of scrutiny Congress has devoted to the regulation during subsequent re-enactments of the statute.27

 

Under the National Muffler standard, courts give weight to Treasury Regulations, but are permitted to consider a variety of factors in determining whether a particular regulation is appropriate.

In 1984, the Supreme Court issued its landmark decision of Chevron USA, Inc. v. Natural Resources Defense Council.28 This case considered regulations promulgated under the Clean Air Act. In this case, the Supreme Court set forth a two-step analysis for determining whether a regulation is valid. The Supreme Court described the framework as follows,

 

When a court reviews an agency's construction of the statute which it administers, it is confronted with two questions. First, always, is the question whether Congress has directly spoken to the precise question at issue. If the intent of Congress is clear, that is the end of the matter; for the court, as well as the agency, must give effect to the unambiguously expressed intent of Congress. If, however, the court determines Congress has not directly addressed the precise question at issue, the court does not simply impose its own construction on the statute, as would be necessary in absence of an administrative interpretation. Rather, if the statute is silent or ambiguous with respect to a specific issue, the question for the court is whether the agency's answer is based on a permissible construction of the statute.29

 

Therefore, if Chevron applies, (i) the court must first determine whether Congress has directly addressed a particular issue in the statute (the "Chevron Step 1 Analysis"); and (ii) if the intent of Congress is unclear, it must give effect to the agency's regulation if it is a reasonable construction of the statute (the "Chevron Step 2 Analysis"). Under Chevron, agency regulations are entitled to significant judicial deference. If a court determines that a statute involves some form of ambiguity, it is not permitted to invalidate an agency regulation on the ground that the court would have adopted a different interpretation. Rather, it must only consider whether the agency's view was reasonable.

In National Cable & Telecommunications Association et al. v. Brand X Internet Services, et al., the Supreme Court considered the issue of whether an agency can issue a regulation interpreting a statute that is contrary to an existing judicial decision.30 According to Brand X, a prior judicial construction of a statute will take precedence over a subsequent construction by an agency where the court follows the unambiguous terms of the statute.31 Where, however, there is a statutory ambiguity, an agency's reasonable interpretation of a statute is accorded deference even if it contradicts judicial precedent directly on point.32

Since Chevron, the courts have taken inconsistent views on the appropriate level of deference for Treasury Regulations. In particular, it was unclear whether so-called interpretive regulations were entitled to Chevron deference or whether they should be reviewed under the lower National Muffler standard. For example, although Cottage Savings Assn. v. Commissioner was issued post-Chevron, the Supreme Court applied the National Muffler standard to Treas. Reg. § 1.1001-1.33 The Supreme Court ultimately determined that the Treasury Regulation was valid. It reasoned that Treasury's interpretation of the term "disposition of property" as including a "material difference" requirement was longstanding and the language of the statute had remained essentially unchanged.34 It also emphasized that the regulations were consistent with early judicial decisions that were issued contemporaneously with Section 202, the predecessor statute of I.R.C. § 1001.35 The Supreme Court determined that it was reasonable to conclude that Congress intended to codify the principles in the case law.36

Moreover, in Intermountain Insurance Services of Vail, et al. v. Commissioner, the Tax Court considered the validity of Treas. Reg. §§ 301.6501(e)-1T(b) and 301.6229(c)(2)-1T(b).37 The temporary regulations adopted the IRS's litigation position that the overstatement of gross income constituted an omission from gross income for purposes of applying the six-year statute of limitations in I.R.C. §§ 6501(e)(1)(A) and 6229(c)(2). The taxpayer argued that the temporary regulations were only entitled to Skidmore deference because the temporary regulations were interpretive regulations. The IRS disagreed. It argued that the Chevron two-step analysis was appropriate, and that if it was not, the National Muffler standard should apply in the alternative.38 In the majority opinion, Judge Wherry acknowledged that, although courts have held that Treasury Regulations are entitled to some deference, the appropriate level of deference remained an open question.39 Judge Wherry declined to reach this issue.40 He concluded that, even if the temporary regulations were entitled to Chevron deference, the temporary regulations might still be improper under Brand X. The temporary regulations attempted to overrule Colony, Inc. v. Commissioner,41 a fifty-year old Supreme Court decision directly on point. In applying the Chevron Step 1 Analysis, the Tax Court stated, "Chevron instructs us to employ traditional tools of statutory construction."42 The Tax Court reviewed Colony and determined that the Supreme Court had found that the predecessor statute was unambiguous in view of the legislative history.43 Therefore, according to Brand X, Treas. Reg. §§ 301.6501(e)-1T(b) and 301.6229(c)(2)-1T(b) were not entitled to judicial deference and were held to be invalid.44

