One of the issues we have looked at from time to time is the relationship of the Administrative Procedure Act (APA) to procedures embedded in the Internal Revenue Code. It is an issue we are currently working on as we finish the rewrite of Chapter 1 in Saltzman and Book, which among other topics addresses the relationship of the APA to certain IRS administrative procedures that generally fall under the broad administrative law category of informal adjudications (recall that agencies perform two broad functions in the administrative state: adjudicating and rulemaking). That relationship is complex, in part because when you mix the murkiness of administrative law with the labyrinth of tax procedure you wind up often with head scratching questions without any clear answers.
I came across an order from late December 2014 in the case of Illinois Tool Works v Commissioner that involved an interesting APA issue. Illinois Tool Works argued 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. Judge Lauber took the APA-issue head on in an order denying Illinois Tool Works’ motion to strike the pleadings.
In this post, I will briefly describe the facts, Illinois Tool Works’ argument, and Judge Lauber’s approach to the issue.
The order lays out the facts:
In a notice of deficiency dated February 11, 2014, the IRS determined a deficiency of $70,174,594 for the 2006 taxable year. This deficiency is attributable to respondent’s determination that a transfer of funds to petitioner from a foreign subsidiary constituted a taxable dividend. The notice of deficiency did not assert a penalty under section 6662(d).
Petitioner timely petitioned this Court, contending that the transfer of funds in question constituted a nontaxable return of capital. Respondent filed his answer on July11, 2014. In paragraphs 3 and 7 of the answer, respondent alleges that, “pursuant to the provisions of I.R.C. § 6214(a), an increased amount [is] due from [p]etitioner, on the grounds that petitioner is liable for the accuracy-related penalty under I.R.C. § 6662(a) for the 2006 tax year in the amount of $14,034,919.”
In response to the answer Illinois Tool Works moved to strike the paragraphs asserting the 20% accuracy-related penalty. In its motion to strike it noted that neither exam or Appeals proposed to assert the penalty with respect to that issue, though exam proposed the penalty with respect to an issue that was resolved.
In support of its motion, Illinois Tool Works looked to administrative law principles:
Citing the Administrative Procedure Act (APA) and Mayo Found. for Med. Educ. & Research v. United States, 562 U.S. 44 (2011), petitioner argues that the assertion of a penalty for the first time in an answer is impermissible as a matter of law because such assertion would be inconsistent with what petitioner describes as a prior “determination” by respondent not to assert that penalty. As such, the delayed assertion of the penalty would supposedly be analogous to a disfavored “post hoc rationalization” by the agency. M Motor Vehicle Mfrs. Ass’n v. State Farm Mut. Auto. Ins. Co., 463 U.S. 29, 50 (1983); SEC v. Chenery, 332 U.S. 194, 196 (1947).
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.
The Chenery issue has been popping up in a number of Tax Court matters. Steve mentioned it last year in a Sum Op discussing a Judge Holmes order in Renka v Commissioner; I discussed it in a post last year considering Bergdale v Commissioner, which involved a CDP case where the taxpayer argued that under Chenery the IRS should not be allowed to argue that the determination should be sustained on the basis that the taxpayer failed to submit a Form 656 because that was a new legal theory not made in the CDP determination.
In my Bergdale post, I referred readers to Professor Steve Johnson’s outstanding 2014 article Reasoned Explanation and IRS Adjudication. One of the points Professor Johnson makes (page 1773) is that while it is clear that administrative law principles apply to tax, “administrative law is about nuance, and it must be adapted to the issues, agencies, and circumstances of the particular situation at hand. (citing to the 2004 Supreme Court case of Hamdi v. Rumsfeld where the Court emphasized the importance of context in applying administrative law to military proceedings).
The point Johnson makes is that yes we are in a post-Mayo world where there is no question that tax lawyers ignore administrative law principles at their own peril. But tax procedure is also nuanced, and there are many differing kinds of determinations that IRS makes. Context matters.
I point readers to the article at around page 1823 where he discusses the legal issues surrounding the application of the APA and general administrative principles to deficiency proceedings. I think Professor Johnson sensibly concludes both on policy and legal grounds that the reasoned explanation requirement (and by extension Chenery) should not apply to deficiency determinations. Other determinations (such as CDP cases) involve differing contexts, and the legal and policy justification for applying general administrative law principles or particular provisions under the APA may be much stronger as I have argued in Tax Notes in an earlier article CDP and Collections: Perceptions and Misperceptions [free link not available] criticizing the Tax Court’s conclusion in Robinette that certain provisions of the APA did not apply to CDP proceedings.
The Order’s Resolution of the Matter
Judge Lauber resolves the issue in large part by looking at how the context of the situation does not support precluding the IRS from asserting the penalty in its pleadings.
First he notes that Tax Court Rule 52 provides that the Court may strike any pleading that is insufficient or frivolous. As the Order describes, the Tax Court “does not favor motions to strike pleadings.”
He then goes on to consider how the Chenery argument “clearly proves too much.”
Our Rules explicitly permit respondent to assert an increased deficiency or “new matter” in his answer, Tax Court Rule 142(a), and Congress has specifically granted this Court jurisdiction to hear such claims. Section 6214(a) provides the Court with jurisdiction to redetermine a deficiency greater than that set forth in the notice of deficiency, “and to determine whether any additional amount, or any addition to the tax should be assessed, if claim therefor is asserted by the Secretary at or before the hearing or rehearing.” On petitioner’s theory, such a determination would be impermissible because it would be inconsistent with a supposed prior “determination” by respondent– embodied in the notice of deficiency–that a smaller deficiency was correct or that the new matter should not be asserted. That is clearly not the law. In this and in other respects, the specific procedures that Congress has ordained for this Court in the Internal Revenue Code may differ from the more general rules embodied in the APA.
We are in the early phases of determining how some administrative law principles and parts of the APA apply to IRS determinations. We will see other creative arguments where taxpayers seek to use general administrative law principles to determinations. While Mayo has heralded in a new phase in opening the door in tax cases to those principles, the hard work is just beginning as we struggle to see how and whether those principles will influence the varied types of IRS’s adjudicative determinations.
Judge Lauber’s approach in a case involving a possible penalty imposition in a deficiency case sensibly resolves the matter, as the context here would make applying Chenery in the way Illiniois Tool Works’ argued inconsistent with the specific approach that Congress and the Court have long applied. I am sure, however, that the Tax Court and circuit courts will have much more to say about applying the APA and general administrative law principles.