Supreme Court Considers IRS’s Micro-Captive Reporting Requirements

On December 1, 2020, the United States Supreme Court heard oral arguments in CIC Servs. LLC v. Internal Revenue Service, a case challenging the Internal Revenue Service’s (IRS) reporting requirements around certain transactions involving captive insurance companies that elect to be taxed under § 831(b) of the Internal Revenue Code (referred to as “micro-captives”).

Background

The IRS has established requirements for certain taxpayers, as well as their advisors, to maintain specific records and submit reports to the IRS relating to any "reportable transactions," i.e., a transaction the IRS believes has the potential for tax avoidance or evasion. Reportable transactions are different from “listed transactions,” which are transactions the IRS deems to be unlawful tax avoidance mechanisms.

In 2016, the IRS published Notice 2016-66, which classified certain micro-captive transactions as reportable transactions — generally, transactions where the captive’s insured losses and claim administration expenses are less than 70% of its premium income less dividend payments or if the captive makes any loans to, or investments in, its parent. As a result of Notice 2016-66, certain micro-captives and their advisors, are required to submit reports relating to such reportable transactions.

In 2017, CIC Services, an advisor to micro-captives engaging in reportable transactions, sued in federal court claiming that Notice 2016-66 violated the Administrative Procedure Act (APA) because the IRS did not follow formal rulemaking processes under the APA when it issued the notice. After the lower court denied the motion for a preliminary injunction, the IRS claimed that the lawsuit was barred by the Anti-Injunction Act and the tax exception to the Declaratory Judgment Act, which deny federal district courts subject matter jurisdiction over suits “for the purpose of restraining the assessment or collection of any tax.” The IRS’s motion to dismiss for lack of subject matter jurisdiction was granted by the federal district court, and the Sixth Circuit Court of Appeals affirmed the dismissal.

The Supreme Court Argument

During oral arguments, Justice Brett Kavanaugh observed that under the current reporting regime a micro-captive or its service provider would be forced to violate the tax code and pay steep penalties before it could challenge the IRS's reporting requirements under IRS Notice 2016-66. Justice Kavanaugh suggested that, because a taxpayer’s ability to challenge IRS guidance could be deterred when the consequences of doing are so severe, perhaps an exception should be carved out. The Court is expected to rule sometime in or after March 2021.

What This Means

If the Court rules in favor of CIC Services and allows preemptive challenges to informal IRS notices that impose penalties, a taxpayer would have the ability to seek court review of the legality of such penalties before they are imposed and paid. However, if the Court rules in favor of the IRS and upholds the Sixth Circuit's ruling, then taxpayers wishing to challenge an IRS rule or notice imposing penalties would, as Justice Kavanaugh observed, have to violate the rule, be assessed a penalty and then pay the penalty before the taxpayer could dispute the validity of such IRS penalty.