 

C. Analysis of Mayo.

 

Until recently, it was unclear what level of deference applied in the context of Treasury Regulations. The Supreme Court finally addressed this issue in Mayo Foundation for Medical Education and Research Et Al. v. United States.45 In Mayo, the Supreme Court considered whether stipends paid to medical residents constituted "wages" within the meaning of the Federal Insurance Contributions Act ("FICA"). The issue was whether the medical residents were exempt from FICA taxes as students. In Mayo's residency programs, medical residents receive on the job clinical training. In many cases, medical residents spend 50 to 80 hours a week treating patients. Additionally, they took part in a formal education program.

In 2004, Treasury promulgated a regulation that clarified the meaning of the term "student" for purposes of applying the exemption. The regulations were enacted under the formal notice and comment procedure in APA § 553(b). The regulations provided guidelines for determining whether the educational aspect of the employment was predominant over the service aspect of employment. Specifically, the regulations set forth a bright line rule that the services of a full time employee are not incident to the purpose of pursuing a course of study.46 The employer's policies are relevant to determining whether an employee is full-time; however, the regulations provide that any employee working 40 hours a week or more will be treated as a full-time employee.47 The regulations clarify that the fact that performing services may have educational value will not affect the determination under the bright-line rule.

The District Court determined that the regulations were inconsistent with the unambiguous text of I.R.C. § 3121. The court applied the factors in National Muffler and determined that the regulation was invalid. The Eighth Circuit disagreed. It applied Chevron and determined that the statute was ambiguous on the issue of whether a medical resident constituted a "student" for purposes of FICA. It reviewed the regulation and determined that it was a reasonable interpretation of I.R.C. § 3121. The Supreme Court granted Mayo's petition for certiorari.

In Mayo, the IRS and taxpayer disagreed over the proper standard for evaluating a Treasury Regulation. The taxpayer argued that the Supreme Court should evaluate the Treasury Regulation under the National Muffler standard. The IRS counter-argued that the Chevron two-step framework superseded the multi-factor analysis in National Muffler. The Supreme Court specifically acknowledged that, "[s]ince deciding Chevron, we have cited both National Muffler and Chevron in our review of Treasury Department regulations . . . Although we have not thus far distinguished between National Muffler and Chevron, they call for different analyses of an ambiguous statute."48 Under National Muffler, a court will consider a number of factors in determining whether a regulation is valid, including: (i) whether the interpretation has been consistent over time; (ii) whether the regulation was promulgated contemporaneously with the statute; and (iii) the manner in which Treasury's interpretation evolved.49 In contrast, under Chevron, the interpretation of an ambiguous statute will only turn on whether Treasury's interpretation of the statute was reasonable.50 The Supreme Court stated that, in applying Chevron, the fact that a regulation was issued in response to litigation is immaterial.51 The Supreme Court determined that Treasury Regulations should not be treated differently from regulations issued by other administrative agencies.52

In Mayo, the Supreme Court rejected the argument that the less deferential National Muffler standard should apply because the Treasury Regulation was issued pursuant to the Treasury's general authority under I.R.C. § 7805(a).53 The Supreme Court stated,

 

We have held that Chevron deference is appropriate "when it appears that Congress delegated authority to the agency generally to make rules carrying the force of law, and that the agency interpretation claiming deference was promulgated in the exercise of that authority." [Citation omitted.] Our inquiry in that regard does not turn on whether Congress's delegation of authority was general or specific.

