Notice & Comment

Can Montana Force the IRS to Break the Law?

The IRS recently changed the rules on how some tax-exempt organizations must report information related to their “substantial contributors” (that is, those who donate $5,000 or more in a year). This change has sparked a political controversy, fueled by concerns over “dark money” in politics and the Citizens United decision. One state (Montana) has already filed an APA-based challenge to the IRS’s action, and its lawsuit raises a novel question over whether the IRS must enforce regulations that may have been promulgated unlawfully.

Under Section 6033(a), organizations that enjoy the Section 501(a) tax exemption must file information returns showing their gross income, receipts, and disbursements, and other information as the IRS “may by forms or regulations prescribe.” The statute also contemplates specific rules for organizations further described in Section 501(c)(3). Among other things, those organizations must provide information returns about their substantial contributors, again in the time and manner as the IRS “may by forms or regulations” prescribe. See Section 6033(b)(5).

In 1971, the Treasury & IRS issued regulations under this statutory regime. See Reg. § 1.6033-2, T.D. 7122 (June 7, 1971). See also Reg. § 1.6033-1 (initial rulemaking under Section 6033(a)(1)). Although the IRS could have required contributor reporting for only Section 501(c)(3) organizations, it did not do so. Instead, the regulations required contributor reporting (and other types of reporting) for all Section 501(a) organizations. See Reg. § 1.6033-2(a)(2)(ii)(f). See also 2017 Schedule B (Form 990 Series).

But the 1971 regulations allow administrative exceptions. Under -2(g)(6), the IRS may waive, in whole or in part, return requirements for most Section 501(a) organizations if it determines that their “returns are not necessary for the efficient administration of the internal revenue laws.”[1]  In Rev. Proc. 2018-38, a document issued without notice and comment procedures, the IRS waived contributor reporting requirements for most Section 501(a) organizations (but not those described in Section 501(c)(3)).

Montana believes that this action violated the APA. The state argues that the contributor reporting regulation is a “binding legislative rule” and can be amended or repealed only through notice and comment procedures. See Montana Complaint at 2-3. Montana argues that -2(g)(6) “does not supersede the statutory requirement that amendments to legislative rules” follow notice and comment procedures. See Montana Complaint at 6. The state claims harm from Rev. Proc. 2018-38 and thus asks that the court set it aside.

Although styled as a challenge to Rev. Proc. 2018-38, Montana’s lawsuit goes to the validity of -2(g)(6) itself. That regulation’s plain language authorizes the IRS to establish exceptions from the regulatory reporting regime, like the ones in Rev. Proc. 2018-38. The IRS has, under various administrations, invoked that regulation to create such exceptions. See, e.g., Rev. Proc. 2011-15; Rev. Proc. 2003-21; Rev. Proc. 94-17; Rev. Proc. 83-23.

The IRS clearly believes that -2(g)(6) follows from the discretionary authority conferred under Section 6033(a)(2)(B) to create exceptions from the Section 6033(a)(1) filing requirements.[2] If that interpretation is correct or if Section 6033(a)(1) does not otherwise require notice and comment rulemaking (important questions better left for another day), Montana’s lawsuit must fail.

But Montana’s concerns over the notice and comment procedures raise another novel issue. The IRS was clearly aware that those procedures existed when it generally addressed reporting requirements for Section 501(a) organizations. See, e.g., T.D. 6980 (Nov. 9, 1968) (amending general reporting rules under Reg. § 1.6033-1 after issuing a notice of proposed rulemaking and after considering comments). But, for the additional reporting rules under Reg. § 1.6033-2, including the contributor reporting rule, the IRS bypassed the notice and comment process. In doing so, the IRS offered no good cause explanation for its failure. (The workload created by the Tax Reform Act of 1969 may have prompted the agency to skip APA procedures.)

In any event, the IRS’s failure to follow notice and comment procedures for the original contributor reporting rule, when coupled with Montana’s complaint over changes to that rule, presents an awkward situation. Montana believes that the IRS acted unlawfully when it amended the Section 1.6033-2 regulations without following notice and comment procedures. But if notice and comment procedures were required to change those regulations — that is, if those regulations were, as Montana contends  “binding legislative rule[s]” — then those procedures were needed to promulgate those regulations. By that standard, the entire Section 1.6033-2 reporting regime, including the contributor reporting requirement, reflects an invalid exercise of agency authority and should be stricken.[3]

Montana’s lawsuit thus demands that the IRS adhere to unlawfully issued regulations (i.e., “break the law”) and require contributor reporting information from tax-exempt organizations. This seems rather odd. Through Rev. Proc. 2018-38, the IRS responded to comments it received from burdened parties, and its open mind here fulfills at least the spirit of the APA, whatever the wisdom of the decision reached.

Nonetheless, the IRS’s open mind may not save it. As Daniel Hemel has argued at the TakeCare blog, the D.C. Circuit, at least, has not allowed agencies to overturn regulations whenever they claim they were defectively issued. But cf. Manhattan Gen. Equip. Co. v. Commissioner, 297 U.S. 129, 134 (1936) (Regulations must “carry into effect the will of Congress as expressed by the statute. A regulation which does not do this, but operates to create a rule out of harmony with the statute, is a mere nullity.”). Though the issues in this area are hardly settled, and the regulations here, imposing substantial burdens on private parties,[4] may be distinguishable from those addressed by the D.C. Circuit, the IRS cannot easily argue that the procedural infirmities related to the Section 1.6033-2 regulations allow the agency to modify those regulations through Rev. Proc. 2018-38.

Montana’s lawsuit thus implicates fundamental and unaddressed questions of administrative law. Those intrigued by issues related to defectively issued regulations would be well-advised to follow the case.

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[1] See Reg. § 1.6033-2(g)(6) (“The Commissioner may relieve any organization or class of organizations (other than an organization described in section 509(a)(3)) from filing, in whole or in part the annual return required by this section where he determines that such returns are not necessary for the efficient administration of the internal revenue laws.”). See also Section 6033(a)(3)(B) (“The Secretary may relieve any organization required under paragraph (1) (other than an organization described in section 509(a)(3)) to file an information return from filing such a return where he determines that such filing is not necessary to the efficient administration of the internal revenue laws.”).

[2] See, e.g., Rev. Proc. 2011-15, Sec. 2.03 (through -2(g)(6), the Secretary has delegated Section 6033(a)(3)(B) waiver authority to the Commissioner of the IRS). Unlike the regulation, the statute does not expressly refer to classes of organizations. Thus Section 6033(a)(3)(B) might contemplate only case-by-case exceptions whenever the IRS wants to grant a waiver from the Section 6033(a)(1) filing requirements. Also, Section 6033(a)(3)(B) seemingly contemplates blanket waivers, rather than waivers from particular reporting requirements.

[3] This would apply only to the regulations issued in 1971. There have been various additions to those regulations since that time, and those additions would be valid to the extent they complied with Section 6033 and APA procedures.

[4] See Bittker & Lokken, Federal Taxation of Income, Estates and Gifts, ¶ 100.11 Procedural Requirements, 2012 WL 2589305, n.22 (“Some organizations and scholars have complained that the requirements added by the revised Form 990 go beyond the IRS’s legitimate role of enforcing the tax laws to making the IRS a general overseer of nonprofit organizations.”) (collecting commentary).

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