CIC SERVICES, LLC, Plaintiff, v. INTERNAL REVENUE SERVICE, DEPARTMENT OF TREASURY, and THE UNITED STATES OF AMERICA, Defendants.
Case No. 3:17-cv-110
UNITED STATES DISTRICT COURT EASTERN DISTRICT OF TENNESSEE AT KNOXVILLE
March 21, 2022
Judge Travis R. McDonough; Magistrate Judge Jill E. McCook
Before the Court are the following motions: (1) Plaintiff CIC Services, LLC‘s (“CIC“) motion to reconsider the scope of preliminary injunction (Doc. 87); (2) CIC‘s motion for summary judgment (Doc. 97); (3) Defendants Internal Revenue Service (“IRS“), Department of Treasury, and the United States of America‘s (collectively, the “Government“) motion for summary judgment (Doc 99); (4) CIC‘s objection to the magistrate judge‘s order denying discovery (Doc. 105); and (5) the Government‘s motion to strike CIC‘s reply brief in support of its motion for summary judgment (Doc. 116). For the following reasons, CIC‘s motion to reconsider the scope of the preliminary injunction and the Government‘s motion to strike will be DENIED AS MOOT. CIC‘s objection to the magistrate judge‘s order denying discovery will be OVERRULED AS MOOT. CIC‘s motion for summary judgment will be GRANTED, and the Government‘s motion for summary judgment will be DENIED.
A. Statutory and Regulatory Background
Through the Internal Revenue Code, Congress requires that certain taxpayers provide the IRS with information regarding “reportable transaction[s].”
Consistent with the authority delegated by Congress, the Secretary has promulgated regulations specifying that taxpayers and material advisors must provide to the IRS information about defined types of reportable transactions, including, but not limited to:
- “Listed transactions“—“a transaction that is the same or substantially similar to one of the types of transactions that the Internal Revenue Service (IRS) has determined to be a tax avoidance transaction and identified by notice, regulation, or other form of published guidance as a listed transaction“;
- “Transactions of interest“—“a transaction that is the same or substantially similar to one of the types of transactions that the IRS has identified by notice, regulation, or other form of published guidance as a transaction of interest.”
On November 1, 2016, the IRS issued Notice 2016-66 (the “Notice“). (Doc. 98, at 381–95.) In the Notice, the IRS expressed concern that “micro-captive transactions” had the potential for tax avoidance or evasion and classified these transactions as “transactions of interest” for the purposes of
B. Procedural History
On March 27, 2017, CIC initiated the present action.2 (Doc. 1.) According to its initial verified complaint, CIC is “a manager of captive insurance companies.” (Id. at 3.) In this capacity, CIC asserts that it is subject to the Notice‘s disclosure requirements for material advisors and that complying with the Notice‘s disclosure requirements will force it to incur
On April 21, 2017, the Court denied the initial motion for preliminary injunction, finding that CIC was unlikely to succeed on the merits of its claims because the claims were foreclosed by Anti-Injunction Act (“AIA“). (Doc. 24.) Then, on November 2, 2017, the Court dismissed the case, finding it lacked subject-matter jurisdiction because the claims were barred by the AIA. (Docs. 35, 36.) CIC appealed the Court‘s dismissal of its claims, and, ultimately, on May 19, 2021, the Supreme Court of the United States held that the AIA did not deprive the Court of subject-matter jurisdiction over CIC‘s claims against the IRS. CIC Servs., LLC v. I.R.S, 141 S.Ct. 1582 (2021).
On July 12, 2021, after the mandate was returned to this Court, the Court entered a scheduling order. (Doc. 57.) CIC then filed a renewed motion for preliminary injunction, again seeking to enjoin the IRS‘s enforcement of Notice 2016-66. (Doc. 59.) On September 15, 2021, CIC moved the Court to reconsider its scheduling order, arguing that it should be modified “to permit discovery into the IRS‘s basis for Notice 2016-66.” (Doc. 80, at 1.) It also filed a motion seeking to supplement the administrative record, arguing that the administrative record filed by the IRS was “wholly inadequate.” (Doc. 84.)