 

It acknowledged that courts distinguish between general and specific delegations of authority under Rowan Cos., but stated that administrative law had evolved significantly.54 It ruled that Chevron was the appropriate framework for assessing the Treasury Regulation.55 In making its determination, the Supreme Court emphasized that the Treasury Regulation at issue had only been issued after the formal notice and comment procedures.56 The Supreme Court ultimately held that the Treasury Regulation was a reasonable interpretation of the statute.57

Since the Mayo decision several circuit courts have addressed the applicability of Chevron to the IRS's regulations under §§ 6229 and 6501 on overstatement of basis as constituting a gross omission of income for purposes of the six year period of limitations. In Beard v. Commissioner58, the Court rejected the opinions of the Ninth Circuit in Bakersfield Energy Partners v. Commissioner59, and the Federal Circuit in Salman Ranch v. United States60 that under The Colony, Inc. v Commissioner61, a gross omission of income did not include an overstatement of basis. Although the Seventh Circuit held that it did not need to reach the issue of the validity of the regulations, it held that if it had to, it would find them valid under Chevron.

In Home Concrete & Supply v. United States62, and Burks v. United States63, the Courts held that the decision in Colony controls. Both Courts rejected the Government's argument that the Court should give deference to the regulations, which had become final, on the ground that the statute was unambiguous and that, therefore, the regulation was an impermissible interpretation of the statute.

II. ADMINISTRATIVE LAW IMPLICATIONS OF MAYO.

Mayo has significant administrative law implications. The decision clarifies that Treasury Regulations issued pursuant to Treasury's general authority under I.R.C. § 7805(a) will be accorded broad deference under the Chevron framework. Taxpayers and tax practitioners rely on Treasury to issue Treasury Regulations that add certainty to the tax system. Nevertheless, there is concern among tax practitioners that Treasury will abuse its discretion under Mayo and will (i) issue retroactive regulations that bolster its position in pending litigation; or (ii) issue regulations that overturn longstanding judicial precedent that is unfavorable to the IRS.

In Mayo, the Supreme Court makes it clear that there is nothing exceptional about tax law. Treasury Regulations should be subject to the same administrative law governing agency rulemaking. In determining that the Treasury Regulation was entitled to Chevron deference, the Supreme Court emphasized that the Treasury Regulation was intended to have the force and effect of law and that it had only been issued after the formal notice and comment process. There seems to be an expectation on the part of the Supreme Court that Treasury Regulations comply with the requirements in the APA. But, a review of Treasury's recent regulatory activity suggests that Treasury's level of compliance with the APA is inconsistent.64

Professor Kristin Hickman has studied Treasury's compliance with the APA extensively. She examined 232 regulatory projects from January 1, 2003 through December 31, 2005.65 APA § 553 requires that an agency first issue an NPRM with a proposed regulation. Then, after considering the public comment, the agency can issue a final regulation. Professor Hickman found that Treasury failed to follow this process in 40.9% of the regulatory projects surveyed.66 Treasury's typical pattern is to: (i) first, issue binding temporary regulations at the same time as it publishes a NPRM; and (ii) then, to consider public comments before it issues final regulations. In 92.7% of the regulatory projects, Treasury specifically claimed that APA § 553(b) was inapplicable.67 But, in 81.55% of the total projects, Treasury failed to identify the exemption upon which it was relying.68 According to Professor Hickman, the failure on the part of Treasury to comply with the strict requirements of the APA makes Treasury Regulations vulnerable to attack on procedural grounds.69

Based on the language in the IRM, it is reasonable to assume that Treasury is relying upon the exception for interpretive regulations when it issues temporary regulations. The issue is that the temporary regulations are treated as having binding effect on taxpayers. If a taxpayer fails to comply, she risks being liable for substantial penalties under I.R.C. § 6662. The fact that interpretive regulations are treated as binding on taxpayers is probably inconsistent with the intent of the APA.

