Companies don’t have to pay a tax penalty before they can challenge an IRS rule, the United States Supreme Court said this week in a unanimous decision. 

CIC Services sued the IRS when the agency issued a notice in 2016 requiring companies that set up a captive insurance operation to report the transaction or face a penalty.

Companies commonly set up a captive insurance operation to protect their assets, because any profits from the operation can stay within the company rather than go to an outside carrier.

In its notice, the IRS said these types of operations need to be reported as a “transaction of interest” because of their potential to lead to tax evasion.

CIC, which is in the business of helping companies set up these operations, challenged the validity of the notice on grounds it violates the Administrative Procedures Act. That 1946 law requires federal agencies to allow for public comment, among other things, before they can issue burdensome notices and other directives. 

The CIC lawsuit was dismissed at both the trial and appellate levels, with the courts pointing to a law, the Anti-Injunction Act, that prohibits taxpayers from challenging an IRS ruling until they first pay any fine that could come from the ruling. 

Criminal disobedience

In its decision, the Supreme Court said that, for CIC to adhere to the Anti-Injunction Act, it would have to pay a tax penalty regardless of whether it actually owed one and would in practice have to risk a criminal violation just to mount a challenge.

“The government’s proposed alternative procedure — having a party like CIC disobey the Notice and pay the resulting tax penalty before bringing a suit for a refund — would risk criminal punishment,” said Justice Elena Kagan, who authored the majority opinion.  

Although the case centers on the IRS’s notice about captive insurance operations, the impact of the ruling is broader to the extent it addresses the right of taxpayers to challenge the IRS without having to first pay a tax penalty that, ultimately, they might not owe.  

"This case is hugely significant given that the IRS has made issuing illegal regulations and enforcing them against taxpayers part of its standard operating procedure," Sean King, general counsel for CIC Services, said in a statement. "An alarming percentage of substantive obligations that the IRS imposes upon taxpayers each year by fiat don't comply with the procedural requirements of the Administrative Procedures Act, and so are illegal, and yet are still shamelessly enforced by the service."