In my previous post, I briefly discussed how the IRS has short-circuited the APA’s notice and comment rulemaking procedures to combat tax motivated transactions by private equity firms. I’d like to further flesh out that point here. Given the general readership of this blog, I’ll start by considering a hypothetical environmental statute and then turn to the tax specific issues.
First, let’s assume that the Congress enacts a statute saying, “Under regulations prescribed by the EPA, companies may not emit pollutants.” Then, the EPA issues proposed regulations stating that it plans to treat carbon dioxide as a pollutant. It solicits comments on the proposal and says that any finalized regulations will operate prospectively. But it simultaneously announces that, pending the notice and comment process, it intends to treat carbon dioxide as a pollutant, because doing so “generally reflects Congressional intent.”
I have no doubt that administrative lawyers would see this as an end-run around the APA. The whole purpose of the APA is to allow public comment before a rule goes into effect. If the EPA nominally “proposes” to restrict carbon dioxide emissions via prospective regulations, but simultaneously announces that it will immediately take enforcement actions to restrict their emission, the agency has, in substance, skirted the notice and comment process mandated by statute.
This is essentially what has happened with the private equity regulations. The governing tax provision, Section 707(a)(2)(A) of the tax code, contemplates that “Under regulations prescribed by the IRS,” transactions between a partner and partnership may be recharacterized such that some claimed tax benefits are disallowed. By issuing regulations proposing to include private equity transactions in Section 707(a)(2)(A), and also announcing it will immediately apply the proposed regulations because doing so “generally reflect Congressional intent,” the IRS has skirted the notice-and-comment rulemaking procedures.
One might defend the IRS by saying that it is simply announcing its view of the statute. That is, the IRS isn’t seeking Chevron deference for its retroactive application of the proposed regulations, but is simply signaling how its agents will audit private equity firms. What’s so bad about that? We should welcome agency transparency in this regard.
But that analysis is flawed. Like the hypothetical environmental statute, Section 707(a)(2)(A)’s plain language applies “Under regulations” and has no effect until those regulations are issued. Any attempt to apply the statute before regulations are finalized is per se unlawful, and the IRS has no legitimate reason to apply the statute during the pendency of regulations. I’ve explained this point at length here.
But let’s make things interesting and pretend like Section 707(a)(2)(A) doesn’t require regulations to operate. In this circumstance, is the IRS’s announcement appropriate? If the IRS must examine tax returns every year, doesn’t it make sense to say that it will essentially treat the proposed regulations as the law, since it must carry out enforcement efforts even before the regulations are finalized?
Nope. When an agency avails itself of notice and comment procedures (presumably with the goal of earning Chevron deference), it must maintain an open mind to public comments. If the EPA announces that it “proposes” to regulate carbon dioxide as a pollutant but says that it will immediately regulate it as such, it’s hard to believe that the agency is sincerely using the APA process to obtain further perspectives. Along the same lines, the IRS’s private equity regulations show that the agency has already made up its mind.
If the IRS believed that it needed to immediately enforce Section 707(a)(2)(A), even in the absence of implementing regulations, it should have taken an approach consistent with the democratic safeguards otherwise guaranteed by the APA. For example, the IRS could have followed its approach in other contexts and said something highly generic, like “Until these regulations are finalized, the IRS will apply Section 707(a)(2)(A) consistent with its language.” This would show that the IRS was maintaining an open mind about the statute and its enforcement. The proposed regulations in fact contain a statement along those lines but then go on to say that the Treasury and IRS believe that the proposed regulations reflect Congressional intent. Thus, IRS agents have received a clear message to treat the proposed regulations as the law. See also Sullivan & Cromwell Client Update (“[T]he IRS may seek to apply the substance of the proposed regulations to existing arrangements.”).
A more flexible approach to pending tax years would be consistent with Chevron and Brand X, which acknowledge that regulatory statutes frequently permit a range of meanings. There is no need for the IRS to effectively handcuff taxpayers to the proposed regulations pending their finalization. In fact, at times, the IRS openly acknowledges that taxpayers can break from proposed regulations when, for example, those regulations offer a particular tax accounting method and the IRS announces that taxpayers can use “any reasonable method” until final regulations are issued.
So what’s the solution for all this? As I mentioned in my prior post, the IRS should show due regard for comments that it receives on the regulations, to help dispel the strong inference that the agency has already made up its mind on this rulemaking project. As it stands now, the IRS has adopted a weaponized approach to the APA, where it uses notice and comment procedures to advance an audit or litigation position. It should instead follow a democratic approach to the APA, where it sincerely solicits public feedback to improve rulemaking. (For more on so-called “fighting regulations,” I would recommend Leandra Lederman, The Fight over “Fighting Regs” and Judicial Deference in Tax Litigation, 92 B.U. L. Rev. 643, 643 (2012).)
Although the contents of the regulations is irrelevant to the procedural issues discussed here, I thought I might disclose my views on them generally (I haven’t dug into their details). As I’ve previously written, I think regulations that attack private equity transactions fit comfortably within Section 707(a)(2)(A). Those transactions apparently allow private equity firms to easily convert high-taxed ordinary income into low-taxed capital gain, and they seem like a perfectly appropriate target for IRS rulemaking. Additionally, I personally don’t care if private equity firms face higher tax rates and would happily support a legislative proposal to phase out the capital gains preference for the ultra-wealthy. And if the IRS seized a fund manager’s summer home in the Hamptons, I’d probably release a hearty giggle.
Nonetheless, one’s subjective sympathy (or lack thereof) for a regulated party should not influence scholarly analysis. And it definitely should not influence the exercise of the IRS’s power. The agency should keep that in mind as it continues to play fast and loose with the APA.
By Andy Grewal