Legislative rules have the force and effect of law while interpretive rules do not. Interpretive rules are the agency's interpretation of a statute and are not binding on the courts.70 Interpretive rules, which are not meant to have the force and effect of law, are, however, entitled to Skidmore deference.71 A number of factors are considered in determining whether a rule is legislative or interpretive, the principle one being whether formal notice and comment rulemaking procedures were followed.72 If the IRS claims that its regulations are exempt from notice and comment procedures because they are "interpretive," a court could refuse to apply Chevron deference.

Recently, in the IRS's Corrected Reply Brief in Intermountain Insurance Service of Vail, LLC v. Commissioner, it argued that Treas. Reg. §§ 301.6501(e)-1T(b) and 301.6229(c)(2)-1T(b) were interpretive regulations and, therefore, were exempt from the notice and comment procedures set forth in APA § 553. The IRS then proceeded to argue that, despite the fact that the regulations were interpretive, Treasury only finalized the regulations after putting them through the formal notice and comment process. Therefore, the IRS claimed that the Treasury Regulations should be entitled to Chevron deference in light of the Mayo decision. The IRS should not be able to have it both ways. If the regulations are intended to have the force and effect of law and are entitled to Chevron deference, then they should be enacted in accordance with the requirements in the APA. If the regulations are exempt from the APA because they are interpretive, they should be entitled to a lower level of deference under Skidmore. The fact that the IRS ultimately observes the notice and comment procedure in finalizing its interpretive regulations should not immunize the regulations.

Temporary regulations are allowed to remain in effect for up to three years before they are finalized.73 In many cases, temporary regulations impose significant tax and reporting burdens on taxpayers before they have an opportunity to comment. Outside of the formal notice and comment process, taxpayers have few avenues to challenge temporary regulations before enforcement. According to Professor Hickman, although APA § 704 creates a cause of action to challenge "final agency action," including final and temporary regulations, there are significant limitations on the ability of taxpayers to obtain pre-enforcement judicial review of Treasury Regulations.74 There are two types of post-enforcement litigation: (i) refund litigation in which the taxpayer has paid taxes and sues to recover the funds; and (ii) deficiency litigation in which the IRS has determined that the taxpayer owes additional taxes and penalties.75 In order to prevent unnecessary impediments to tax collection, I.R.C. § 7421 and the Declaratory Judgment Act limit the ability of taxpayers to challenge Treasury Regulations before enforcement. 76 In applying these sections, the Supreme Court has disallowed pre-enforcement review in those cases that involve issues that may potentially affect other taxpayers' tax liability.77 In addition to the statutory limits, judicial doctrines such as standing and ripeness also limit a taxpayer's ability to seek pre-enforcement judicial review.78 Moreover, even if a taxpayer can challenge a Treasury Regulation on procedural grounds, the costs of litigation are significant because taxpayers are required to exhaust administrative remedies before they can go to court. With regard to temporary regulations, there is a disincentive to challenge them on procedural grounds because it is highly likely that the Treasury will finalize the temporary regulations before the issue even arrives in court.79

Mayo applies in the context of Treasury Regulations. Mayo leaves open the question of the appropriate level of deference for Revenue Rulings, Revenue Procedures, private letter rulings and other IRS guidance. In U.S. v. Mead, the Supreme Court considered letter rulings issued by Customs. The Supreme Court determined that the Skidmore standard was appropriate because the letter rulings were too fact specific to be entitled to broad deference under Chevron.80

III. PROPOSALS.

The Mayo decision confirms that courts will accord broad deference to Treasury Regulations. Treasury has a responsibility to ensure that its regulations are in compliance with the APA. In the past, many practitioners have accepted the proposition that Treasury Regulations are exempt from APA § 553.81 But, in the wake of Mayo, more practitioners may consider challenging regulations on procedural grounds. There is nothing to suggest that Treasury's failure to comply with the APA is intentional.82 Government attorneys often consult the IRM in drafting Treasury Regulations. The IRM guidelines are outdated and should be amended to reflect current developments in administrative law.

