March 1, 2012
On December 7th, oral argument was held in the Fifth Circuit in the NPR case before Judges Dennis, Clement, and Owen. You can find a detailed explanation of the issues here but in summary the questions involve whether, in the context of a Son of BOSS case: the gross valuation penalty applies when the basis producing transaction is not invalidated solely due to a bad valuation; whether other penalties apply; how the TEFRA jurisdictional rules function as to those penalties; and whether an FPAA issued after a non-TEFRA partnership no-change letter falls afoul of the no-second-FPAA rule.
Although both parties appealed, as the initial appellant DOJ began the argument. DOJ counsel argued that the Supreme Court’s decision in Nat’l Cable & Telecomm. Ass’n v. Brand X Internet Servs., 545 U.S. 967, 982 (2005), allowed Treas. Reg. § 1.6662-5(d) to override the Fifth Circuit’s position in Heasley v. Commissioner, 902 F.2d 380 (5th Cir. 1990), that a valuation misstatement cannot apply where there are grounds for invalidating the transaction other than an incorrect valuation — such as where the transaction is totally disallowed under economic substance or on technical grounds. In this regard, DOJ requested that the court submit the matter for en banc review to address this issue and to consider the impact of Weiner v. United States, 389 F.3d 152 (5th Cir. 2004), which counsel characterized (as DOJ had in the brief) as calling the “total disallowance” rule into question.
As to the substantive application of penalties, DOJ argued that the complete concession by the taxpayer of the substance of the transaction compelled the conclusion that the position lacked substantial authority. Furthermore, counsel argued that there was no substantial authority at the time the transaction was reported on the taxpayer’s return. In this regard, DOJ posited that although Helmer v. Commissioner, 34 T.C.M. (CCH) 727 (1975), had held that a contingent liability was not a liability for purposes of section 752, it did not address the questions of buying and selling offsetting options and of contributing them to a partnership only to arrange for a distribution and sale. As to these points, the only authority on point was Notice 2000-44, which stood for the proposition that the transaction did not work. This appears to be a repackaged version of the argument that there can never be substantial authority for transactions lacking economic substance.
Argument transitioned to the question of whether the district court had jurisdiction to consider a penalty defense put on by the partners and not by the partnership in this partnership action. For a prior discussion of this confusing question see our analysis here. Citing Klamath Strategic Inv. Fund, LLC v. United States, 568 F.3d 537 (5th Cir. 2009), DOJ counsel argued that the Fifth Circuit had already decided that an individual reasonable cause argument (such as one based on a legal opinion issued to the partner) cannot be raised in a TEFRA proceeding. The court seemed to recognize the impact of Klamath on this point. DOJ counsel then attempted to box the partnership in (as it had in the brief) on the question of whether the defense was raised by the partner or the partnership (several statements in the district court’s opinion seem to view the defense as a partner-level defense).
Moving on to the question of the merits of the reasonable cause position, DOJ argued that the district court erred in considering reliance on the tax opinion (which was written by R.J. Ruble) to be reasonable. Initially, counsel questioned whether the partners’ testimony that they did not believe Ruble had a conflict was reasonable in light of the partners’ knowledge of fee sharing and of the fact that Ruble had written opinions for other shelters for the same promoter. The court seemed to be honed in on this question. In closing, DOJ attempted to poison the well of partner good faith by reminding the Court that the partners in this case were repeat tax-shelter offenders and had attempted to hide the Son-of-BOSS losses as negative gross revenue from their law firm business.
Perhaps indicating a weakness on the penalty issues raised by DOJ, taxpayer’s counsel spent most of his time on the question of whether the second FPAA was invalid. The Court focused counsel on the fact that an error on the tax return (the Form 1065 did not check the TEFRA box although it did check the flow-through partner box (which would indicate a TEFRA partnership)) led the agent originally to pursue the case as non-TEFRA. Undeterred, counsel argued that this error was not material and that the agent had indicated in a deposition that he eventually learned that the partnership was TEFRA. Testimony was also offered in the district court that the reporting was an innocent mistake and not negligent or deceptive. The Court spent significant time questioning why the agent did not testify at trial (which appears to have been due to a mix-up on the part of DOJ). In summarizing his position, taxpayer’s counsel tried to focus the court on the language of the partnership no-change letter but to us it appears that the real question has to be whether the agent intended this to be a TEFRA audit. An FPAA simply cannot come out of a non-TEFRA audit. Based on the agent’s deposition transcript it seems clear that he did not believe he was involved in a TEFRA audit when he opened the audit and thus it is impossible that the initial notice was an FPAA.
