The relationship between administrative law principles and tax procedure is one that the courts are increasingly addressing. We have written before about the reach of administrative law principles as applied to Tax Court cases. For example we ran an excellent two-part post by Stephanie Hoffer and Chris Walker that pivots off their Minnesota Law Review article The Death of Tax Court Exceptionalism. More recently, I discussed a Tax Court order in the case Illinois Tool Works v Commissioner in Tax Court Order Rejects APA Claim That IRS Precluded from Asserting Penalty in Answer. In that post, I discussed how the Tax Court rejected the taxpayer’s argument that under the APA the IRS’s failure to assert a penalty in its notice of deficiency meant that IRS was barred from asserting a penalty in pleadings.
Yesterday the Tax Court held in Ax v Commissioner that the APA and general administrative principles embedded in the SEC v Chenery Supreme Court decisions of the mid-1940’s do not prevent the IRS from filing leave to amend its answer to raise grounds for a deficiency that were not raised in the original notice of deficiency. The Ax case is a regular division opinion and has a fuller discussion of the principles the Tax Court discussed in Illinois Tool Works and in other opinions as well. It also is noteworthy in that it has some harsh language for the taxpayer’s argument, referring to it as a “distortion” of Mayo, the APA and Chenery.
I will briefly describe the case below.
Ax involves an IRS examination that resulted in disallowed insurance expenses that flowed through from the taxpayers/shareholders’ interests in S-Corporations that paid over a million dollars in insurance premiums annually over two years to captive insurance companies. The initial notice of deficiency disallowed the deductions and relied on one theory, that the amount paid was not an insurance expense. The taxpayer timely petitioned, with the IRS timely filing an answer that generally denied the petition’s allegations. About 8 months after filing its original answer, IRS then filed leave to amend the answer and raise new grounds, that the transaction lacked economic substance and alternatively that the expenses were not ordinary or necessary. The taxpayer opposed the motion, essentially arguing that Chenery and the APA mandate limiting the Service to the positions in the stat notice.
I discussed Chenery in my post last year, noting that “SEC v Chenery generally stands for the proposition that the courts are not supposed to allow agencies to argue a new reason for their determination, or justify agency actions based upon arguments or issues that were not properly made below.”
Here is how the taxpayer used Chenery in its argument:
Chenery mandates “the orderly functioning of the process of review requires that the grounds upon which the administrative agency acted [be] clearly disclosed and adequately sustained. ‘The administrative process will best be vindicated by clarity in its exercise.’” Chenery Corp., 318 U.S. at 94, quoting Phelps Dodge Corp. v. National Labor Relations Board, 313 U.S. 177, 197 (1941). Also, “[t]he grounds upon which an administrative order must be judged are those upon which the record discloses that its action was based.” Id. at 87. Therefore, Respondent cannot add post-hoc grounds to support the final agency action in the notice of deficiency.
The Tax Court disagreed, noting that all of the above is accurate with the exception of the last sentence:
However, petitioners’ “Therefore” does not at all follow, because they have erred in selectively extracting statements from Chenery I. That case does not apply to all agency action that is subject to judicial review. Instead, the [Chenery] opinion plainly states:
“If an order is valid only as a determination of policy or judgment which the agency alone is authorized to make and which it has not made, a judicial judgment cannot be made to do service for an administrative judgment. For purposes of affirming no less than reversing its orders, an appellate court cannot intrude upon the domain which Congress has exclusively entrusted to an administrative agency.” [citation omitted; emphasis in original.]
Ax discusses numerous Code provisions that suggest Chenery has no place in limiting the IRS to arguments made in the notice itself:
- Section 7491, the burden shift rules, suggesting “Congress’s intention that the Tax Court will decide deficiency cases not by reviewing the agency’s determinations for abuses of discretion but by deciding issues according to the evidence”);
- Section 7522(a), discussing adequacy of a notice of deficiency, which states that inadequacy of the notice does not invalidate it;
- 6512, which provides that Tax Court can decide an overpayment and how a deficiency case can be expanded in taxpayer’s favor; and
- 6213, which says that the Tax Court “redetermines” a deficiency and the IRS below “determines” a deficiency.
In light of the above, the Court concluded that the “Internal Revenue Code thus reflects Congress’s intention that the Tax Court will decide deficiency cases not by reviewing the agency’s determinations for abuses of discretion but by deciding issues according to the evidence. Consequently, the Chenery I principle simply has no application to this deficiency case.”
