Judicial deference, consolidated returns, and loss disallowance: could LDR survive a court challenge? Amending section 1502 to deal comprehensively with single entity issues
The loss disallowance regulations published in March and November 1990 (LDR) are historic — economic losses will be disallowed despite the unbroken congressional and regulatory directive to allow such losses since 1918. In a court challenge, the Internal Revenue Service will heavily rely on the single entity theory of consolidation and the deference the courts accord legislative regulations. This article concludes that:
* The doctrine of judicial deference runs contrary to the premise of Marbury v. Madison that the judiciary is under a “duty” to “say what the law is.” It also places great weight on the judgment of the Department of the Treasury and the IRS, even though they are burdened with a potential conflict of interest that may force them to promulgate regulations testing the outer limits of reasonableness.
* The precise origins of judicial deference are obscure. The original source appears to be the notion that the administrators have superior knowledge in that they help write the laws and therefore are the “masters of the subject.” Other origins incude: avoidance of complex areas and the desire for stability.
* Two separate and distinct origins could be viewed as deference to the legislature since Congress (i) requested the IRS in section 7805(a) to adopt all needful regulations (for “enforcement” purposes) and (ii) is deemed to endorse certain regulations under the “legislative reenactment” doctrine. This last origin, as currently interpreted, is the strongest pillar of judicial deference.
* Except in rare cases, the deference principle fails to provide meaningful help for the IRS. Although not to be invalidated except for “weighty reasons,” or if “plainly inconsistent” with the Code, the courts have not quantified or otherwise refined these amorphous tests. Rather, the courts essentially make a de novo review of the issues and arguments, and the IRS must be right on the merits if it expects to have its regulations upheld by a court.
* Although regulations play an essential role in the administration of the tax laws, the evolving tighter standard of deference may be appropriate since it provides the required judicial check of overreaching executive action. A similar tightening is occurring outside the tax law.
* The validity of eleven 1954 Code regulations has been challenged before the Supreme Court and the taxpayer is batting a strong .363 (4 for 11).
* A portion of LDR is likely to be invalidated, particularly the portion dealing with duplicated losses. The anti-duplication portion of LDR will fail primarily because it changes the law. Losses on the disposition of a subsidiary — regardless of the potential for duplication — have been allowed by the Code and the consolidated return regulations since 1918. Several Supreme Court cases fiercely defend the taxpayer’s right to recapture its investment.
* The legislative reenactment doctrine is applicable to consolidated returns and would deem the current regulations to have the force and effect of law since (i) the regulations have historically approved of the double use of losses by unrelated parties, (ii) Congress from 1986-1989 handcrafted four Code provisions that could limit losses arising in consolidation, and (iii) Congress specifically rejected a proposal to eliminate duplicated losses by unrelated parties (see section 336(d)) filing separate returns.
* The legislative standard for consolidated return regulations (“clearly to reflect the income tax liability”) is barren of meaningful guidance since it avoids the basic question — should income be reflected on a single or separate entity basis?
* Because of the present structure of the regulations, the existing separate entity precedent, many difficult policy decisions, and the potential for being whipsawed, the IRS is unlikely to deal with other single entity issues on a comprehensive basis without a clear statutory statement on which direction Congress wants is to take.
* If a single entity standard were incorporated in the statute, there would be little need for lengthy regualtions; nor would the customary March 14th trip to the Federal Register be required since the section 1503 contract preventing retroactive regulations could probably be modified.
* In connection with the single entity standard, Congress would still need to decide how and when inside and outside basis should be conformed (e.g., a deemed section 332, a deemed section 338, or a choice between the two) and whether to disallow a loss because it might be duplicated in the hands of an unrelated beneficial owner.
* Any approach to conforming basis would be bitter medicine and would force most taxpayers to acquire assets rather than stock. As a partial offset to the additional current taxes an asset transaction would produce, it would be essential to combine a conforming basis rule with a realistic, statutory solution providing a fixed amortization schedule for goodwill and all other intangibles.
* Such a change would be a stunning blow for simplification, fairness, and competitiveness in that it (i) would avoid the burdensome audit and litigation activity that is underway and (ii) would be consistent with domestic accounting rules, as well as tax and accounting rules of many of our foreign competitors.