Rebutting DOJ’s reasonable cause position, taxpayer’s counsel focused on the trial testimony and factual determinations by the district court that the taxpayers were acting reasonably and in good faith. On the question of jurisdiction, the taxpayer reverted to the tried and true (but not very strong) argument that requiring a later refund suit to address the reasonable cause question would be a waste of judicial resources and, in essence, a meaningless step. A cynic might say that the purpose of TEFRA is to waste judicial resources and create meaningless steps.
In rebuttal, DOJ counsel focused on the no-second-FPAA question and did a good job from our perspective. He noted that you have to have a TEFRA proceeding to have a TEFRA notice. Undermining the district court’s determination that the finality of the notice is relevant, counsel noted that all non-TEFRA notices are “final” but that doesn’t mean they are FPAAs. TEFRA is a parallel audit procedure and it is simply not enough that the IRS intended a final determination in a non-TEFRA partnership audit. The question is whether the IRS intended to issue a final notice in a TEFRA proceeding; since there was no “first” TEFRA proceeding, there was no “first” FPAA. We think this argument is right on target.
With limited questions coming from the Court it is difficult to see where this is headed. Our best guess is that the partnership will prevail on the reasonable cause position (it is difficult for an appellate court to overturn credibility determinations of witnesses) but lose on everything else including the no-second-FPAA issue.
November 7, 2011
The NPR case (involving penalty application and TEFRA issues in the context of a Son of BOSS transaction: see latest substantive discussion here) has been calendared for argument in New Orleans on December 7th in the East Courtroom.
August 18, 2011
As we mentioned in our last post, the only brief remaining to be filed in NPR was the taxpayer’s reply brief. That brief has now been filed and with it a DOJ motion to strike part of that reply as an inappropriate sur-reply. The motion concerns a section in the reply in which the taxpayer takes on DOJ for arguing (in its previously filed reply brief ) that the only relevant factor in determining the incidence of the valuation misstatement penalty (between partnership and partner) is whether there are partnership items involved and not where the specific misstatement results in a loss.
The taxpayer’s view is that DOJ is trying to have its cake and eat it too – arguing that the penalty applies at the partnership level becuase it is related to partnership items but refusing to allow section 6664 arguments to be heard on the grounds that those are specific to the partner. DOJ’s position is that it would be barred from raising the penalty outside of the context of a partnership proceeding becuase the penalty relates to a partnership item (or items) and that it is not inconsistent to require section 6664 intent to be evaluated at the partner level (and, in any event, it is required by the regulations). All of this, as we have extensively discussed, is interwined in the silliness of trying to separate partner and partnership intent between TEFRA levels something the regulations perhaps should not have done but clearly do. It will be interesting to see how the Fifth Circuit handles the case.
August 12, 2011
It has been a while since we published an update on NPR (please no comments on Supreme Court Justices, schoolchildren, and bloggers taking summers off). Since our last post discussing the government’s opening brief, the taxpayer filed its brief responding to the government and opening the briefing on their cross-appeal. The government also filed its response/reply. All that remains now is the taxpayer’s reply brief on its cross-appeal, currently due on August 15. There are a slew of technical TEFRA issues that are raised by the parties. The taxpayer is appealing the district court’s rulings regarding whether a no change letter can ever be an FPAA and, if it can be, whether an erroneously checked box on the tax return (claiming that the partnership was not a TEFRA partnership) can constitute a misrepresentation of a material fact such that the no-second-FPAA rule of section 6223(f) is inapplicable. As we discussed last post, the parties are jointly briefing — in the government’s appeal — the application of the Heasley/Weiner line of cases to the taxpayer’s concession strategically made to circumvent the gross valuation misstatement penalty. Mayo is implicated by the application of Treasury Regulation section 1.6662-5(d) (DOJ relies on Brand X to argue that the regulation controls over the contrary rule previously announced in Heasley).