First, Treasury should rethink its position that most of the regulations it issues are interpretive regulations.83 This may have been true when general authority regulations (i.e. regulations issued pursuant to the general grant of authority under I.R.C. § 7805(a)) were not treated as binding, but this is not the case anymore. There is a widespread understanding that Treasury Regulations are binding on the government and taxpayers alike regardless of whether they are issued pursuant to specific or general authority. In fact, taxpayers risk being subject to substantial penalties under I.R.C. § 6662 if they take positions that are inconsistent with Treasury Regulations. Because most Treasury Regulations are legislative in nature, Treasury should consistently follow the APA's notice and comment procedure to ensure that its regulations are not vulnerable to procedural challenges.

Second, Treasury should only issue temporary regulations after following the notice and comment procedures. In its Corrected Reply Brief in Intermountain Insurance Service of Vail, LLC v. Commissioner, the IRS argued that the temporary regulations were finalized according to the notice and comment procedure. But, the fact that Treasury ultimately observes the notice and comment procedures before finalizing a Treasury Regulation should not immunize it from procedural challenge. I.R.C. § 7805(b) creates a retroactivity issue because the effective date of a final regulation can relate back to the date of the proposed and temporary regulations. There is no indication in the statute that Congress intended for temporary regulations to be exempt from the APA. In order to ensure that Treasury Regulations withstand procedural challenges, Treasury should take the following steps: (i) issue an NPRM and have an initial comment period; (ii) issue temporary and proposed regulations; and (iii) before the regulation is finalized, hold further hearings and solicit further comments. Treasury officials may argue that the proposed procedure is inefficient; however, Treasury is already engaging in the notice and comment procedure before it finalizes Treasury Regulations. Notice and comment should occur earlier in the process rather than later to ensure that the taxpayers most affected by a regulatory project are allowed to participate in the process before a temporary regulation takes effect. Temporary regulations have a significant effect on the economy and behavior of individuals and businesses. It is possible that the suggested procedure may actually be more efficient than Treasury's current practice. By engaging in notice and comment procedures before issuing binding temporary regulations, Treasury can address issues early rather than issuing several versions of the regulations. This will reduce the burden on taxpayers who are expected to conform their conduct to the Treasury Regulations.84

Third, there may be some instances where immediate guidance is necessary. If Treasury determines that it will be overly burdensome to follow the notice and comment procedure, the good cause exception under APA § 553(b) may be available. In order to rely on this exception, Treasury must be able to show that the notice and comment procedure is "impracticable, unnecessary or contrary to public interest." Treasury should amend the IRM to require that it set forth an explicit statement of its basis for relying on the good cause exception. The good cause exception was meant to apply in limited circumstances. But, it may be appropriate where Treasury needs to respond to emergency situations or correct typographical errors.85 Treasury may also be able to rely on the good cause exception when it issues temporary regulations to curb abusive tax shelters.86 Specifically, the Treasury may be able to argue that by giving advance notice, taxpayers may have an incentive to complete tax shelter transactions before the effective date of the temporary regulations.87

Fourth, Treasury should be required to provide a concise statement explaining its rationale for adopting a regulation. Such a statement will facilitate judicial review. In Mayo, the Supreme Court referred to Treasury's rationale for enacting a bright-line full time employee rule when it determined that the Treasury Regulation was a reasonable interpretation of the statute.88 Moreover, in the dissenting opinion in Mannella v. Commissioner, Judge Ambro stated that he would have held the Treasury Regulation invalid because of the failure on the part of Treasury to give a rationale for the two-year limitation period on innocent spouse claims under I.R.C. § 6015(f).89 Judge Ambro states,

 

It is well-established that an agency's action must be upheld, if at all, on the basis articulated by the agency itself. [Citation omitted.] Here, however, the IRS has not advanced any reasoning for its decision to impose a two-year limitations period on taxpayers seeking relief under [I.R.C. § 6015(f)], leaving us no basis to conduct the analysis mandated by Chevron step two. There may exist justifications on which the IRS could have reasonably relied in order to impose a two-year limit on [I.R.C. § 6015(f)] relief. The problem is that there are also arbitrary and capricious reasons that, if articulated by the Service as the basis for the two-year limit, would require us to strike down the limit-for example, if the IRS enacted a two-year deadline on the incorrect belief that the statute required it, or based on a factual supposition belied by the administrative record.

