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Supreme Court Rules Tax Penalty Does Not Bar Pre-Enforcement Regulatory Challenge

The Supreme Court held that a company may bring a pre-enforcement challenge under the Administrative Procedure Act ("APA") to an IRS reporting requirement backed by a tax penalty.

On May 17, 2021, the U.S. Supreme Court unanimously reversed the Sixth Circuit and permitted a company's challenge to an IRS reporting requirement to proceed, notwithstanding the Anti-Injunction Act ("AIA"). 

The reporting requirement, imposed in 2016 regulatory guidance, mandates that certain "micro-captive" insurance transactions be reported to the IRS. Micro-captive transactions are an arrangement in which a parent company establishes a subsidiary insurance company to receive more favorable tax treatment. Under the guidance, taxpayers and advisors that do not report micro-captive transactions may face statutory tax penalties and even criminal penalties. 

A Tennessee company that advises taxpayers participating in micro-captives sued under the APA to have the IRS guidance declared unlawful. The company sued without first facing any IRS enforcement action for noncompliance. 

The district court ruled that the suit was barred by the AIA's prohibition against challenging tax assessments prior to enforcement. The court concluded that the only way the company could bring its claims would be to disobey the guidance, face an IRS enforcement action, be forced to pay the tax penalty, and then sue for a refund of it. A divided Sixth Circuit panel affirmed.  

The Supreme Court unanimously reversed. It held that the AIA did not bar the suit, because the "relief requested" was invalidating the guidance's reporting requirements, not "the statutory tax penalty that serves as one way to enforce it." The Court viewed the reporting requirement as distinct from the tax penalty because: (i) the reporting requirement imposed substantial compliance costs unconnected to, and perhaps greater than, any tax liability; (ii) the causal chain connecting the reporting requirement to the tax was attenuated; and (iii) the reporting requirement was enforced by criminal penalties. 

The Court's ruling may open the door to more "pre-enforcement suits challenging regulations backed by tax penalties," as a concurring Justice put it. Organizations should note this potentially expanded opportunity to bring pre-enforcement challenges under the APA to onerous government regulations backed by tax penalties.

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