However, as we discussed in prior posts, the main issue here is good faith reliance on counsel — R.J. Ruble — by the taxpayer for purposes of the section 6664 reasonable cause defense and when, procedurally, that defense can be raised. The government continues to hew to the line that reliance is inappropriate (because of a technical conflict and because reliance was just not reasonable under the circumstances). DOJ also argues that the defense can be raised only in a partner-level proceeding pursuant to then Temporary Treasury Regulation section 301.6221-1T(d) (the judges may want to get a cholesterol test with all of this Mayo being spread around). For its part, the taxpayer argues that the district court already determined — after seeing the witness testimony — that the reliance was in good faith. Furthermore, since one of the partners is the TMP, the reasonable cause defense is being raised by the partnership as much as by the partners. Setting aside whether you believe the testimony (which the district court judge did), if we could decide cases based on the fact that section 301.6221-1T(d) of the TEFRA penalty regulations is stupid, this would be easy. As we have said before, separating partner and partnership intent in a transaction involving a partnership that was purposefully created by the partners to implement that very same transaction is like trying to dance on a headless pin. With deference under Mayo, however, “stupid is as stupid does” is not the test for striking down regulations. We will just have to wait and see how much patience the Fifth Circuit has for this Forrest Gump of a regulation.
April 27, 2011
The Government has filed its brief in its Fifth Circuit appeal from the denial of penalties in the NPR Investments case (for prior discussion go here). There are no surprises. The Government takes the position that the district court’s reliance on Heasley v. Commissioner, 902 F.2d 380 (5th Cir. 1990) (likely abrogated by Treas. Reg. § 1.6662-5(g) and certainly weakened on these facts by Weiner v. United States, 389 F.3d 152 (5th Cir. 2004)) is misplaced. Thus, the government argues that the mere fact that the taxpayer’s entire transaction (and not just a valuation or basis item) was concededly devoid of substance is not a bar to valuation misstatement penalties. The Government also takes issue with the alleged consideration by the district court of the partners’ (as opposed to the partnership’s) reasonable cause defenses in this TEFRA proceeding contrary to Temp. Treas. Reg. § 301.6662-1T(c)-(d). At a big picture level, the Government is still none-too-pleased with the district court’s open reliance on an R.J. Ruble opinion as contributing to such defenses, an act of reliance that it argues is contrary to case law prohibiting a taxpayer from relying on conflicted advisers for reasonable cause and also contrary to, among other things, the restriction on relying on a legal opinion that is based on representations the taxpayer knows are untrue. Treas. Reg. Sec. 1.6662-4(c)(1)(i).
This case has the potential to be another Mayo/Brand X battle-royale (what tax case doesn’t these days?) given that there are at least three regulations explicitly relied on by the Government some of which post-date contrary court opinions. But at bottom the case is just about a district court judge who looked into the eyes of the taxpayers and found not malice but, rather, an objectively good faith belief in the adviser who was hired to bring them safely past the landmines and snipers that fill the no-man’s land also known as the tax code. Although they didn’t make it across (the taxpayers abandoned defense of the claimed tax benefits and R.J. – metaphorically shot – is serving time), the district court apparently couldn’t fault them for trying. The government’s view is much harsher. In essence, it thinks that in trying to find a way to make it to the tax-free promised land, the taxpayers should have tried a little harder to explore the obstacles in their way before taking their guide’s word for it. At least their place shall never be with those cold and timid souls who know neither victory nor defeat.
The taxpayer’s brief is due May 17th. We will keep you posted.
February 23, 2011
I will be participating in what promises to be an interesting panel discussion on the Mayo Foundation decision on Monday February 28 at 1:00 EST. The other two distinguished members of the panel are: Gil Rothenberg, Chief of the Appellate Section of the United States Department of Justice’s Tax Division, who is also currently serving as Acting Deputy Assistant Attorney General for Review and Appellate; and Emily Parker, partner at Thompson & Knight LLP, and former Acting Chief Counsel and Deputy Chief Counsel for the IRS.
Information on how to register for the program can be found here.
We will be discussing the Mayo decision and its ramifications for future litigation and the regulatory process from both the government and taxpayer perspectives.
