Earlier this week, the IRS issued regulations related to private equity “fee waiver” transactions, which are designed to convert high-taxed ordinary income into low-taxed capital gain. At first, I was pleasantly surprised by the IRS’s method of rulemaking here. Usually, when it issues regulations, the IRS announces that the APA does not apply, and it issues immediately effective regulations. But here, the IRS issued regulations in proposed form. Finally, the agency was allowing the public a meaningful opportunity to participate in the rulemaking process.

But there’s a catch. The IRS first announces that the regulations will be effective only upon being finalized and published in the Federal Register. Then it goes on to say:

Pending the publication of final regulations, the position of the Treasury Department and the IRS is that the proposed regulations generally reflect Congressional intent.

So, the proposed regulations aren’t effective until they are finalized. But until they are finalized, the proposed regulations are essentially effective because they “generally reflect Congressional intent.” I sincerely hope that someone at the IRS recognized the irony of using such gamesmanship in a regulation project designed to combat private equity firm gamesmanship.

In making the strange statement about the regulation’s effect, the IRS may have opened the entire project open to taxpayer challenge. Generally, if an agency maintains a closed mind during the notice and comment process, an affected party can challenge the agency in court and have the regulations set aside.

Here, the IRS has already announced its view that the regulations properly implement the statute and has not offered a true proposal. Although the regulations will be nominally prospective, the IRS will presumably use the proposed regulations to challenge taxpayer transactions for prior tax years. This gives the impression that the regulations are being proposed as a litigating tool and not as a sincere effort to solicit comment. To combat this inference, the IRS should show due regard for any taxpayer comments that it receives on the project.

By Andy Grewal