On November 4, 2021, United States Magistrate Judge H. Bruce Guyton entered an order denying CIC‘s motion requesting discovery into the IRS‘s basis for Notice 2016-66 and denying CIC‘s motion to supplement and complete the administrative record. (Doc. 101.) CIC, after filing an amended verified complaint,3 objected to Magistrate Judge Guyton‘s order to the extent it denied the opportunity to conduct discovery in this case. (Doc. 105.)
The parties then filed response briefs in support of their cross-motions for summary judgment. (Docs. 112, 113.) On January 21, 2022, CIC filed a reply brief in support of its summary-judgment motion. (Doc. 114.) The IRS then moved to strike CIC‘s reply brief, or in the alternative, for leave to file a sur-reply. (Doc. 116.)
On March 3, 2022, the United States Court of Appeals issued its opinion in Mann Construction. v. United States, Case No. 21-1500, 27 F.4th 1138, 2022 WL 619822 (6th Cir. 2022).
II. ANALYSIS
A. The Parties’ Cross-Motions for Summary Judgment
In cases challenging whether an administrative agency complied with the requirements of the APA, the normal summary-judgment standard set forth in
In its first cause of action, CIC asserts that the IRS unlawfully promulgated Notice 2016-66 because it is a “legislative rule” under the APA, and the IRS failed to observe notice-and-comment procedures required by the APA.4 (Doc. 104, at 9–11; see also Doc. 97, at 4–8.) The IRS does not contend that it complied with the APA‘s notice-and-comment requirements but argues that Congress exempted it from the APA‘s notice-and-comment requirements, or, alternatively, that the Notice constitutes an interpretive rule which does not require notice and comment. (Doc. 99-1, at 8–21.)
In Mann Construction, the Sixth Circuit rejected the IRS‘s arguments in connection with a similar IRS notice that designated “certain employee-benefit plans featuring cash-value life insurance policies” as “listed transactions” and required taxpayer disclosure of participation in such plans. 2022 WL 619822, at *1. After failing to disclose participation in such a plan, the IRS imposed penalties on Mann Construction. Id. at *1–2. Mann Construction challenged the validity of the IRS notice, arguing, among other things, that the notice failed to comply with the notice-and-comment requirements set forth in the APA. Id. On appeal, the IRS did not dispute that it did not follow notice-and-comment procedures when it issued the notice but argued that the notice was merely an interpretive rule which did not require notice and comment and that, even if the notice was a legislative rule, Congress exempted it from the APA‘s requirements with respect to its disclosure rules. Id. at *2. The Sixth Circuit expressly rejected these arguments, holding that the IRS‘s notice regarding disclosure obligations for listed transactions constituted a
The Sixth Circuit‘s analysis in Mann Construction is binding on this Court and applies equally to the arguments advanced by the IRS regarding Notice 2016-66 in this case. Accordingly, and for the same reasons previously stated by the Court in granting CIC‘s motion for preliminary injunction (Doc. 82, at 6–10), Notice 2016-66 is a legislative rule that is invalid because the IRS failed to observe notice-and-comment procedures required by the APA.
ii. Arbitrary and Capricious under the APA
CIC also argues that the Notice must be set aside under the APA because the IRS acted arbitrarily and capriciously in issuing the Notice. (Doc. 97, at 8–14.) A court shall “hold unlawful and set aside agency action, findings, and conclusions found to be . . . arbitrary, capricious, an abuse of discretion, or otherwise not in accordance with the law.”
has relied on factors which Congress has not intended it to consider, entirely failed to consider an important aspect of the problem, offered an explanation that runs counter to the evidence before the agency, or is so implausible that it could not be ascribed to a difference in view or the product of agency expertise.
Atrium Med. Ctr., 766 F.3d at 567 (quoting Motor Vehicle Mfrs. Ass‘n, 463 U.S. at 43). The standard of review is “narrow,” and the reviewing court will “uphold a decision of less than ideal clarity if the agency‘s path may be reasonably discerned.” Id. The agency‘s reasoning, however, must be “discernable and defensible.” Id. at 568.
