Since the Supreme Court in Mayo Foundation v. U.S., 562 US 44 (2011)’ held that IRS regulations are subject to the same standard of review as are regulations of other agencies, several prominent attorneys have kicked around the idea that IRS notices of deficiency were subject to review under the Administrative Procedures Act (APA) just like the adjudicative determinations of other agencies. After all, the Tax Court and federal appeals courts have turned to the APA to decide whether a tax regulation was procedurally valid. The taxpayers raised a claim that the APA applies to deficiency proceedings in Ax v Commissioner, 114 TC No. 10 (April 11, 2016), only to have the claim felled by the Tax Court.
The taxpayers owned a S corporation that had set up a captive insurance company. After audit, the IRS issued a deficiency notice disallowing deductions for payments to the captive insurer on the ground that a) the arrangement was not insurance and b) the taxpayers failed to substantiate the payments. Seven months after it answered, the IRS moved to amend its answer to raise 2 new claims: a) that the transactions lacked economic substance and b) that the payments were not ordinary and necessary business expenses. The taxpayers opposed the motion on the grounds that allowing amendment would violate the APA and Chenery Corp. v SEC, 318 US 80 (1943). They also argued that granting the motion would cause undue prejudice.
The taxpayers’ argued that under the APA and Chenery an agency adjudication can only be reviewed on the grounds articulated in the agency’s determination. The Tax Court explained that, under Chenery, a court can review an action left to the agency’s sole discretion only on the grounds articulated by the agency in its decision. A reviewing court cannot “perform a pseudo-review” of a decision that the court may have reached if it were the agency. This is not the situation in a deficiency case. While the IRS makes the initial determination that there is a deficiency, the Tax Court is authorized to “redetermine” the deficiency and also has the authority to determine that more is owed than claimed in the deficiency notice or that the taxpayer is owed a refund for the years under review. Further, while the notice of deficiency must describe the basis for the deficiency determination, an inadequate description does not affect the validity of the notice.
Turning to the APA, the Tax Court noted that under the APA, review of agency action “is the special statutory review proceeding relevant to the subject matter in a court specified by statute,” in this case the Tax Court. Deficiency procedures were in existence 20 years before the APA was enacted and the APA was not meant to supplant these procedures. In deficiency cases, the IRS had always been allowed to raise new matters, for which it had the burden of proof. Mayo Foundation did not affect deficiency procedures, since it only dealt with the deference to be accorded IRS regulations.
A motion to amend can be defeated by showing that granting the motion will cause undue prejudice. Since the case had not been set for trial, the taxpayers had adequate time to prepare to meet the IRS’s new contentions. Thus, the motion to amend was granted.
The taxpayers in this case wanted to have their cake and eat it to, in a sense. Under the Administrative Procedures Act, a reviewing court not only is limited to considering the grounds upon which the administrative agency based its determination, it is also normally limited to reviewing the agency record to determine whether the agency’s determination was an abuse of discretion. This is the standard used in collection due process cases. A case in which a court applied the Administrative Procedures Act was Moore v. United States, the non-willful FBAR case we will revisit in the near future.
ROBERT S. HORWITZ – For more information please contact Robert S. Horwitz – firstname.lastname@example.org or 310.281.3200 Mr. Horwitz is a principal at Hochman, Salkin, Rettig, Toscher & Perez, P.C., a former Assistant United States Attorney of the Tax Division of the Office of the U.S. Attorney (C.D. Cal) and represents clients throughout the United States and elsewhere involving federal and state, administrative civil tax disputes and tax litigation as well as defending criminal tax investigations and prosecutions. Additional information is available at http://www.taxlitigator.com