Supreme Court Opts for Chevron Analysis of Treasury Regulations, Discarding the Traditional National Muffler Dealers Analysis
January 11, 2011
The Supreme Court this morning issued its opinion in the Mayo Foundation case, ruling unanimously that medical residents are not “students” exempt from FICA taxation. As previously discussed several times on this blog (see here, here, and here), the Mayo case carried the potential for broad ramifications beyond its specific context because the parties had framed the question of whether deference to Treasury regulations is governed solely by general Chevron principles that supersede the deference analysis previously developed in tax cases like National Muffler Dealers. The Court in fact addressed that question and has now endorsed use of the Chevron standard in tax cases, thereby providing the IRS with a big victory that will make it more difficult for taxpayers to prevail in court in the face of contrary regulations, even if they are “bootstrap” regulations designed primarily to influence the outcome of litigation. And for good measure, the Court obliterated the long-held view by many in the tax world that “interpretive” regulations promulgated pursuant to Treasury’s general rulemaking authority under Code section 7805(a) are entitled to less deference than “legislative” regulations promulgated pursuant to more specific rulemaking authority.
The Court’s opinion was authored by the Chief Justice, who was the Justice who spoke out most forcefully during the oral argument in favor of the position that Chevron had superseded earlier decisions in tax cases, as noted in our previous post. Thus, the opinion sought to be very clear on this point and to identify some of the familiar approaches to regulatory deference in tax cases that the Court was now consigning to the trash heap. First, the Court pinpointed some of the key factors that had been identified as important under the National Muffler Dealers analysis, stating that under that analysis “a court might view an agency’s interpretation of a statute with heightened skepticism when it has not been consistent over time, when it was promulgated years after the relevant statute was enacted, or because of the way in which the regulation evolved.” Slip op., at 8-9 (citing Muffler Dealers, 440 U.S. at 477). The Court continued: “Under Chevron, in contrast, deference to an agency’s interpretation of an ambiguous statute does not turn on such considerations.” Id. at 9.
The Court amplified its rejection of the Muffler Dealers analysis by citing a series of non-tax decisions under Chevron that decline to attribute significance to these considerations. Thus, the Court remarked that it had “repeatedly held that ‘[a]gency inconsistency is not a basis for declining to analyze the agency’s interpretation under the Chevron framework’” (quoting National Cable & Telecommunications Assn. v. Brand X Internet Services, 545 U.S. 967, 981 (2005)); “that ‘neither antiquity nor contemporaneity with [a] statute is a condition of [a regulation’s] validity’” (quoting Smiley v. Citibank, N.A., 517 U.S. 735, 740 (1996)); and that it is “immaterial to our analysis that a ‘regulation was prompted by litigation’” (quoting Smiley, 517 U.S. at 741). Trying to link these decisions to its tax law jurisprudence, the Court then observed that in United Dominion Industries, Inc. v. United States, 532 U.S. 822, 838 (2001) (which involved the calculation of product liability losses for affiliated entities under Code section 172(j)), it had “expressly invited the Treasury Department to ‘amend its regulations’ if troubled by the consequences of our resolution of the case.” Mayo slip op., at 9. The Court emphasized that it saw no good reason “to carve out an approach to administrative review good for tax law only.” Id. Thus, the Court concluded: “We see no reason why our review of tax regulations should not be guided by agency expertise pursuant to Chevron to the same extent as our review of other regulations.” Id. at 10.
Second, the Court moved to squash another area where it discerned a difference between Chevron principles and those developed in tax cases – even though the parties had not focused on that point. Pointing to an amicus brief filed by Professor Carlton Smith arguing for reduced deference because the regulations in Mayo were “interpretive” regulations promulgated pursuant to Treasury’s general rulemaking authority under 26 U.S.C. § 7805(a), the Court acknowledged that there is pre-Chevron authority for the proposition that courts “‘owe the [Treasury Department’s] interpretation less deference’ when it is contained in a rule adopted under that ‘general authority’ than when it is ‘issued under a specific grant of authority to define a statutory term or prescribe a method of executing a statutory provision’” (slip op., at 10-11 (quoting Rowan Cos. v. United States, 452 U.S. 247, 253 (1981)). The Court tossed that precedent aside as well, ruling that the Rowan statement was not compatible with the current approach to administrative deference, which is unaffected by “whether Congress’s delegation of authority was general or specific.” Slip op., at 11.
