In this post, Michael Desmond of the Law Offices of Michael J. Desmond discusses recent judicial developments highlighting limits on IRS and Treasury’s authority under Circular 230 to regulate aspects of practitioner conduct. The post explains the connection between the IRS’s efforts to use Circular 230 in a more muscular way and its lack of resources. The post comes on the heels of a panel presentation at the ABA Tax Section this past month in Denver where Mike, Stuart Bassin and Professor Steve Johnson appeared on a panel of the Standards of Tax Practice Committee. Les
This is a reposting of this article because something in our software prevented the article from going out on Wednesday. The article is super and we wanted to make sure that all of our email subscribers got it in addition to those coming to the website. Keith
In 1984, the Treasury Department and the Internal Revenue Service (“Service”) first amended Circular 230 to target practice standards on “tax shelter” transactions. Since then, Circular 230 has been amended on a number of occasions. Many of these amendments have refined the focus of Circular 230 on new generations of aggressive tax planning through, for example, the much-maligned and now repealed “covered opinion” rules in former section 10.35. Other amendments have addressed more mundane aspects of practitioner conduct ranging from the fees that can be charged to a practitioner’s ability to endorse refund checks and the failure by a practitioner to file a client’s tax return electronically. A common theme reflected in these changes is the use of Circular 230 as a tool to improve compliance, as distinguished from the more general role of fostering good practice standards.
The 30-year evolution of Circular 230 and, more broadly, the Service’s effort to use Circular 230 as a tool to improve compliance, has recently been called into question. The D.C. Circuit’s opinion earlier this year in Loving v. IRS, 742 F.3d 1013 (D.C. Cir. 2014) was the first shoe to drop. Loving has been discussed extensively in recent months and is noteworthy not only for the fact that it upheld the District Court’s order enjoining the Service from implementing key components of its highly publicized and far reaching return preparer initiative, but also because it marked the reversal of a prior leaning in the courts to uphold the Service’s authority to regulate a broad range of conduct under Circular 230. While Loving raises fundamental questions about what role Circular 230 will play in the Service’s enforcement toolbox going forward, it also highlights shortcomings with other tools in that box, which may be the better place to focus going forward.
Legal Challenges to Service’s Authority to Regulate Practice
Prior to Loving there had been only a handful of court challenges to the scope of the Service’s authority to regulate “practice” under 31 U.S.C. § 330. In Tinkoff v. Campbell, 158 F.2d 855 (7th Cir. 1946), the appellant was a disbarred attorney who moved into the business of “advising taxpayers in filling out income tax returns.” Enforcing the limited practice rules under Circular 230 (currently found in section 10.7(c)), the Service prohibited the appellant from representing taxpayers in a non-legal capacity, “explaining adjustments and computations in their returns” and “accompanying them upon interviews” in connection with an audit of their return. The Seventh Circuit had little trouble dismissing the appellant’s constitutional challenge to the Service’s authority to regulate his return preparation “practice” under Circular 230: “We find no merit whatsoever in any of the contentions raised by appellant and are fully in accord with the District Court in dismissing the petition for injunction.” Id. at 856.
Sixty years later, in Wright v. Everson, 543 F.3d 649 (11th Cir. 2008), the Eleventh Circuit rejected a challenge to the Service’s refusal to allow, under Circular 230, an “unenrolled” return preparer to represent taxpayers through use of an IRS Form 2848 Power of Attorney. In Wright, the court framed the issue as whether the practice limits applicable to unenrolled preparers were “arbitrary, capricious, or manifestly contrary to statute” (a Chevron “Step Two” inquiry), without questioning the Service’s threshold ability to regulate “practice” under 31 U.S.C. § 330 or the scope of its authority under that statute. The Eleventh Circuit in Brannen v. United States, 682 F.3d 1316 (11th Cir. 2012) similarly had little trouble finding authority for the Service to require return preparers to obtain registration numbers, distinguishing what was then the district court’s holding in Loving by citing the specific statutory authority under Code section 6109 for requiring preparer identification numbers. Tinkoff, Wright and Brennen were not cited by the D.C. Circuit in Loving. While not involving the Administrative Procedure Act arguments at issue in Loving, the trend seen in those prior cases to uphold the Service’s broad authority to act under 31 U.S.C. § 330 was nonetheless reversed.
The Service did not seek en banc review or certiorari from the Supreme Court in Loving. Rather, the Service indicated that it would follow the Court’s holding narrowly and not apply its interpretation of the terms “practice” and “representatives” in 31 U.S.C. § 330 to other aspects of Circular 230. In other words, while Loving may have enjoined the Service from mandating testing and continuing education for paid return preparers, its holding would not be applied to other provisions of Circular 230 that also purport to regulate conduct not involving direct interaction with the Service.
The Service’s effort to limit Loving lasted less than six months. In July 2014, the U.S. District Court for the District of Columbia issued its decision in Ridgely v. Lew, 2014 U.S. Dist. LEXIS 96447 (D.D.C. July 16, 2014), enjoining the Service from enforcing the limitation on a practitioner’s ability to charge a contingent fee for “ordinary refund claims” in Circular 230 section 10.27. In doing so, the court rejected the government’s effort to distinguish Loving on the basis that the plaintiff was a practicing CPA who, at some point in his career, had had direct interaction with the Service even if not in connection with the contingent fee arrangements at issue. The Service has long relied on (and continues to rely on) this “once a practitioner, always a practitioner” position as a jurisdictional hook for Circular 230. (n.b., in the IRS Form 2848 Power of Attorney and Declaration of Representative released in July 2014, the Service now requires that practitioners affirmatively declare that they are “subject to regulations contained in Circular 230.” The Form 2848 previously required only that practitioners declare they were “aware” of the regulations.).
