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DC Circuit Criticizes Government in Case Alleging an Israel Special Policy for Tax Exemptions

Posted on June 5, 2015

On my list of tax procedure things to do was to listen to last month’s oral argument in the DC Circuit Court of Appeals case of Z Street v Koskinen. Longtime readers of the blog with a good memory may recall Stephen discussing the case last year in a Sum Op. The case involves the government’s appeal of a district court decision involving allegations that the IRS subjected an organization seeking 501(c)(3) status to special scrutiny. In particular, Z Street argued that the IRS scrutiny violated the First Amendment because IRS had an internal review policy that subjected Israel-related organizations “to more rigorous review procedures than other organizations applying for that same status.” According to the complaint, an IRS agent told Z Street counsel that organizations whose policies differed from the Obama administration on Israel were “being sent to a special unit in the D.C. office to determine whether the organization’s activities contradict the Administration’s public policies.”

Viewpoint discrimination like that alleged raises serious constitutional issues. DOJ argued below that the court should not hear the case because the Anti-Injunction Act denied the district court jurisdiction to hear the case. Organizations with a beef about the exemption process, according to the government, should make their arguments in refund or deficiency cases, or in cases authorized under Section 7428 allowing for declaratory judgments relating to an organization’s qualifications for tax exempt status.

The District Court denied the government’s motion to dismiss; the government appealed. The case revolves around the reach of the Anti-Injunction Act, which holds that “no suit for the purpose of restraining the assessment or collection of any tax shall be maintained in any court by any person, whether or not such person is the person against whom such tax was assessed.”

In Z Street the government essentially argued that the lawsuit related to the assessment or collection of tax, thus squarely precluded by the AIA. Taking a broad view of the AIA, the government suggested both below and in last month’s argument that lawsuits that may have an impact on assessment or collection should be barred, especially if the suit arises prior to the time that there has been an assessment. The district court rejected that approach in a well-reasoned opinion, emphasizing that Z Street was not seeking a determination on its tax-exempt status, but was seeking relief from allegedly constitutionally infirm practices:

In other words, Z Street’s ultimate tax liability will be a function of whether it qualifies for tax-favored treatment under the criteria laid out in Section 501(c)(3), not whether it prevails in this lawsuit, and the IRS’s analysis of its qualifications will be based on Z Street’s activities as an organization. The only matter at issue in the instant lawsuit is whether, in addition to evaluating Z Street’s activities as it would any other organization’s, the IRS may constitutionally apply a more stringent standard of review that is allegedly reserved for organizations whose activities relate to the promotion of Israel.

What about the government’s chances on appeal? Using the AIA as a bar to review of allegedly constitutionally suspect practices did not sit well with the panel last month. The Wall Street Journal hit the nail on the head in its brief write up of the Z Street oral argument where it noted how Judge Sentelle criticized the government for essentially mischaracterizing the relief Z Street sought:

They are not in court seeking to restrain the assessment or collection of a tax, they are in court seeking a constitutionally fair process.

The argument itself is at some levels entertaining for the reason that the judges each come up with differing ways of expressing their incredulity and displeasure with the government’s position in the case. Most of the criticism centered around that Z Street was not seeking a remedy that went to its tax status but instead looked to expose and prohibit conduct that if true undoubtedly raised serious issues. If the case did not involve such serious allegations I might have found the argument, and the government attorney’s on the ropes responses, more entertaining. Yet the charges are serious, and allegations of that sort of agency and executive branch misconduct go to the very heart of the tax system’s integrity. Allowing the case to proceed gives the taxpayer the right to get to the merits. When the allegations are as serious as this I would have thought that the government would not hide behind a weak AIA argument.

As a technical matter, in the last few years have been a few cases where courts have rejected the government’s argument for an expansive read of the AIA, including the DC Circuit’s en banc opinion in Cohen and the Supreme Court last month in Direct Marketing, an analogous case under the Tax Injunction Act (I might add that the DOJ lawyer was admonished during the oral argument for the government’s only citing to Direct Marketing in a footnote in its reply brief). For readers wanting more on the technical AIA issues, I recommend the district court Z Street opinion itself and the excellent guest post by Patrick Smith on the Direct Marketing case. The trend in these cases is for a more restrained reading of the reach of the AIA, and while one can make a straight-faced argument that most every suit involving the IRS connects in some way to assessment or collection, some cases (like Z Street) are too attenuated from tax assessment or collection to warrant a dismissal.

One reason (among many) for IRS’s unpopularity is that for many years a significant amount of its actions escaped judicial review. As IRS has increased responsibility beyond its paramount mission of collecting revenues, the historical reasons for the discretion IRS has exercised have lessened. Yet there are still strong reasons to be wary of an unfettered right to review of all of the agency’s decisions. IRS has long been able to use the broad reach of the Anti-Injunction Act and Declaratory Judgment Act to avoid having many of it its actions brought before a court in the absence of a specific statutory right to such review. Nonetheless, in cases such as Z Street I find it hard to square my support of some exceptional agency protections. While it is sometimes hard to gauge a court’s likely decision on the oral argument alone I would be shocked if the DC Circuit does not find in favor of Z Street on the issue of whether the suit should proceed to the merits. Stay tuned for more cracks in the government’s AIA defense, and in years to come a renewed judicial focus on where the courts will draw the line on suits challenging IRS actions.

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