With the Chevron analytical framework in place, the Court made short work of the FICA issue before it. It reasonably concluded that the statutory text did not unambiguously resolve whether medical residents qualify for the FICA student objection. Hence, the Court moved to “Chevron stage two” – namely, whether the regulation was a “reasonable interpretation” of the statute. Observing that “[r]egulation, like legislation, often requires drawing lines” (slip op., at 13), the Court held that it was reasonable for Treasury to establish a rule that anyone who works a 40-hour week, even a medical resident, is not a “student” for purposes of the FICA student exception.
In sum, the Court’s decision in Mayo resolves the deference issues that have recently divided the lower courts in a way that is extremely favorable to the government. Treasury likely will be emboldened to issue regulations that seek directly to overturn cases that the government loses in court on statutory interpretation issues, or to issue regulations even earlier to sway the outcome of pending litigation before the courts interpret the statute in the first place. Of course, we have seen that phenomenon already in the Mayo case itself, with respect to the statute of limitations issue litigated in Intermountain and a host of other cases (see here and here), and in other settings. The Mayo decision will further encourage the Treasury Department to issue such regulations and will make it tougher for taxpayers to prevail in court in the face of those regulations.
Mayo Foundation Oral Argument Tilts Towards the Government and Raises Doubts About the Continuing Vitality of National Muffler Dealers
November 10, 2010
At oral argument on November 8, several Supreme Court Justices expressed skepticism regarding the claim that medical residents fall within the “student exemption” from FICA taxation. Although it is always hazardous to predict the outcome of a case from the questions asked at oral argument, it is difficult to envision the taxpayer getting the five votes needed to overturn the court of appeals’ rejection of the exemption.
The Justices’ objections to the taxpayer’s position came from a variety of angles. Justice Sotomayor focused on the essence of what a medical resident does, suggesting that a person working unsupervised for more than 40 hours per week, and for signficant remuneration, is “really not a student.” Justice Ginsburg focused more on Congress’s intent, suggesting that the exemption seemed directed at “the typical work/study program in a college.” Chief Justice Roberts observed that the line between student and worker is a difficult one to draw and suggested that it was therefore appropriate to let the IRS draw the line in a categorical way and then defer to the IRS’s interpretation. Justice Breyer took a different tack, arguing that the IRS’s position was a valid interpretation of a requirement that had been in the regulations for a long time – namely, that the employment has to be “incident” to the study. Full-time employment, he suggested, would not be “incident” to the study because it is “so big in comparison to the study.”
Justice Alito seemed the most sympathetic to the taxpayer. He rose to the taxpayer’s defense by offering an alternative reading of word “incident.” Later, he challenged the government’s counsel to explain why medical residents should not be eligible for the exemption when law students who write briefs are eligible, arguing that the medical residents should be treated as students if their primary motivation is to complete a course of study rather than to earn money. Justice Ginsburg and the Chief Justice also questioned government counsel, though not as sharply as they had questioned the taxpayer’s counsel. Justices Scalia and Kennedy were uncharacteristically silent during the argument. In accordance with his usual practice, Justice Thomas did not speak. Justice Kagan is recused in the case because of her prior involvement when she was Solicitor General.
In our prior posts on this case (see here, here, and here), we discussed the possibility that this case could be a vehicle for the Supreme Court to address the correct standard for deference to Treasury regulations – that is, whether the more generic Chevron analysis has superseded the more specific, and in some respects less deferential, approach set forth in National Muffler Dealers Ass’n v. United States, 440 U.S. 472 (1979). The Justices did not exhibit any independent interest in this issue, as their questions focused on the meaning of the statute, not on deference to the regulation. At one point in his opening argument, taxpayer’s counsel noted that the new regulation was issued only after the government had repeatedly lost in court (a fact that would argue for less deference under the National Muffler Dealers approach), but that point did not elicit any reaction from the Justices.
