On May 17, 2021, the income tax filing deadline for most Americans, the Supreme Court issued a decision that bolstered taxpayers’ rights to challenge IRS reporting rules in court. Here’s a summary of the decision and its practical effects on taxpayers and their financial/tax advisors.
The Anti-Injunction Act
A federal law called the Anti-Injunction Act has long barred taxpayers from filing lawsuits that attempt to stop the IRS from assessing or collecting a tax. Historically speaking, it’s never been an especially controversial law. No one likes paying taxes, obviously. However, allowing taxpayers to sue the IRS to stop the collection of taxes would risk choking off tax revenue, and would bring government and court operations to a grinding halt. That’s why, in most cases, taxpayers who dispute a tax obligation must first pay, and then sue for a refund.
IRS rulemaking and the dangers of non-compliance
Federal law also gives the IRS broad powers to request information from taxpayers. From time to time, for example, the IRS may identify certain types of financial transactions that it deems worthy of extra scrutiny and will require taxpayers or financial/tax advisors to report those transactions to the agency. The IRS will often enforce those reporting requirements by imposing tax penalties, and even potential criminal sanctions, for non-compliance.
The Supreme Court’s Tax Day decision addressed what happens when a taxpayer sues to challenge a new IRS reporting rule that’s backed up by those sorts of non-compliance penalties.
CIC Services v. Internal Revenue Service
In 2016, the IRS issued Notice 2016–66, which identified a type of insurance agreement called a micro-captive transaction as a potential vehicle for tax evasion. The Notice required taxpayers and their advisors to report any such transaction to the IRS. Failing to report micro-captive transactions could result in hefty tax penalties and criminal liability.
CIC Services is an advisor to taxpayers in micro-captive transactions. Shortly after issuance of Notice 2016-66, CIC sued in federal court to stop the IRS from enforcing the Notice’s reporting requirements, arguing that they were adopted in violation of federal administrative law. The IRS responded by asking the court to dismiss the case, claiming that the lawsuit violated the Anti-Injunction Act by seeking to prevent assessment and collection of a tax (specifically, the tax penalty for non-compliance with the Notice).
In its Tax Day opinion, a unanimous Supreme Court sided with CIC. A lawsuit challenging a potentially burdensome IRS reporting rule is not the same as one attacking collection of a tax, even if the reporting rule is backed up by a tax penalty, it held. If the Anti-Injunction act were to prevent CIC’s lawsuit, the Court reasoned, CIC would be placed in the impossible position of having to violate the rule. They would then face both tax penalties and criminal liability before ever having an opportunity to question the validity of the Notice itself.
Takeaways from the SCOTUS tax day decision
The Supreme Court’s CIC Services decision empowers taxpayers and advisors to challenge potentially burdensome IRS reporting rules in court, without fear of suffering harsh tax penalties and criminal sanctions for non-compliance. That’s something we can all celebrate at tax time.