So, we did not write on the first District Court case which was a loss for CIC Services, LLC (“CIC”) and Ryan, LLC(“Ryan”), the Plaintiffs. But, a Supreme Court decision gave the Plaintiffs another bite at the apple. This case involves Notice 2016-66 (“Notice”), the older-sibling notice to Notice 2017-10, in which micro-captive insurance transactions were labeled transactions of interest, thus becoming a reportable transaction requiring significant additional disclosure and return filings.
Micro-captive insurance companies are as the name implies, captive insurance arrangements where a taxpayer decides to self-insure their own risks. Without going into detail on the taxability of insurance companies, Section 831 of the Code provides for taxation of insurance companies other than life insurance companies. A key component of qualifying to be taxed pursuant to Section 831 of the Code requires being an insurance company. Breaking some barriers to entry for smaller taxpayers and giving them a potentially tax-advantageous manner in which to self-insure, we have Section 831(b), allowing micro-captives. Effectively, a micro-captive, under Section 831(b) is a captive qualifying to be taxed as a U.S. insurance company which may pay tax on its investment income only in any year its total written premium amounts are under a stated threshold, $2.2 million. Effectively a taxpayer can pay its insurance premiums to an affiliate entity, deduct the premium, subsequently not recognize the premium receipt by the insurance company as taxable income, and then only pay tax on the investment income and subsequent dividend. Unsurprisingly, there were some bad actors out there peddling a medley of arrangements, some of which not constituting insurance, others pitching unnecessary insurance (think volcano insurance) for the sake of banked and untaxed premiums.
CIC and Notice 2016-66
CIC is a captive insurance company manager and Ryan is a self-identified “broad-based accounting, consulting, and tax services corporation which also manages captive insurance companies.” CIC and Ryan stated that they would be subject to the Notice’s disclosure requirements as material advisors, particularly the filing of Form 8918 with the Office of Tax Shelter Analysis and the list maintenance requirements, and that compliance would be tremendously expensive.
On March 27, 2017, CIC and Ryan filed suit in the United States District Court in the Eastern District of Tennessee seeking, among other things, an injunction, stopping the IRS from enforcing Notice 2016-66, in part due to failure to comply with the notice and comment requirements under the Administrative Procedure Act (“APA”) as it is a “legislative-type rule” (more on that later). In a hearing on April 19, 2017, the parties argued the Plaintiffs’ motion for preliminary injunction. At the hearing, Sean King, principal and founder of CIC, testified about the harm he expected CIC to suffer if forced to comply with the Notice’s onerous reporting requirements. Among these harms were that (1) CIC would incur significant fees and costs to comply with the Notice’s reporting requirements; and (2) that the Notice’s designation of certain micro-captive transactions as reportable transactions has undermined the market value of CIC and caused reputational damage to CIC.
The Second Hearing
Unfortunately for the Plaintiffs, the Court believed that they would not succeed on the merits (likeliness to succeed on the merits being a requirement for a preliminary injunction) as their claims were foreclosed under the Anti-Injunction Act (“AIA”) because application of the AIA, as the Court believed, would render the Plaintiffs without remedy. Accordingly, the Court ruled against them, denying their motion. Subsequently, on November 2, 2017, the case was dismissed by the Court due to lack of subject matter jurisdiction because the Plaintiffs’ claims were barred by the AIA. Fast forward to May 17, 2021, after a lengthy appeals process, the Supreme Court of the United States unanimously held that the AIA did not deprive the Court of subject matter jurisdiction of the Plaintiffs’ claims. Unsurprisingly, CIC renewed its motion for preliminary injunction.
The Court heard the motion on September 17, 2021. Mr. King returned with additional testimony. Since 2017, and the prior hearing for preliminary injunction where King testified that he believed that CIC would incur significant costs for compliance, King added what CIC had actually experienced since that time. Reality seemed to be worse than his original forecast. Originally estimating around $60,000+ per year in compliance costs, CIC had, at the time of the hearing, expended about $400,000 and even coincidentally received an audit notice, as a potential tax shelter promoter, from the IRS. There was no statement that the audit was linked to any filings pursuant to the Notice, but was noted nonetheless.
While the injunction was the remedy sought here, the relevant part of the analysis, for this discussion at least, is the analysis by the Court of the application of the APA to the Notice. As a critical factor, the Court had to determine whether the Notice was, in effect, a legislative rule or interpretive rule under the APA.