Thus, the oral argument did not touch on the Chevron/National Muffler Dealers issue until the very end when taxpayer’s counsel affirmatively raised it during his few minutes of rebuttal time. Counsel sought again to persuade the Court that the government’s position is suspect because it is a recent invention that seeks to overturn a series of adverse court decisions, and this time phrased the argument explicitly in terms of the standard for deferring to a regulation. Taxpayer’s counsel argued that deference to the new Treasury Regulation is inappropriate under “[t]he National Muffler standards, which we understand still to be appropriate to evaluate deference given to an IRS regulation,” because the regulation “is not a contemporaneous regulation.” Justice Sotomayor quickly objected, asserting that the Court has “said that agencies can clarify situations that have been litigated and positions that they have lost on.” (She was referring here not to tax cases, but to decisions that apply the Chevron analysis.). Shortly thereafter, Chief Justice Roberts zeroed in on the issue, asking:
Why are we talking about National Muffler? I thought the whole point of Chevron was to get away from that kind of multifactor ad hoc balancing?
Taxpayer’s counsel tried to respond by arguing that the National Muffler Dealers factors were “sensible factors” that the Court should continue to apply in the case of a “regulation that pops up 65 years of the enactment of the statute, after the government has lost five cases.” But the Chief Justice was dismissive, stating simply: “If Chevron applies, those considerations are irrelevant, right?”
The outlook for the case therefore is that the Court will likely affirm the Eighth Circuit’s ruling that medical residents do not come within the student exemption from FICA. Such a decision would not necessarily require a discussion of deference to Treasury regulations, but if there is such a discussion, the Court may well be ready to conduct the analysis explicitly in the Chevron framework and consign National Muffler Dealers to the dustbin of history. As noted in our previous post, that would in some respects be an unfortunate outcome – giving too much deference to regulations that may well be unduly influenced by the IRS’s narrow interest in maximizing tax revenues rather than a neutral effort to implement the will of Congress.
Attached below are links to the taxpayer’s reply brief and to the transcript of the oral argument. A decision is expected in the next few months.
October 20, 2010
In our initial post on the Mayo Foundation case pending in the Supreme Court, which concerns whether medical residents are exempt from FICA taxation, we noted that the case potentially raised a broad question that has surfaced in the courts of appeals and the Tax Court in recent years — namely, whether Chevron deference principles have supplanted the traditional Muffler Dealers approach to analyzing the deference owed to Treasury regulations. Although that issue was not flagged by the parties at the certiorari stage, we later observed that the taxpayers’ opening merits brief served that ball into the government’s court by relying heavily on some of the Muffler Dealers factors that are not ordinarily part of the Chevron analysis. The government has now responded by directly challenging the continuing vitality of Muffler Dealers. (The government’s brief is attached below.) As a result, there is a good chance that the Supreme Court will address the question and resolve the disagreement between the Tax Court and some courts of appeals on the proper analysis of deference to Treasury regulations.
The government’s brief does not mince words. It states that Muffler Dealers “has been superseded by Chevron” and therefore “the considerations on which [taxpayers] rely are largely irrelevant.” In particular, the government identifies three Muffler Dealers factors relied upon by the taxpayers that are allegedly irrelevant under Chevron: (1) “the recency of [the] adoption” of the regulation; (2) that the new regulation “was enacted ‘to overturn judicial decisions’ interpreting the student exemption”; and (3) that “Treasury’s interpretation of the student exemption has purportedly been inconsistent.”
It is by no means a foregone conclusion that the Supreme Court will resolve the question of the proper deference standard, as there are many ways to resolve the ultimate question of the applicability of the FICA exemption without having to decide on a deference standard. Nor is it as clear as the government would like that Chevron did or should supersede Muffler Dealers. (If it were, the question probably would not still be open 26 years after Chevron was decided). The IRS is often in an adversarial relationship with taxpayers; it has an inherent fiscal interest in interpreting the Internal Revenue Code in a way that maximizes tax revenues. Therefore, there are good reasons for the courts to afford less deference to Treasury regulations that would determine the outcome of tax disputes than to regulations of more neutral agencies that are merely administering a federal statute. Can the government really respond to an IRS defeat in court by promulgating a regulation to overturn the decision and then expect the courts to defer to that regulation without taking any account of how it came to pass? Or can it reverse a regulatory interpretation simply because it determines that the reversal will benefit the public fisc, without paying some price in terms of judicial deference? Perhaps the Supreme Court will answer those questions soon.