Through the Internal Revenue Code, Congress requires that certain taxpayers provide the Internal Revenue Service (“IRS“) with information regarding “reportable transaction[s],” which is defined as “any transaction . . . which the Secretary determines as having a potential for tax avoidance or evasion.”
The Department of Treasury (“Treasury Department“) and the Internal Revenue Service (the “IRS“) are aware of a type of transaction, described below, in which a taxpayer attempts to reduce the aggregate taxable income of the taxpayer, related persons, or both using contracts that the parties treat as insurance contracts and a related company that the parties treat as a captive insurance company. Each entity that the parties treat as an insured entity under the contracts claims deductions for premiums for insurance coverage. The related company that the parties treat as a captive insurance company elects under § 831(b) of the Internal Revenue Code (the “Code“) to be taxed only on investment income and therefore excludes the payments directly or indirectly received under the contracts from its taxable income. The manner in which the contacts are interpreted, administered, and applied is inconsistent with arm‘s length transactions and sound business practices.
The Treasury Department and the IRS believe this transaction (“micro-captive transaction“) has a potential for tax avoidance or evasion. See IR-2016-25 (discussing characteristics of an abusive micro-captive insurance structure). However, the Treasury Department and the IRS lack sufficient information to identify which § 831(b) arrangements should be identified specifically as a tax avoidance transaction and may lack sufficient information to define the characteristics that distinguish the tax avoidance transactions from other § 831(b) related-party transactions. This notice identifies the transaction described in section 2.01 of this notice and substantially similar transactions as transactions of interest for purposes of § 1.6011-4(b)(6) of the Income Tax Regulations and §§ 6111 and 6112 of the Code. This notice also alerts persons involved in such transactions to certain responsibilities and penalties that may arise from their involvement with these transactions.
(Doc. 98, at 381–82 (emphasis added).) The Notice simply states that the IRS is aware of micro-captive transactions and “believes” these transactions have the potential for tax avoidance or evasion. (Id.) While the Notice goes on to describe these transactions, it does not identify any facts or data supporting its belief. (Id.) The IRS‘s executive summary regarding the Notice similarly fails to provide underlying facts and data; rather, in the section titled “Reason Guidance Initiated,” the summary simply provides:
In recent years the Service has become aware of a large number of these arrangements. For the past two years the arrangement has been among the abusive tax shelter‘s on the Service‘s “Dirty Dozen” list of tax scams. See e.g., IR-2016-25 ad IR-2015-19. Though many taxpayers are under audit and several are in litigation for using this arrangement, the Service is concerned that it is not fully aware of the breadth of this arrangement to capture all variants exhibiting the characteristics that make the arrangement potentially abusive and how to distinguish the tax avoidance transactions from other §831(b) related-party transactions
(Id. at 375 (emphasis added).) Again, while the executive summary states that taxpayers are under audit and in litigation for using this arrangement, it does not include any underlying facts or data explaining how it became aware of “a large number of these transactions” or facts regarding taxpayers under audit and in litigation that explain how this transaction has the potential for tax avoidance or evasion. This executive summary also cites to two IRS news releases from 2015 and 2016, which are included in the administrative record, in which the IRS identifies micro-captive insurance arrangements a potentially “abusive tax structure.” (Id. at 11–18.) The news releases, however, do not include any underlying facts or data supporting the IRS‘s determination that micro-captive insurance arrangements have the potential for tax evasion. (Id.) Internal IRS and Department of Transportation e-mails in the administrative record also do not include any underlying facts or data. (Id. at 366–74.) Instead, these e-mails merely circulate draft and final versions of the Notice. (See id.)
