From Procedurally Taxing Blog On Phantom Regulations

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This was posted yesterday on the Procedurally Taxing blog. https://procedurallytaxing.com/. The text is reproduced below. The substance of this blog will be published as a letter to the editor of Tax Notes, Tax Analysts, Fairfax VA, on this coming Saturday/Monday.

Introduction 

In recently finalized small business accounting regulations (T.D. 9942, Dec. 23, 2020), the IRS and Treasury refused to promulgate regulations dealing with providing an exception to the syndicate tax shelter rule for small business taxpayers. The grant of regulatory authority was discretionary in this case (Congress used the words “if the Secretary determines”) and, ordinarily, that would mean that the taxpayer and the courts are and were powerless to compel such promulgation and for the courts to fill in the gap. 

However, in today’s environment where the Administrative Procedure Act (APA) is taking more prominence in tax rulemaking, the question has become whether, if the IRS and Treasury take it upon themselves to address the reasons why they are not exercising their discretionary regulation authority and the explanation does not “jive with reality”, meaning that it is arbitrary and not grounded in sound reasoning, can the courts fill in the gaps if a taxpayer litigates the issue and, in effect, force the government to in substance issue the very same regulations it refused to issue? See my prior PT post, Conservation Easement Donation and the Validity of Tax Regulations  I think the answer is or should be yes. 

Analysis

In the seminal article dealing with the issue of the courts filling in the gaps for missing tax regulations (See Philip Gall,  Phantom Tax Regulations: The Case Of Spurned Delegations, 56 Tax Law 413 (2002-2003)), the author correctly described the case law at that time as precluding the courts from filling in the gaps with phantom regulations where the regulatory delegation was what is called a “policy delegation”, that is, a delegation where it is discretionary with the IRS whether to issue regulations or not. 

I am not disputing the correctness of that assertion in the article generally but, rather, I am questioning the correctness of that statement today in cases where the IRS offers a reason(s) for its refusal to issue regulations in response to public comments asking for the regulatory grant to be exercised and that explanation(s) is not sufficiently well reasoned and responsive to the intent of the Congressional grant as to pass muster. In those cases, I believe that the courts should be free to promulgate phantom regulations on the issue. 

The key question for a future court is did the IRS provide an adequate answer (see below) to taxpayer comments asking it to exercise its regulatory authority? I think not because the grant of authority in section 1256(e)(3)(C)(v) (“if the Secretary determines (by regulations or otherwise) that such interest [in an entity] should be treated as held by an individual who actively participates in the management of such entity, and that such entity and such interest are not used (or to be used) for tax avoidance purposes”) was added in the tax act of 1981 to allow certain passively held interests to be treated as active and thus not a syndicate under section 1256 and thereby eligible for the hedging exception to mark to market treatment under section 1256. 

The fact that the TCJA in 2017 did not say anything about providing an exception for certain syndicates as tax shelters, as the IRS asserted as an explanation in the final regulation preamble for not issuing regulations, should not lead to any inference one way or the other. The Congress merely provided statutory cross references in the TCJA to other statutes in providing an exception to the small business carve-out for tax shelters, and the grant of regulatory authority should be viewed in that light. (For background and analysis of this tax shelter carve-out generally, see Monte Jackel, Small Business Tax Shelters Under the Business Interest Expense Limitation, 165 Tax Notes Federal 607, Oct. 28, 2019). 

The principal defect in the government’s position on the syndicate issue is that the explanation(s) given for the refusal to issue regulations would lead to the conclusion that all passive investments are established or maintained for tax avoidance purposes. Without the government explaining why that is the case, I believe that the failure to issue regulations in at least some cases involving passive investment is contrary to the Congressional intent that there could be cases where passive investment should be deemed active and, thus, not a tax shelter. The government’s statement in the final regulation preamble that allowing a passive investment exception would be “overbroad” and lead to the conclusion that no syndicates are tax shelters is and was just plain wrong. It is the failure of the government to either state (1) that all passive investment syndicates are tax shelters per se and explain why that is so, or (2) that it is not administratively possible to provide for any passive investments to not be syndicates, that results in an arbitrary application of the tax law that a court should not allow to stand. What do you think?

FROM THE FINAL SMALL BUSINESS ACCOUNTING REG PREAMBLE

“Several comments were received concerning issues related to tax shelters, including the definition of “syndicate,” under proposed §1.448-2(b)(2)(i)(B). Some commenters recommend using the authority granted under section 1256(e)(3)(C)(v) to provide a deemed active participation rule to disregard certain interests held by limited entrepreneurs or limited partners for applying the Section 448(c) Gross Receipts Test if certain conditions were met. For example, conditions of the rule could include that the entity had not been classified as a syndicate within the last three taxable years, and that the average taxable income of the entity for that period was greater than zero.

“The final regulations do not adopt this recommendation. The Treasury Department and the IRS have determined that it would be inappropriate to provide an exception to the active participation rules in section 1256(e)(3)(C)(v) by “deeming” active participation for small business taxpayers. The Treasury Department and the IRS believe that the deeming of active participation in this context would be overbroad and would run counter to Congressional intent. Sections 448(b)(3) and (d)(3), 461(i)(3) and 1256(e)(3)(C) were not modified by the TCJA, and the legislative history to section 13012 of the TCJA does not indicate any Congressional intent to modify the definition of “tax shelter” or “syndicate.” By not modifying those provisions, Congress presumably meant to exclude tax shelters, including syndicates, from being eligible to use the cash method of accounting and the small business taxpayer exemptions in section 13102 of the TCJA, even while otherwise expanding eligibility to meet the Section 448(c) Gross Receipts Test.”

PROPOSED REGULATION PREAMBLE

“One commenter expressed concern that the definition of syndicate is difficult to administer because many small business taxpayers may fluctuate between taxable income and loss between taxable years, thus their status as tax shelters may change each tax year. The commenter suggested that the Treasury Department and the IRS exercise regulatory authority under section 1256(e)(3)(C)(v) to provide that all the interests held in entities that meet the definition of a syndicate but otherwise meet the Section 448(c) gross receipts test be deemed as held by individuals who actively participate in the management of the entity, so long as the entities do not qualify to make an election as an electing real property business or electing farm business under section 163(j)(7)(B) or (C), respectively. The Treasury Department and the IRS decline to adopt this recommendation. The recommendation would allow a taxpayer that meets the Section 448(c) gross receipts test to completely bypass the “syndicate” portion of the tax shelter definition under section 448(d)(3). Neither the statutory language of section 448 nor the legislative history of the TCJA support limiting the application of the existing definition of tax shelter in section 448(d)(3) in this manner.”  

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