 

To facilitate judicial review, the Treasury should clearly set forth its rationale for adopting a rule in the preamble.

Finally, revenue rulings and revenue procedures should be entitled to a lower level of deference under Skidmore. This would be consistent with U.S. v. Mead in which the Supreme Court held that rulings issued by Customs were too specific to apply heightened deference under Chevron.

IV. CONCLUSION.

Mayo confirms that Treasury Regulations will be accorded broad deference under the Chevron framework. It is difficult to predict how courts will apply Mayo, but it is clear that the decision will have significant administrative law implications. Treasury has a poor record of complying with the strict requirements for rulemaking under the APA. The IRM should be amended so that Treasury can ensure that its Treasury Regulations are not vulnerable to procedural challenges.

 

FOOTNOTES

 

 

1 The comments contained in this paper are the individual views of the authors who prepared them, and do not represent the position of the State Bar of California or the Los Angeles County Bar Association.

2 Although the participants on the project might have clients affected by the rules applicable to the subject matter of this paper and have advised such clients on applicable law, no such participant has been engaged by a client to participate in this project.

3 562 U.S. ____ (2011).

4 5 U.S.C. § 553(b).

5 5 U.S.C. § 553(c).

6 5 U.S.C. § 553(d).

7 5. U.S.C. § 553(d).

8 5 U.S.C. § 553(b).

9 Unless otherwise indicated, all references to the Internal Revenue Code are to the Internal Revenue Code of 1986, as amended.

10 See, for eg., I.R.C. §§ 469 or 1502.

11 Hickman, Kristen E., "Coloring the Outside of the Lines: Examining the Treasury's (Lack of) Compliance with Administrative Procedure Act Rulemaking Requirements.", 82 Notre Dame L. Rev. 1727, 1736 (June 2007).

12Id. at 1795.

13Id. at 1798.

14Id.

15 IRM 32.1.2.3(3).

16Id.

17 IRM 32.1.5.4.7.1.

18Id.

19 I.R.C. § 7805(e)(2).

20 Hickman, Kristin E. "Coloring Outside the Lines: Examining the Treasury's (Lack of) Compliance with Administrative Procedure Act Rulemaking Requirements." 82 Notre Dame L. Rev. 1727, 1760 (June 2007); Hickman, Kristin E. "A Problem of Remedy: Responding to the Treasury's (Lack of) Compliance with Administrative Procedure Act Rulemaking Requirements." 76 George Washington L. Rev. 1153 (August 2008).

21Id.

22 IRM 32.1.2.3(3)

23 452 U.S. 247, 253 (1981).

24 See, for eg., City of Tucson v. Comm'r, 820 F.2d 1283 (Fed. Cir. 1987) (Court held that Treasury had exceeded its delegated authority by ascribing an unreasonably broad meaning to the term "replace" in I.R.C. § 103(c)(2)(B).)

25 323 U.S. 134, 139-140 (1944).

26 440 U.S. 472, 477 (1979).

27Id.

28 467 U.S. 837 (1984).

29Id. at 842-843.

30 545 U.S. 967 (2005).

31 545 U.S. at 982.

32Id. at 983.

33 499 U.S. 554, 560-561 (1991).

34Id.

35Id.

36Id.

37 134 T.C. No. 11.

38Id.

39Id.

40Id.

41 357 U.S. 28 (1958).

42Id.

43Id.

44Id.

