Notice-and-Comment Rulemaking: How the IRS Can Change Tax Reporting Rules
Most taxpayers assume that once they submit a tax return for the year, they will have satisfied the tax reporting rules, and their duty to the IRS is done. For those with more complicated tax situations, they may rely on a tax preparer to make sure everything is filed properly. But what happens when the IRS changes the tax reporting rules without notice? A recent United States Tax Court decision explains the importance of the notice-and-comment rulemaking process.
What is the Notice-and-Comment Regulatory Process?
When the IRS (or many other federal regulatory agencies) wants to change its regulations, it must follow the instructions of the Administrative Procedure Act (APA). This federal law sets out a notice-and-comment rulemaking process designed to make sure the people and legal entities affected by these regulatory rule changes have a chance to learn the change is coming and provide written feedback to the agency about the effect of the change.
The APA sets out a three-step “notice-and-comment rulemaking” procedure that the IRS must generally use to change tax reporting rules:
- The IRS must issue a general notice describing the proposed rule change
- Interested persons must be allowed to provide comments on the change
- The IRS must issue a “concise general statement of [the rule change’s] basis and purpose”
Can the IRS Skip Publishing Notices and Still Change Tax Reporting Rules?
The notice-and comment rulemaking process is time-consuming. Often, the IRS must issue multiple versions of a proposed notice to respond to taxpayer feedback before the final change to the tax reporting rules can go into effect. Because of this, the IRS sometimes tries to skip publishing the required notices and still change tax reporting rules.
This happened in the years leading up to the American Jobs Creation Act of 2004 (AJCA). The IRS had identified certain “Syndicated Conservation-Easement Transactions” that it sought to restrict. Congress held oversight hearings about these transactions, in which the IRS provided a list of problematic tax-avoidance transactions. Following those hearings, Congress passed the AJCA, authorizing the IRS to identify listed transactions that would need to be disclosed in greater detail than the standard tax reporting rules required. But the IRS never used the notice-and-comment rulemaking procedure to identify those “listed transactions.”
Then, in 2016, the IRS issued Notice 2017-10, without inviting public comment as required by the APA. The new notice added a syndicated conservation easement transaction to the “listed transactions” requiring additional disclosures. The disclosure requirement applied retroactively. Any taxpayer who had engaged in such a transaction over the past six years had 90 days to amend their tax returns to include the additional information.
When certain companies failed to do so, the IRS issued penalties. But the companies said that the penalties could not be asserted because the IRS had improperly skipped the notice-and-comment rulemaking requirements. They sued the IRS in Green Valley Investors LLC v IRS for adjustments of those notices and penalties. This caused the United States Tax Court to review the notice in question to decide if the IRS was allowed to shortcut the process.
Legislative Rules vs Interpretive Rules
The IRS isn’t required to use notice-and-comment rulemaking for every minor rule change. Interpretive rules, which “merely advise the public of an agency’s construction of the statutes it administers” can be made without inviting comment. However, legislative rules that impose new rights and duties and change tax reporting rules must use the notice-and-comment rulemaking process. The question for the Court was whether changes to the “listed transactions” were legislative or interpretive.
The Tax Court said that identifying a transaction as a “listed transaction” imposed new tax reporting and recordkeeping requirements on taxpayers and tax preparers. These duties went beyond a mere change in forms. Reporting listed transactions required taxpayers to prepare detailed narratives of their transaction histories. Tax preparers were required to disclose such transactions and keep copies of any tax opinions or documents related to them, in case the IRS decided to investigate.
If taxpayers or tax preparers failed to report the newly listed transactions, they faced stiff penalties of between $10,000 to $200,000 dollars. Some of these penalties applied even if the taxpayer’s treatment of the transaction as a charitable donation was correct. In other words, even if the taxpayer owed no taxes and properly claimed all deductions related to the transaction, the failure to provide the additional disclosure forms could cost them thousands of dollars. If tax preparers were asked to produce records related to a listed transaction and didn’t do so within 20 days, they could also be charged a penalty of $10,000 per day until the information was provided.
The Tax Court called this change “the prototype of a legislative rule.” It held that the IRS could not change those tax reporting rules without following the notice-and-comment rulemaking process.
United States Tax Court Strikes Down IRS Notice Issued Without Comment
The IRS claimed that even if the APA would ordinarily apply, the ACJA and the hearings Congress held leading up to it excused the IRS from publishing notice and receiving comments on new tax reporting rules for “listed transactions.” However, the Tax Court could find nothing in the ACJA that excused the IRS from following the APA. It disagreed that the hearings and the language of the ACJA resulted in an “implied repeal” of the APA, since no new process was described for how the IRS can change tax reporting rules related to the “listed transactions.”
As a result, the Tax Court set aside Notice 2017-10 because it was “issued without notice and comment as required under the APA.” The Tax Court went out of its way to state “the Court intends to apply this decision setting aside Notice 2017-10 to the benefit of all similarly situated taxpayers who come before us.” In other words, it warned the IRS not to impose penalties related to the newly added transactions until the notice-and-comment rulemaking process had been met.
Attorney Joseph R. Viola is a tax attorney in Philadelphia, Pennsylvania with over 30 years experience. If you are facing tax penalties for failure to report a “listed transaction,” contact Joe Viola to schedule a free consultation.