When Congress delegates legislative power to government agencies, the Administrative Procedures Act (APA) directs how those agencies are allowed to regulate the American people through rules and regulations. Among other things, the APA polices improper agency behavior and can open the door for an individual to challenge agency actions in federal court. Recently, in the context of the Employee Retention Credit (ERC), a growing number of tax professionals and taxpayers are voicing concerns that the Internal Revenue Service (IRS) may have run afoul of both the APA and administrative agency case law.
The APA applies to all executive agencies except for the President of the United States. Therefore, the Treasury Department and the IRS are bound by the APA and must follow it when creating rules and regulations. There are some exceptions from rulemaking1:
When creating new rules, agencies must generally follow procedures allowing for the public to have a period of notice and comment on the proposed rule or regulation. This process is called informal rulemaking, and it is the most common form of rulemaking that agencies use.
Broadly speaking, an agency must publish a version of the proposed rules or regulations along with an explanation of what they are intended to do and their statutory authority for proposing them. After that, the public is given a period—usually 60 days—in which to comment on the regulations and raise concerns that may not have been contemplated by the agency. After the comment period, the agency is given the ability to reformulate the regulations, so long as they are a logical outgrowth of the comments and address important comments. After that, the regulations are made final and added to the Code of Federal Regulations.
Agency rulemaking is usually given what is commonly referred to as “Chevron deference.”Chevron deference gives agencies the benefit of the doubt in cases where the agency follows its statutory authority. If the statutory authority is silent or ambiguous, then the courts ask if the agency’s actions were “arbitrary or capricious.” If the action was not, then the courts will uphold the action.3
Agencies are given more latitude when making guidance or interpretative statements pertaining to their own regulations. Courts will generally defer to agencies’ reasonable construction of their own ambiguous regulatory language (“Auer deference”),4 subject to the limitations prescribed in Kisor v. Wilkie.5 In order for an agency to receive Auer deference it must satisfy all of the following:
The courts also look to the legal effects test to determine whether an agency is trying to create guidance or binding rules and regulations.7 Courts will examine the following factors when making these determinations:
If the answers to those statements are in the affirmative, then a court is likely to conclude that the agency was attempting to create a new rule or regulation through its actions and therefore should have followed the APA’s rulemaking process.
When analyzing guidance documents, assuming they are not rules or regulations in disguise, courts may give deference to the agency’s understandings and rationales as applied to statutes. The courts will review the following factors and determine if the agency “gets an A.” If the agency does “get an A,” then the court may accept the reasoning of the agency and the interpretation then becomes binding case law.8 The factors to consider are:
On the other hand, if the agency, on the whole, fails those factors the court may repudiate the interpretation and require the agency either drop the interpretation or consider an alternative.
Generally, the Supreme Court has not allowed Congress to delegate away its core legislative authority.9 The Court has stated the following principles with regards to the limitations on Congress’s authority to delegate away its legislative functions:
Recently, the Court’s decisions appear to indicate that it is likely moving in an even more restrictive direction that may reduce executive agencies’ leeway in creating rules and regulations.10
As part of the effort to implement the ERC, the IRS issued considerable guidance on how to claim the ERC, including several Notices. For example, Notice 2021-20 specifically outlines what the IRS considers as governmental orders and specifies the much maligned “nominal effect” and “nominal portion” tests.11
The IRS would not be able to argue Chevron deference in this case because the Notices are not regulations. Additionally, they would not be able to argue for deference on the interpretation of one of its own regulations under the Auer doctrine, because the Notices do not purport to interpret any Treasury Regulations. The IRS has already, in the pandemic era, been rebuffed by the Sixth Circuit Court of Appeals for attempting to create new rules through notices.12
The IRS could attempt to argue that its interpretation is persuasive under the factors developed for agency guidance. The IRS would likely argue that they have the experience implementing the tax Code and the lack of any substantive legislative history on ERC should result in the IRS’s guidance being persuasive. However, even if the agency argues its guidance is persuasive, it is important to remember that the Notices issued in the wake of ERC are not binding on taxpayers. Taxpayers could completely ignore them; however, they do so likely to their own detriment. Most of the guidance in the Notices could be viewed as the IRS establishing safe harbors for which they will not challenge taxpayer conduct. Ultimately, the IRS can deny refund requests or attempt to reclaim erroneous credits. It will be up to either the IRS and the taxpayer to come to a joint resolution on credit eligibility or a judge will decide the issue.
The IRS is also likely to point out that Congress, despite knowing that the definition the IRS uses for “partial,” has not repudiated its interpretation yet. A court could very easily conclude that a ten percent test makes sense for “partial” as the credit was designed to help struggling employers during the pandemic. To the extent that an employer is on the fringe, say an eight or nine percent effect, the Notices do not prevent them from filing for the credit and having the IRS, at its discretion, issue the refund or litigate the issue.13
The IRS may have run much more afoul of the APA regarding the regulations it issued in relation to reclaiming erroneous ERC refunds.14 The final regulations were published on July 26, 2023, and were effective July 24, 2023. The regulations, at least in reference to ERC, derive their authority from 26 U.S.C. §3134. In that section, Congress allowed the Treasury Secretary to issue regulations on how to reclaim the credits that were made as advanced payments. The IRS has, however, issued regulations that purport to allow for reclaiming any erroneous credit through the assessment of employment taxes by treating the refund as an underpayment of taxes.
Again, Congress delegated authority to the IRS to regulate advanced credits, but there is no statutory authority for regulating credits received after amending a Form 941 for previous calendar quarters. Rather, the IRS appears to have ignored the first step of the Chevron deference inquiry when it disregarded the clear parameters of the underlying statutory authority to issue regulations. Throughout its discussion of its assessment authority in the Federal Register entry for the final regulations, the IRS continually refers to the authority granted to assess taxes resulting from erroneous “advanced portions of the credit.”15
This regulation, issued despite the plain language of its enabling statute, is also belied by existing statutory authority to reclaim erroneous refunds. The government is granted authority to sue an individual to reclaim an erroneous refund in 26 U.S.C. §7405. This would be the normal process whereby the IRS would seek to reclaim any erroneous refund paid through an ERC claim. Understandably, some tax professionals are wondering if the IRS issued these final regulations to potentially try to deny, or delay, taxpayers a remedy in court by forcing the case to go through an administrative process. Additionally, because the regulations treat the overpayment of the credit as an underpayment of tax, it is not yet clear if the IRS will attempt to use the guise of these regulations as authority for issuing additional penalties.
This should have been, as with many aspects of this credit, an area that Congress should have spoken about. To the extent Congress did speak on the issue, it appears that the IRS has disregarded those words. As the IRS begins assessing taxes under this new self-appointed authority, this is likely an area that will be litigated.
It appears that the IRS may have overstepped its bounds when issuing final regulations trying to circumvent the normal erroneous refund process. The agency deviated from the plain meaning of the statute in what appears to be an attempt to make its administrative burden easier. Additionally, the Notices issued after the creation of ERC are simply guidance. They do not create binding law, and their edicts and definitions are not binding until a court agrees with their reasoning.
Administrative law is an incredibly important area of the law to understand and respect. Per Section 702 of the APA: “A person suffering legal wrong because of agency action, or adversely affected or aggrieved by agency action within the meaning of a relevant statute, is entitled to judicial review thereof.”16 And in the ERC context, there are growing concerns that the IRS failed to understand and respect the APA, wronging individuals in the process. If that’s true, it is going to take determined litigants and the courts to put the IRS back in line with the law. If you need assistance, contact our team at (410) 497-5947 or schedule a confidential consultation.