Ivins’ Pat Smith Continues Leading Role in Analysis of APA and Tax Regs

We are pleased to attach Pat Smith’s latest article on the applicability of the Administrative Procedure Act to IRS pronouncements, Mannella, State Farm, and the Arbitrary and Capricious Standard, Tax Notes, April 25, 2011.  While the field has gained more prominence with the Supreme Court’s recent Mayo decision[1] holding that challenges to tax regulations are evaluated under the same standards that apply to regulations issued by every other federal agency, as set forth in the 1984 Chevron decision,[2] even before the Mayo decision Pat has been a leading voice on the application in tax of general administrative law principles that have often been overlooked or misunderstood in the tax community.[3]  Since Mayo, a decision widely viewed as granting the IRS great discretion in the promulgation of tax regulations, Pat has taken the lead in explaining how that decision requires the IRS and Treasury to pay greater attention to administrative law restrictions on agency action, as articulated by the courts over decades with respect to agency action outside the tax field, but often ignored by the IRS and Treasury.[4]  Where some observers see Mayo as a shield from judicial review, Pat sees it as a potent sword in the hands of taxpayers challenging regulations.

In his most recent article, Pat examines the APA requirement that an agency explain its reasoning for adopting a rule contemporaneously with its adoption – a principle that formed the basis for the dissent in a recent Third Circuit case involving a challenge to IRS regulations, Mannella v. Commissioner.  While the particular regulations at issue in Mannella have no relevance in the context of business operations, nevertheless, the administrative law principles raised by this dissent are potentially relevant with respect to regulations that would be applicable to business operations.

In Mannella, the Third Circuit agreed with the Seventh Circuit’s decision in Lantz v. Commissioner,[5] upholding against taxpayer challenge the rule in the regulations imposing a two-year time limit on claims for equitable innocent spouse relief under section 6015(f).  In a dissent in Mannella, Judge Ambro would have held that the IRS made it impossible for the court to determine whether its action in adopting the rule was “reasonable,” as required under step two of Chevron, because the IRS provided no explanation of its reasons for imposing this two-year time limit at the time the rule was adopted.

Judge Ambro concluded that, in the absence of such a contemporaneous explanation of the agency’s reasoning, it was impossible for a reviewing court to exercise its role under Chevron in evaluating whether the agency’s action represented reasonable decision-making.  Judge Ambro’s conclusion has substantial support in the area of administrative law relating to the Administrative Procedure Act’s arbitrary and capricious standard, as that standard was interpreted in the Supreme Court’s landmark 1983 State Farm decision.[6]

State Farm requires that agencies engage in reasoned decision-making and that agencies also provide contemporaneous explanations of their reasoning to make it possible for reviewing courts to evaluate whether the agency has satisfied the reasoned decision-making requirement.  The requirements imposed by State Farm are commonly viewed as substantially similar to the requirements of Chevron step two.  Although assertions that agencies have violated State Farm are commonplace for agencies other than the IRS, violations of State Farm have almost never been asserted against the IRS, even though IRS preambles to regulations are vulnerable to challenge under this standard because these preambles often do not provide the type of explanation State Farm requires.

Tax practitioners do not plan based on a conclusion that regulations are invalid, and, indeed, such arguments are difficult at best to sustain on audit, but in the changing landscape of judicial review of IRS actions, it can be critical to sow the seeds of such challenges early in the process.  Pat’s writings are a roadmap to such potential challenges.

[4] In Omissions from Gross Income and Retroactivity, Tax Notes, Apr. 4, 2011, Pat argued that one consequence of the IRS success in Mayo in claiming broad authority to make choices as to the substantive content of regulations should be an offsetting limiting effect on the authority of the IRS to make regulations exercising that broad substantive authority retroactive in effect, particularly for regulations issued under statutory provisions enacted before 1996, since the rationale justifying retroactive regulations is that they merely clarify what the law always was, a rationale which is fundamentally inconsistent with the rationale of Chevron and Mayo, which allows agencies to make choices among a range of alternatives based on policy considerations rather than based on an effort to arrive at the most accurate interpretation of Congressional intent.  Pat’s next article, on the taxpayer-favorable implications of Mayo, is scheduled for publication in Tax Notes on June 20.