Finally, the administrative record includes: (1) prior IRS notices issued in 2002 and 2004 regarding “Certain Reinsurance Arrangements” (id. at 4–9); (2) selected federal statutes and legislative history (id. at 19–132); and (3) selected cases regarding insurance and captive insurance (id. at 133–365). In arguing that the administrative record includes sufficient facts to support its decision, the IRS does not explain how its previously issued notices or the statutes and legislative history included in the administrative record provide the facts or data necessary to comply with the APA but notes that it “compiled cases in which a court found the tax payer
While the IRS may ultimately be correct that micro-captive insurance arrangements have the potential for tax avoidance or evasion and should be classified as transactions of interest, the APA requires that the IRS examine relevant facts and data supporting that conclusion. The administrative record in this case simply does not include underlying facts and data showing that micro-captive insurance arrangements have a potential for tax avoidance or evasion. As a result, the Notice must also be set aside as agency action that is arbitrary and capricious.6
B. Relief
Having found that the IRS failed to engage in notice-and-comment procedures required by the APA and that its issuance of the Notice was arbitrary and capricious, the Court must now determine the appropriate relief. In its amended complaint, CIC requests that the Court: (1) enter a judgment declaring the Notice unlawful and setting it aside; (2) enjoin all agencies from enforcing the notice and offering documents produced by any individual or entity in response to the Notice in judicial or administrative proceedings; and (3) require the IRS to destroy or return materials produced in response to the Notice. (Doc. 104, at 15–16.) Conversely, the IRS argues that the Court need not set aside the Notice and, instead, should remand the rule to the IRS and leave in place the rule pending promulgation of a new or
The text of the APA provides that the reviewing court “shall . . . hold unlawful and set aside agency action, findings, and conclusions found to be . . . arbitrary, capricious, and abuse of discretion, or otherwise not in accordance with law” or “without observance of procedure required by law.”
In this case, vacating the Notice in its entirety is appropriate. The IRS did not comply with notice-and-comment procedures, and it acted arbitrarily and capriciously. While it may be able to rectify these deficiencies if it pursues promulgating a new rule,7 nothing about its actions supports leaving the Notice in place while it takes the actions necessary to comply with the APA or vacating the Notice as to CIC only, especially given the Sixth Circuit‘s prior observations that the IRS “does not have a great history of complying with APA procedures,” CIC Servs., LLC v. I.R.S., 925 F.3d 247, 258 (6th Cir. 2019), and that it does not follow the basic rules of administrative law, CIC Servs., LLC v. I.R.S, 936 F.3d 501, 507 (6th Cir. 2019).
At least some of CIC‘s requests for permanent injunctive relief are also warranted. The Notice has required taxpayers and material advisors to expend time and resources, which they cannot recoup, to comply with the Notice‘s reporting requirements for more than four years. In turn, the IRS has received documents and information it was not entitled to because it failed to comply with the APA. Under these circumstances, it is entirely reasonable and equitable to require the IRS to return to the taxpayers and material advisors information and documents it collected pursuant to the Notice. The Court will not, however, enter an injunction barring agencies from offering documents produced by any individual or entity in response to the Notice in judicial or administrative proceedings. The Notice is merely one source of information for the IRS, and granting such relief risks depriving the IRS of the use of such documents for the public‘s benefit even if it acquires them lawfully in the future. The IRS may attempt to promulgate an APA-compliant rule requiring taxpayers and material advisors to produce the same information in the future. The Court declines CIC‘s invitation to, in effect, create future litigation over how and when the IRS received information in its possession. Accordingly, the Court will order that the IRS return all documents and information produced pursuant to the Notice to taxpayers and material advisors.
III. CONCLUSION
For the following reasons, CIC‘s motion to reconsider the scope of the preliminary injunction (Doc. 87) and the Government‘s motion to strike (Doc. 116) are DENIED AS MOOT. CIC‘s objection to the magistrate judge‘s order denying discovery (Doc. 105) is
The Court will enter judgment: (1) vacating the Notice in its entirety; and (2) ordering the IRS to return all documents and information produced pursuant to the Notice to taxpayers and material advisors.
AN APPROPRIATE JUDGMENT WILL ENTER.
/s/ Travis R. McDonough
TRAVIS R. MCDONOUGH
UNITED STATES DISTRICT JUDGE