We lasted visited the action by microcaptive manager CIC Services, LLC, against the IRS to vacate IRS Notice 2016-66, which essentially imposed tax shelter reporting requirements on captive owners and their advisors, in my article IRS Notice 2016-66 On Microcaptives Vacated By U.S. District Court On Procedural Grounds In CIC Services Case (3/28/2022). I will spare readers on humanitarian grounds a full rehashing of that ruling and my article. Suffice it to say that the U.S. District Court for the Eastern District of Tennessee ruled that the IRS’s promulgation of Notice 2016-66 had violated the Administrative Procedure Act (APA), and thus was null and void. Further, the court also held that the IRS must return all the materials that it had received from responding taxpayers and their advisors back to those folks.
Arguably, this latter part of the court’s ruling — that the IRS must return materials to taxpayers and their advisors which were sent to the IRS in response to Notice 2016-66 — was the most practically important part of this opinion. The reason is that if the IRS had to send the documents back to taxpayers and their advisors, it might disrupt some of the IRS’s current audit and tax court cases against those involved in microcaptive cases who haven’t settled yet.
The IRS filed a motion for reconsideration which raised a singular issue: Whether it was appropriate for the court to enter an order which required the IRS to return the materials received from all taxpayers and their advisors, even if they were not formally parties to the CIC Services case. Essentially, the IRS argued that if CIC Services desired that result, then it should have brought its case as a class action, and followed the class action procedures, but it did not.
In reviewing this argument, the court still felt that it was wrong for the IRS to benefit from documents that were obtained under Notice 2016-66 when the IRS failed to follow the APA.
“Nonetheless, CIC did not assert class claims and it did not demonstrate compliance with any of Rule 23’s procedural prerequisites necessary to seek injunctive relief on behalf of nonparty taxpayers and material advisors. While CIC successfully demonstrated that the Notice must be set aside for failure to comply with the requirements of the APA, CIC is ultimately the only plaintiff in this action. As a result, the Court should not have ordered affirmative injunctive relief that extends to nonparty taxpayers and material advisors.”
The court’s original ruling had the potential to cause the IRS a lot of problems in audits and in its pending U.S. Tax Court cases, since the IRS doubtless built a part of those remaining cases on the documents that it received pursuant to Notice 2016-66. These problems might or might not have been insurmountable in particular cases, but the original ruling had the potential to cause the IRS a lot more work if not occasional heartburn.
Now, the IRS only has to give responsive documents back to CIC Services and that’s probably not going to give the IRS much more work or heartburn at all — particularly since only CIC Services itself gets its documents back — but even CIC Services’ own clients and their advisors do not. The effect of this ruling on reconsideration is thus analogous to reducing the Goodyear Blimp to a child’s birthday balloon. Notice 2016-66 is still invalid under the APA, but it is difficult to see the practical effects of that on the IRS’s enforcement actions against microcaptive taxpayers generally.
From the moment that Notice 2016-66 came out, I’ve said that it was an oddity because of its “transaction of interest” funkiness that falls well short of defining a microcaptive transaction and then making it a full listed transaction (a presumed tax shelter). Thus, the U.S. Tax Court cases (and the appeal before the 10th Circuit in Reserve Mechanical) were not predicated upon Notice 2016-66 but on the underlying tax law. In other words, Notice 2016-66 really didn’t accomplish much other than to require microcaptive taxpayers and their advisors to start making disclosures which helped the IRS to identify potentially abusive microcaptive deals. While this certainly helped the IRS in the early years of its microcaptive activities, that was a bell that could not be unrung even if Notice 2016-66 ultimately was vitiated due to APA noncompliance.
Because Notice 2016-66 didn’t do much in the first place other than to assist the IRS in identifying microcaptive transactions, having Notice 2016-66 set aside now may be in the nature of a pyrrhic victory as to everybody except CIC Services who gets their documents back. Whether even that helps CIC Services remains to be seen.
The IRS will appeal the court’s ruling that Notice 2016-66 is invalid under the APA, and probably the issue about the documents not being returned to all microcaptive taxpayers and their advisors (again, except as to CIC Services) will likely be appealed as well. With the recent opinion of the 10th Circuit in Reserve Mechanical, which frankly sets standards for a risk pool (an integral part of a microcaptive transaction) so high that probably no group of small captives can meet it, all this may be for naught anyway. The Fat Lady has already sung and is now drinking champagne at the after party.
Nonetheless, we’ll just have to wait and watch how this shakes out on appeal, for academic interest if nothing else.
Memorandum Opinion in CIC Services, LLC v. IRS (E.D.Tenn. Case No. 17-CV-110, June 2, 2022).