The taxpayers then served up their APA argument. Essentially, it argued that
[t]he APA separately imposes upon the reviewing court, in mandatory terms, the obligation “to hold unlawful and set aside any agency action, finding[s], and conclusion[s] found to be … unwarranted by the facts to the extent the facts are subject to trial de novo by the reviewing Court.” 5 U.S.C. § 706(2)(f). Here too, the Petition contends that the findings and conclusions in the Notice are unwarranted by the facts.
Tying this up, Ax argued that the Tax Court was limited to review the IRS actions findings and conclusion below. The Tax Court disagreed, pointing to how Ax ignored the context and other specific provisions the APA , such as venue, codified at 5 USC 703:
The form of proceeding for judicial review is the special statutory review proceeding relevant to the subject matter in a court specified by statute or, in the absence or inadequacy thereof, any applicable form of legal action, including actions for declaratory judgments or writs of prohibitory or mandatory injunction or habeas corpus, in a court of competent jurisdiction. If no special statutory review proceeding is applicable, the action for judicial review may be brought against the United States, the agency by its official title, or the appropriate officer. Except to the extent that prior, adequate, and exclusive opportunity for judicial review is provided by law, agency action is subject to judicial review in civil or criminal proceedings for judicial enforcement. [Emphasis in original.]
The Tax Court then found that its deficiency proceedings, which were in existence prior to the APA, superseded any limitations that the APA’s judicial review provisions imposed:
A deficiency case is one such “special statutory review proceeding”, and the Tax Court is the “court specified by statute”. Before the APA, “prior, adequate, and exclusive opportunity for judicial review” of a notice of deficiency was provided in the predecessor statutes to section 6213(a)–i.e., in section 272(a)(1) of the Internal Revenue Code of 1939, as in effect when the APA was enacted in 1946. By its terms, then, 5 U.S.C. sec. 704 thus left undisturbed the deficiency case regime described above…
I deleted the footnotes in the block quote above but notes 6 and 7 in the opinion also hit the point home that the APA did not come in on a blank slate, discussing both 5 USC 702 (which states that the APA is not meant to allow a court to “deny relief on any other appropriate legal or equitable ground”) and 5 USC 704 (essentially that the APA allows for court review when there is no other adequate remedy available). With respect to these, the opinion notes that the deficiency proceedings are an adequate legal remedy and that the APA is not meant to limit what the Tax Court had the statutory power to deny a taxpayer relief on appropriate legal or equitable grounds.
This this is a regular division opinion and that it has a detailed discussion of the APA as it is applied to Tax Court deficiency proceedings makes Ax significant. The Tax Court is surely correct in its conclusion. Yet, there is some loose language in the opinion, including a reference and citation to language in the O’Dwyer Fourth Circuit case from 1949 which stated that the Tax Court was not subject to the APA. As Professors Walker and Hoffer explained in their post here last year
This approach [the Tax Court’s view that it is not governed at all by the APA] contradicts general administrative law principles that every other federal court applies when reviewing agency actions. As we explain in Part II of our paper, the APA establishes the default standards for judicial review of all federal agency action. The IRS, an executive agency within the Treasury Department, is plainly an “agency” for purposes of the APA (5 U.S.C. § 701(b)(1)). And while the Tax Court used to be an agency before the enactment of the APA, as of 1969 it is an “[A]rticle I . . . court of record” (26 U.S.C. § 7441). For purposes of the APA, it is thus “a court of the United States” (5 U.S.C. § 702) and, for its review of IRS agency actions, a “reviewing court” subject to the APA’s judicial-review provisions (5 U.S.C. § 706).
The Ax opinion makes a forceful case that Congress has overridden the APA standard in deficiency cases. Yet some language in the opinion goes beyond the notion of overriding and still leaves perhaps for another day the application of these principles in other non-deficiency contexts. Administrative law principles are notoriously muddy. With Tax Court’s jurisdiction now including many types of cases beyond the traditional deficiency cases, I believe that courts will be wrestling with these issues in many more contexts. Those other cases are much more difficult from a policy and legal perspective. Stay tuned.
For a follow-up post on Ax by Professors Christopher Walker and Stephanie Hoffer, see here.