This week, the Supreme Court heard oral arguments in CIC Services v. IRS. That case involves a challenge to Notice 2016-66. Under that notice, material advisors to some reportable transactions face substantial reporting requirements. A failure to satisfy those reporting requirements subjects the taxpayer to potentially severe penalties. See 26 U.S.C. §§ 6111(a) and 6707A(a)-(b).

Though CIC Services faces reporting obligations under Notice 2016-66, it believes that the notice is invalid. The IRS issued that guidance without following the notice & comment procedures specified in 5 U.S.C. § 553(b). CIC Services has thus brought a lawsuit asking a court to enjoin IRS enforcement of the notice.

The IRS has responded that, because of 26 U.S.C. § 7421(a), CIC Services cannot challenge Notice 2016-66 prior to its enforcement. Instead, CIC Services must first engage in the conduct prohibited by the notice. Then, after the IRS penalizes CIC Services and the company pays its penalty, it can seek judicial relief. In that potential civil proceeding, CIC Services could ask the court to hold Notice 2016-66 unlawful and order its penalty payment refunded. Alternatively, if the DOJ criminally prosecuted CIC Services for its failure to comply with Notice 2016-16 the company could argue, at its criminal trial, that the notice was invalid.

During oral arguments, several Justices seemed skeptical that a taxpayer should need to break a law in order to challenge it. See Bloomberg Tax, SCOTUS Justices Grill IRS in Fight Over Tax Reporting Rule (Dec. 1, 2019). However, Justice Breyer asked about an alternative path for judicial review. He pondered whether the taxpayer could file a petition with the IRS to initiate notice-and-comment rulemaking on the matters addressed in Notice 2016-66. See 5 U.S.C. § 553(e) (“Each agency shall give an interested person the right to petition for the issuance, amendment, or repeal of a rule.”). Then, if the IRS denied that petition, the taxpayer could seek a judicial order compelling the IRS to initiate notice-and-comment rulemaking. See 5 U.S.C. § 702 (establishing right to judicial review).That way, the taxpayer could get what it wanted: The IRS could impose reporting obligations and penalties only after it followed the notice-and-comment process.

CIC Services responded to Justice Breyer by noting the high standards of review that arise when a party files a § 553(e) petition for an agency to initiate rulemaking. See 5 U.S.C. § 706(2)(A) (courts may hold unlawful and set aside agency actions that are arbitrary, capricious, an abuse of discretion, or otherwise not in accordance with law). Thus, the company argued that the § 553(e) route would not providing a meaningful avenue for judicial review. See also Cellnet Commc’n, Inc. v. F.C.C., 965 F.2d 1106, 1111 (D.C. Cir. 1992) (“an agency’s refusal to initiate a rulemaking is evaluated with a deference so broad as to make the process akin to non-reviewability.”). As a practical matter, taxpayers would be left to violate Notice 2016-66 if they wanted to challenge it.

Even aside from CIC Services’ argument, Justice Breyer’s suggested path, which may have stemmed from an amicus brief filed by former government officials, suffers from problems. See Brief amici curiae of Former Government Officials, pp. 27-28. First, it’s unclear why a taxpayer would ever petition the IRS to initiate rulemaking in this context. The relevant statutes do not themselves impose reporting requirements or impose penalties. Instead, reporting requirements arise only when the IRS issues regulations on reportable transactions. See §§ 6111(a)(1) (material advisors face reporting requirements for reportable transactions) and 6707A(c)(1) (leaving definition of “reportable transaction” to regulations issued under § 6011). From the taxpayer’s perspective, no rulemaking would be the best rulemaking.

But even if, for whatever reason, a taxpayer wanted the IRS to issue regulations on reportable transactions, general APA principles would thwart its efforts. As the Supreme Court explained in Norton v. SUWA, “the only agency action that can be compelled under the APA is action legally required.” 542 U.S. 55, 65 (2004). This “limitation to required agency action rules out judicial direction of even discrete agency action that is not demanded by law (which includes, of course, agency regulations that have the force of law).” Id.

These principles foreclose judicially ordered rulemaking on reportable transactions. Section 6707A(c)(1) states that a reportable transaction is any transaction that is subject to disclosure requirements under the § 6011 regulations when the “transaction is of a type which the Secretary determines as having a potential for tax avoidance or evasion.” Nothing in § 6011 compels the IRS to issue regulations on reportable transactions, and Section 6707A(c)(1)’s language (“the Secretary determines”) affirms the discretion enjoyed by the agency.

If a taxpayer filed a § 553(e) petition and then followed through with a lawsuit under § 706(2)(A), the taxpayer would hit a quick dead end. Even if a court applied a strict standard of review, it would defer to the IRS’s discretion over whether to initiate rulemaking on reportable transactions. Relief under 5 U.SC. § 706(1) would be similarly foreclosed. That statute allows courts to “compel agency action unlawfully withheld or unreasonably delayed.” But it does not apply to discretionary rulemaking decisions. See Norton, 542 at 65 (“a claim under § 706(1) can proceed only where a plaintiff asserts that an agency failed to take a discrete agency action that it is required to take.”).

When it comes to challenging Notice 2016-66, taxpayers thus face the difficulties described by CIC Services. They must break the law in order to challenge the notice. That may very well be the regime that Congress established through Section 7421(a). However, the Supreme Court should be mindful of that consequence if it holds against the taxpayer.

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This post may be updated. Comments welcome.