Oral argument in the Mayo Foundation case is scheduled for November 8.
August 30, 2010
The Supreme Court has released the oral argument schedule for its November session. The argument in Mayo Foundation is scheduled as the second case on Monday November 8, meaning it will begin around 11:00. A decision is expected to issue in the spring, almost certainly no later than June 2011. We will provide a report on the argument in November.
August 16, 2010
The taxpayers have filed their opening brief in Mayo Foundation, a copy of which is attached. They argue primarily that the statutory language of the exemption unambiguously includes medical residents, and therefore there is no occasion to consider the reasonableness of the IRS regulation. Secondarily, they argue that the regulation is in any event arbitrary and unreasonable.
With respect to the question of the correct deference analysis discussed in our previous post, the brief relies heavily on the National Muffler Dealers factors. It identifies five factors that militate against the reasonableness of the regulation: (1) does not harmonize with the origin and purpose of the statute; (2) not contemporaneous; (3) did not “evolve in an authoritative manner” because it was designed to overturn adverse judicial decisions; (4) has not been in effect for long; and (5) the government’s position has been inconsistent. Although the first factor is basic to any analysis of the reasonableness of a regulation, the other four all come from National Muffler Dealers and are not commonly associated with the Chevron deference analysis applied to non-tax statutes.
The taxpayers have not asked the Court to choose between Chevron and Muffler Dealers. To the contrary, they have finessed the possible tension between two lines of cases by purporting to examine “the factors that indicate the reasonableness of a tax regulation under this Court’s decisions in Chevron and National Muffler” and observing that the “Court has given special consideration to several factors identified in National Muffler” “in determining the reasonableness of a regulation interpreting a revenue statute.” As discussed in our previous post, this approach is entirely consistent with the way the Supreme Court has approached this issue in recent years – that is, citing to the National Muffler Dealers factors in tax cases without addressing whether the analysis is fully consistent with Chevron. But the courts of appeals have begun to question whether the two approaches are compatible. It will be interesting to see whether the government’s brief challenges the continuing vitality of the National Muffler Dealers analytical framework. That brief is due on September 27.
August 2, 2010
In Mayo Foundation, et al. v. United States, No. 09-837, the Supreme Court will consider whether medical residents are exempt from FICA taxation, with the decision likely to turn on the level of deference the Court is willing to accord to a recent regulatory change. Although the issue may seem obscure, there are 8,000 residency programs in the United States, and the government estimates that $700 million in taxes per year is at stake, with $2.1 billion in refund claims pending.
The issue involves the meaning of the “student exemption” to FICA, which excludes from the definition of “employment” “service performed in the employ of a school” by a “student who is enrolled and regularly attending classes at such school.” I.R.C. § 3121(b)(10). The regulations implementing that statute long provided that “student” status depends on the relationship between the employee and the institution and that when the services are performed “incident to and for the purpose of pursuing a course of study,” the employee can qualify for the student exemption. Beginning in the late 1990s, there have been several cases addressing whether this exception applies to medical residents, who work more than full-time and earn a $40,000-$60,000 stipend, but perform their duties as part of an educational process in which they also attend classes.
In 2003, a federal district court in Minnesota ruled that the Mayo Clinic’s residents qualified for the student exception under the statute and existing regulations. The government responded by amending the regulations, effective April 1, 2005, to provide a bright-line rule that does not allow full-time employees to qualify for the exception. Thereafter, four other courts of appeals ruled against the government, stating that the residents fell within the terms of the statutory exception. All four of those cases, however, involved pre-2005 periods, and therefore the courts did not directly consider the impact of the amended regulation. In this case, the first to address the new regulation, the Eighth Circuit held that it owed Chevron deference to the new regulation as a reasonable interpretation of an ambiguous statute. Thus, contrary to the other four circuits, it sided with the government and held that the residents are subject to FICA taxation.