The Court’s analysis began citing the fact that the APA distinctly distinguishes “rules” as “legislative rules” and “interpretive rules” to determine whether the notice and comment period, described below, applies. Legislative rules are subject to notice and comment while interpretive rules are not subject to the APA additional procedural requirement. In the case of the APA, a “rule” is defined as a “statement of general or particular applicability and future effect” that is designed to “implement, interpret, or prescribe law or policy.”
Section 4 of the APA provides a three-step process for the notice and comment rulemaking, summarized as follows:
- Issuance of general notice of proposed rulemaking;
- Following notice, the provision of opportunity to interested persons to participate in the rule making through submission of written data, views, or arguments; and
- In the case of issuance of a final rule, a concise general statement of basis and purpose must be provided in the rule’s text.
Importantly for CIC (and likely many other advisors and taxpayers), such rules issued by agencies without abiding by the APA’s notice and comment procedural requirements are invalid.
What is the Difference Between Legislative Rules and Interpretive Rules?
So, enter every lawyer stereotype answer now, “the line between interpretive rules and legislative rules is fuzzy and enshrouded in considerable smog.” The Court did however provide some contrast providing that, generally, legislative rules have the “force and effect of law.” Interpretive rules, on the other hand, are “issued by an agency to advise the public of the agency’s construction of the statutes and rules which it administers.” Simplified in Azar, interpretive rules simply state what the agency thinks the statute means, or only remind affected parties of existing duties.
Notice 2016-66, Legislative or Interpretive? – Merits Issue
Treas. Reg. § 1.6011-4, issued under delegated authority from Congress, sets forth types of transactions that qualify as reportable transactions, through required notice and comment procedures. The issue in the case of Notice 2016-66 is that the IRS gave a “TBD” in its list of reportable transactions, being “transactions of interest” (what CIC was involved in) and “listed transactions” (like that found in Notice 2017-10). These definitions were given in regulation, but in the case of those two types, the IRS just reserved the later right to identify. As the Court stated, “the crux of this dispute is whether the IRS can classify certain transactions as ‘transactions of interest’ […] thereby making them ‘reportable transactions’ and triggering reporting requirements, through an agency issued notice that did not go through notice and comment.”
The original regulation providing definitions for certain types of reportable transactions were subject to notice and comment, under the APA. In the case of a “transaction of interest,” the IRS just provided a “circular” definition being subject to change later at the whims of the IRS. A “transaction of interest” is just a transaction, identified by the IRS, believed by the IRS to have a potential for tax avoidance or evasion.
The Court quickly noticed the issue at hand. The IRS retained unlimited discretion to create new duties and obligations having force of law by mere issuance of a notice identifying the transaction, by description, and as noted by the Court, especially when the new reporting requirements subject those like CIC to monetary fines and criminal prosecution.
In concluding that the Plaintiffs would be likely to succeed on the merits, the Court discussed the irreparable harm component. In the case at hand, the Plaintiffs (CIC, at least) demonstrated expense without any legal (monetary) remedy available to provide compensation, should they even prevail. The Court seems to agree with the Plaintiffs that the IRS is just cutting corners with Notices and violating their legal obligations under the APA.
In the end, the Court enjoined the IRS from enforcing the Notice as to CIC. So, what does this mean? Likely, the injunction will result in application as to all of those subject to reporting under the Notice. Additionally, the silent, yet enormous, elephant in the room, at least for those following the subject-matter, is the syndicated conservation easement. This ruling, at least pending appeal, should pour gas on the fire for material advisors in that arena. But where do we go from here? Save for a right to a ruling to say “you have to stop what you’re doing,” those subject to enhanced reporting are out their costs of compliance and virtual certain targeting by the IRS without remedy. The stress, expense, and reputational impact of the stigma of being involved in “reportable transactions” is there to stay without recompense. Perhaps in a criminal prosecution, the Court may look upon the gathering and acquisition of this information as acquiring the fruit of the poisonous tree giving some type of remedy.
 CIC Services, LLC and Ryan, LLC v. IRS, et. al., Case 3:17-cv-110 (Eastern District of Tennessee)
 IRC § 831(b).
 5 U.S.C. § 533
 CIC Services, LLC v. IRS, et al., 141 S.Ct. 1582 (May 17, 2021).
 Perez v. Mortg. Bankers Ass’n, 575 U.S. 92 (2015).
 5 U.S.C. §551(4).
 Tenn. Hosp. Assoc v. Azar, 908 F.3d 1029, 1042 (6th Cir. 2018).
 NRDC v. Wheeler, 955 F.3d 68 (D.C. Cir. 2020).
 See Perez, 575 U.S. at 96.