45 562 U.S. ___ (2011).

46 Treas. Reg. § 31.3121(b)(10)-2(d)(3)(iii).

47Id.

48 562 U.S. ____ (2011). The Supreme Court cites a number of examples in which it failed to distinguish between Chevron and National Muffler. See, for eg., United States v. Cleveland Indians Baseball Co., 532 U.S. 200, 219 (citing National Muffler); Cottage Savings Assn. v. Comm'r, 499 U.S. 554, 560-561 (1991) (citing National Muffler); U.S. v. Boyle, 469 U.S. 241, 246 (1985) (citing Chevron); and Atlantic Mutual Insurance Co. v. Comm'r, 523 U.S. 382, 387, 389 (1998) (citing Chevron and Cottage Savings).

49Id.

50Id.

51Id.

52Id.

53Id.

54Id.

55Id.

56Id.

57Id.

58 ___ F.3d ___, 2011 U.S. App. LEXIS 222249 (7th Cir. 2011).

59 568 F.3d 767 (9th Cir. 2009).

60 573 F.3d 1362 (Fed. Cir. 2009).

61 357 U.S. 28 (1958).

62 ___ F.3d___, 2011 U.S. App. LEXIS 2334 (4th Cir. 2011).

63 ___ F.3d ___, 2011 U.S. App. LEXIS 2417 (5th Cir. 2011).

64 Hickman, Kristin E. "Coloring Outside the Lines: Examining the Treasury's (Lack of) Compliance with Administrative Procedure Act Rulemaking Requirements." 82 Notre Dame L. Rev. 1727, 1760 (June 2007).

65Id. at 1740.

66Id. at 1748.

67Id. at 1749.

68Id.

69 A "failure to comply with the APA requirements of prior notice and comment would invalidate" a regulation. Western Oil & Gas Ass'n v. EPA, 633 F.2d 803 (9th Cir. 1985); see also Paulsen v. Daniels, 413 F.3d 99, 1008 (9th Cir. 2005) (noting that a rule issued in violation of the APA is normally invalid).

70 See Dia Navigation v. Pomery, 34 F.3d 1255, 1263 (3d Cir. 1994).

71United States v. Mead Corp., 533 U.S. 218, 234-235 (2001).

72Id. at 228-232.

73 I.R.C. § 7805(e).

74 Hickman, Kristin E. "A Problem of Remedy: Responding to the Treasury's (Lack of) Compliance with Administrative Procedure Act Rulemaking Requirements." 76 George Washington L. Rev. 1153, 1162 (August 2008).

75Id. at 1164.

76Id. at 1165.

77Id. at 1168.

78Id. at 1174.

79Id. at 1190.

80 533 U.S. 218, 234-235 (2001).

81 Hickman, Kristin E. "Coloring Outside the Lines: Examining the Treasury's (Lack of) Compliance with Administrative Procedure Act Rulemaking Requirements." 82 Notre Dame L. Rev. 1727, 1800 (June 2007).

82Id. at 1798.

83Id. at

84Id. at 1804.

85Id. at 1782.

86Id. at 1785.

87Id.

88 562 U.S. ____ (2011).

89 US App. LEXIS 1182 (3d. Cir. 2011).

 

END OF FOOTNOTES
DOCUMENT ATTRIBUTES
  • Authors
    Horwitz, Robert S.
    Hopley, Courtney A.
  • Institutional Authors
    State Bar of California
    Taxation Section
    Procedure & Litigation Committee
  • Cross-Reference
    For Mayo Foundation for Medical Education and Research v. United

    States, No. 09-837 (U.S. Sup. Ct. Jan. 11, 2011), see Doc

    2011-609 or 2011 TNT 8-10 2011 TNT 8-10: Court Opinions.
  • Code Sections
  • Subject Area/Tax Topics
  • Jurisdictions
  • Language
    English
  • Tax Analysts Document Number
    Doc 2011-12386
  • Tax Analysts Electronic Citation
    2011 TNT 111-31
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