The government did not appeal Ridgely and has since stated, consistent with its reaction to Loving, that it will apply the holding in that case narrowly. William R. Davis, ABA Meeting: OPR Will Narrowly Apply Ridgely, 2014 TNT 184-11 (Sept. 23, 2014 (quoting IRS Office of Professional Responsibility Director Karen Hawkins as saying “I am going to treat Ridgely the same way I treated Loving, which is I’m going to stick to the issue that was decided and the dicta is very colorful but it is not law.”). The Service has, however, yet to confront or develop a response to the basic rationale of Loving: That a person’s conduct in assisting taxpayers in any manner that does not involve direct interaction with the Service does not constitute “the practice of representatives of persons before the Treasury Department” within the meaning of 31 U.S.C. § 330(a). While some have pointed to the Service’s authority under 31 U.S.C. § 330(b) to regulate “incompetent” or “disreputable” representatives, or to the “nothing shall be construed to limit” language of 31 U.S.C. § 330(d) which applies to the rendering of certain written advice, the Service’s authority under those provisions is far more limited than under 31 U.S.C. § 330(a).
Were the logic of Loving and Ridgely to be extended, not only is the Service’s ability to regulate paid return preparers under Circular 230 limited or non-existent, but the vitality of other “non-practice” provisions in Circular 230 has also been called into serious question. If the Service cannot regulate return preparation because it does not constitute “practice” before the Treasury Department, where is its authority to promulgate the “due diligence” standards applicable to communications between practitioners and their clients under Circular 230 section 10.22(a)(3)? To promulgate the standards applicable to advice with respect to documents submitted to the Service other than tax returns under section 10.34(b)? To enforce the “written advice” standards in new section 10.37? Or to promulgate numerous other provisions in Circular 230 that purport to regulate conduct not involving direct interaction with (or “practice” before) the Service? As a practical matter, there may be little incentive for a practitioner to challenge the Service’s authority to enforce these provisions, at least through an injunction action similar to Loving or Ridgely. If a practitioner were to be sanctioned by the Service under any of these “non-practice” rules, however, it is easy to see a judicial challenge to their validity in a district court appeal of an administrative law judge’s final determination upholding that sanction. And under Loving and Ridgely it is easy to see that challenge succeeding.
Why the IRS Attempted to Use Circular 230 to Regulate Preparers: Resource
While Loving and Ridgely provide an interesting look at the application of the Administrative Procedure Act to tax administration, their holdings—and the potential for a broad extension of their holdings—begs the question of why Circular 230 evolved into a enforcement tool targeted at “tax shelters,” “covered opinions,” contingent fee arrangements and other real and perceived compliance problems in the first place. The holdings similarly beg the question of why Circular 230 was chosen as the vehicle through which the Treasury Department and the Service would subject hundreds of thousands of paid return preparers to mandatory competency testing and continuing education requirements. A report from the Treasury Inspector General for Tax Administration (“TIGTA”) released on September 25, 2014, helps to highlight an answer: resources.
Apart from Circular 230, the Service has unchallenged authority to regulate the conduct of paid return preparers and others who assist taxpayers in complying with the tax law (or not complying with the tax law, as the case may be) through a broad range of civil and criminal provisions in the Code. These include the preparer penalty provisions in Code sections 6694 and 6695, the penalty for promoting abusive tax shelters under Code section 6701 and the civil injunction provisions in Code sections 7407 and 7408. To enforce these provisions, however, takes a commitment of significant resources. After identifying the bad actors and developing an administrative case against them (itself a resource-intensive effort), the Service can be dragged into protracted litigation in seeking to obtain a court injunction or in defending its penalty determinations against a challenge brought by a preparer or practitioner who is highly motivated to clear their name or delay imposition of an inevitable sanction.
Notwithstanding the wide range of tools that can be used against problematic preparers, the recent TIGTA report found that the Service failed to follow up on more than one third of preparer conduct referrals, most of which were from internal sources within the Service. The TIGTA report references a prior report, which evaluated the Service’s inability to timely respond to thousands of other referrals that are submitted each year on IRS Form 14157, mostly by taxpayers who have been victimized by unscrupulous or fraudulent preparer conduct. Rather than build an entirely new regulatory regime under the questionable authority of 31 U.S.C. § 330 at a cost estimated to be up to $77 million annually, could that same $77 million could be targeted at the thousands of preparer conduct leads that seem to go unopened each year?
The problem, of course, is that committing resources to enforcing existing law must come from the Service’s general enforcement budget, an area that Congress has been moving down on its funding priority list. Using Circular 230 as the vehicle for regulating paid return preparers and “practitioner” conduct more generally sidesteps this problem because, as originally envisioned, the $77 million cost would be self-funded through user fees imposed on all (or most) practitioners. Legislative proposals authorizing the Service to regulate paid preparers (which would address the holding in Loving)similarly envision a user-fee regime to sidestep the funding problem. See Tax Return Preparer Accountability Act of 2014, section 3, H.R. 4470 (113th Con., 1st Sess.).
The funding problem raises the larger policy question of why such a basic tax enforcement issue as regulating paid return preparers should be funded by a user fee, a question the courts might have an opportunity to consider in the context of a pending challenge to the remains of the preparer user fee regime. The politics of that question extend beyond this posting, but they will have to be addressed if there is to be any comprehensive response, legislative or otherwise, to Loving and the largely unchallenged proposition that paid return preparers should be subject to broader oversight than current law appears to permit.