United States: United States Supreme Court Allows Pre-Enforcement Suit Challenging IRS Notice Backed By Tax Penalties

On May 17, 2021 the Supreme Court of the United States issued its decision in CIC Services, LLC v. Internal Revenue Service et al. Reversing the lower court decision, the Supreme Court unanimously held that the Anti-Injunction Act 26 U.S.C. §7421(a) did not preclude a pre-enforcement suit to set aside an IRS Notice that establishes an information reporting requirement backed by civil tax and criminal penalties.

The suit centred around Notice 2016-66 issued by the IRS, which identifies micro-captive agreements as reportable transactions. A micro-captive transaction is typically an insurance agreement between a parent company and a "captive" insurer under its control, which provides the parties to the agreement with certain tax advantages. Notice 2016-66 requires taxpayers and material advisors associated with micro-captive agreements to describe the transaction in sufficient detail for the IRS to be able to understand its tax structure, and to ultimately  determine whether the taxpayer is entitled to the tax benefit claimed. Non-compliance can subject a taxpayer or material advisor to civil penalties, which are deemed to be taxes for purposes of the Internal Revenue Code, as well as criminal penalties. 

The underlying suit challenged the lawfulness of Notice 2016-66. The petitioner, CIC Services, is a material advisor to taxpayers participating in micro-captive transactions and brought this suit  before the Notice's first reporting date. CIC sought to enjoin the enforcement of Notice 2016-66 as an unlawful IRS rule in violation of the Administrative Procedure Act. The suit has not yet proceeded to the merits, because the Government moved to dismiss the action on the basis that it violates §7421(a) of the Anti-Injunction Act, which states that "no suit for the purpose of restraining the assessment or collection of any tax shall be maintained in any court by any person."

The Government argued that enjoining enforcement of the Notice would prevent the IRS from conducting tax penalty assessments against non-compliant material advisors, contrary to §7421(a) of the Anti-Injunction Act. The Government argued that CIC could only dispute the lawfulness of the Notice after disobeying the Notice and suing for a refund of any resulting tax penalty. The District Court agreed with the Government and the Court of Appeals for the Sixth Circuit affirmed that ruling in a divided decision, with the majority holding that CIC's suit would restrain and eliminate the tax penalty by invalidating the Notice, which is the basis of the tax. 

The Supreme Court has now unanimously reversed that decision, holding that CIC's suit can proceed on the merits because the Anti-Injunction Act does not apply. In so holding, the Court found that the true purpose of CIC's suit was to contest the legality of the Notice itself, rather than the statutory tax penalty which can be used to enforce the Notice. The Court rejected the Government's argument that this was a tax action in disguise given the following three aspects of the regulatory scheme:  

• The Notice imposes onerous reporting obligations, which take a lot of time and money to comply with; costs not tied to any tax.
• The Notice's reporting rules and statutory tax penalty are several steps removed from one another.
• The risk of criminal penalties, including imprisonment, for "wilful failure" to comply with the Notice's rules necessitates a pre-enforcement suit, instead of the Anti-Injunction Act's typical  "pay-now-sue-later" refund actions.

The Court also rejected the Government's argument that allowing a suit to enjoin enforcement of the Notice would open the "floodgates" of pre-enforcement tax litigation because nothing has really changed in the law. The Anti-Injunction Act did not apply in this particular case, because it was simply not a dispute over taxes. Had the IRS imposed a tax on micro-captive transactions themselves, the Anti-Injunction Act would have applied to bar pre-enforcement proceedings, but Notice 2016-66 imposes a reporting requirement, not a tax. 

Justices Sotomayor and Kavanaugh each wrote concurring decisions. Justice Sotomayor wrote separately to note that the outcome might have been different if CIC were a taxpayer instead of a tax advisor, considering a tax on noncompliance may operate as a substitute for the tax liability evaded by withholding required information. Justice Sotomayor narrowed the holding to the facts of this case, stating that the outcome in any particular case will depend on a context-specific inquiry into the relief requested and the regulatory scheme at issue. Justice Kavanaugh, on the other hand, casts the Court's opinion more broadly, claiming that  pre-enforcement suits challenging regulations backed by tax penalties are generally allowed as a carve out to the established precedent that pre-enforcement suits challenging regulatory taxes or traditional revenue-raising taxes are barred by the Anti-Injunction Act. 

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