Most tax cases reach the Supreme Court on the strength of a request for further review by the government, but in this case the Court granted a petition filed by the taxpayers over the government’s opposition. The taxpayers predictably argued that the circuit conflict, and dollars at stake, necessitated Supreme Court review. In situations like this, the government often acquiesces in certiorari, because the IRS likes to get circuit conflicts resolved to promote its own institutional interest in uniformity. In this case, however, the government sought to avoid taking its chances in the Supreme Court by arguing that there was no genuine circuit conflict, because the other four circuits had not considered the new regulation. Evidently, the government hoped that it could build on this decision and use it to get the other circuits to retreat from their prior decisions and adopt a rule going forward under the new regulation that would subject medical residents to FICA taxation. The Court, however, was apparently persuaded by the taxpayers that the new regulation is unlikely to lead to a different result in those circuits — because they had already indicated a view that medical residents qualify for the exception under the unambiguous statutory language, which would leave no room for Chevron deference to the new regulation.
A decision by the Court will, of course, resolve the question of FICA taxation of medical residents — unless Congress steps in. But the decision could have a much broader impact because it implicates the general topic of deference to IRS regulations, particularly the question whether Chevron deference principles have superseded the more specialized analysis developed over the years in tax cases dating back to National Muffler Dealers Ass’n v. United States, 440 U.S. 472 (1979). In recent years, courts of appeals have begun to trend towards applying standard Chevron analysis in tax cases, but the Tax Court has resisted. See, e.g., Swallows Holding Ltd. v. Commissioner, 126 T.C. 96 (2006), rev’d, 515 F.3d 162 (3d Cir. 2008). The Supreme Court has not specifically addressed the issue.
There is not a huge difference in the two deference approaches, and, in most cases, choosing between them is not likely to affect the outcome. Like Swallows Holding, however, this case could be an exception. Among the factors listed in Muffler Dealers for determining deference that have been oft-applied in later cases are whether the regulation is contemporaneous with the statute and “the consistency of the Commissioner’s interpretation.” 440 U.S. at 477; see also, e.g., United States v. Cleveland Indians Baseball Co., 532 U.S. 200, 220 (2001); Cottage Savings Ass’n v. Commissioner, 499 U.S. 554, 561 (1991). In this case, those factors support the taxpayers’ rejection of the regulation, as the government is arguing for reliance on a new regulatory approach that departs from a 65-year old regulation. Contemporaneity and consistency, however, play no role in the Chevron analysis, which does not penalize the agency for inconsistency or for promulgating new regulations designed to overturn adverse court decisions. Indeed, the Court has specifically ruled that prior contrary judicial constructions of a statute do not foreclose owing Chevron deference to a subsequent regulation, unless the court decision had determined that the statute is unambiguous. National Cable & Telecommunications Ass’n v. Brand X Internet Services, 545 U.S. 967, 982-86 (2005).
The parties did not tee up this potential issue in the briefs filed at the certiorari stage. The court of appeals’ opinion straddled the fence, purporting to apply Chevron but also stating that the Muffler Dealers factors were “instructive” on the second part of the Chevron inquiry – whether the regulation is a reasonable interpretation of the statute. The certiorari petition focused mostly on the circuit conflict. To the extent it discussed the merits of the case, it argued that the Eighth Circuit’s decision was inconsistent with Chevron and and did not cite the Muffler Dealers line of cases. (The petition argued that the Eighth Circuit had “effectively eliminate[d]” the first step of Chevron analysis in tax cases when it stated that, when common words are found in “a provision of the Internal Revenue Code, a Treasury Regulation interpreting the words is nearly always appropriate.”) The government’s brief was happy to embrace the notion that Chevron governs the deference inquiry. It will be interesting to see whether the taxpayers try to get more mileage out of Muffler Dealers and its progeny at the merits stage.
The parties will be briefing the case over the summer, with the taxpayers’ opening brief currently due on August 6, 2010. Oral argument is expected to be scheduled for November or December. One important note is that this is one of the cases in which Elena Kagan has stated her intent to recuse because she participated in the case as Solicitor General. That means the case will be decided by an eight-Justice Court, with the possibility of a 4-4 split. If that occurs, the Court would issue a one-line order affirming the Eighth Circuit’s decision by an equally divided court. The government’s victory in this case would stand, but the decision would have no precedential value, and the issue would remain in play outside the Eighth Circuit.
The opinion of the Eighth Circuit and the parties’ briefs at the certiorari stage are linked below. We will provide the briefs on the merits after they are filed.