II. STANDARDS OF JUDICIAL REVIEW
Everyone knows regulations carry “great weight,” are at times “given the force and effect of law,” etc. But why? And can we quantify the effect of this judicial deference on a particular decision? Herein follows an attempt to answer these questions. (1)
A. Origins of the Deference Concept
It is not clearly why any deference is given to the executive branch when Marbury v. Madison, 5 U.S. 137,176 (1803), tells us “[i]t is, emphatically, the province and duty of the judicial department, to say what the law is.” In addition, think of the potential conflict of interest. The prime function of the IRS is to collect revenue, and the charter of the Treasury Department includes both administering the internal revenue laws and formulating tax policy. If given the unfettered discretion to chose among reasonable alternatives, the IRS and Treasury (hereinafter collectively referred to as “the IRS”) may feel obligated to promulgate regulations that test the outer limits of reasonableness, particularly if they are sometimes pushed to construe a statute based on the revenue estimates.
Despite these obvious impediments, the judicial deference doctrine is deeply entrenched, (2) and we can only hope it is not too late to refine the doctrine. The restraint it exercises on judicial independence can probably be traced to at least five separate reasons, two of which are more properly viewed as deference to the legislature, not the executive branch.
1. Deference to the Masters of the Subject,
Especially the Drafters of the Law Who
Contemporaneously Write the Regulations
A critical source of the doctrine of judicial deference is the assumption that agencies participate in the legislative process, have more expertise in their assigned areas, and are therefore better able to construe a statute than the courts. A leading case is United States v. Moore, 95 U.S. 760, 763 (1877), which provides:
The construction given to a statute by those charged with the duty of executing it is always entitled to the most respectful consideriration, and ought not to be overruled without cogent reasons…. The officers concerned are usually able men, and masters of the subject. Not infrequently they are the draftsmen of the laws they are afterwards called upon to interpret. (Emphasis supplied.)
Thus, although not elevated to a pre-condition, the Supreme Court obviously linked the “masters of the subject” to a participating role in the legislative process. This linkage probably explains the general deference accorded “contemporaneous” regulations:
A regulation may have particular force if it is a substantially contemporaneous construction of the statute by those presumed to have been aware of Congressional intent. National Muffler Dealers Association Inc. v. United States, 440 U.S. 472, 477 (1979) (emphasis supplied).
2. Deference in Complex Areas
A deep bow to the masters of the subject is especially evident when the Court feared it was dealing with a particularly complex issue. For example, in a case dealing with the installment sale of encumbered real estate, the Court deferred to the IRS because:
[t]he Commissioner and Board of Tax Appeals have practical knowledge of the intricate details incident to tax problems, and their determination in circumstances like those under consideration here should be given effect when not clearly contrary to the will of Congress. Burnett v. S&L Building Corporation, 288 U.S. 406, 415 (1933) (emphasis supplied).
See also Helvering v. Wilshire Oil Co., 308 U.S. (1939), which involved the deductibility of development expenses in connection with the depletion allowance:
In sum, the highly technical and involved factors entering into a practical solution of the problem of depletion in administration of the tax laws points to the necessity of interpreting section 23(l) so as to strengthen rather than to weaken the administrative powers to deal with it equitably and reasonably. (Emphasis supplied.)
3. Deference for Stability
A longstanding, consistently applied regulation often elicits judicial deference. The rationale is based on a desire for stability and may be a subset of stare decisis. One of the earliest Court decisions on judicial deference framed the rationale in colorful language:
A practice so long … would, it self, furnish strong grounds for a liberal construction; and could not now be disturbed, without introducing a train of serious mischiefs. United States v. State Bank of North Carolina, 31 U.S. 29, 39 (1832).
Almost 100 years later, the “serious mischiefs” resulting from a reversal of a longstanding regulation were described as “inconvenience” and “inequality.” Brewster v. Gage, 280 U.S. 327, 336 (1930). (3)
4. Deference for Legislative Reenactment
A separate origin of judicial deference is, in reality, a deference to the Congress. The Court in National Lead Co. v. United States, 252 U.S. 140, 145 (1920), added the following reason as a distinct premise for deferring to a regulation which was in effect for 40 years:
To this we must add that the department’s interpretation of the statute has had such implied approval by Congress that it should not be disturbed.
Thus, the Court will take a deep bow to Congress, if there is some reason to believe Congress has placed its imprimatur on the regulation. Although this source produces the highest level of deference, it does not come into play until undergoing a fairly intense review of its legitimacy.
5. Deference to Adjust for the Variations
Again bowing to Congress, the Court has tried to wash its hands of the technical details of the law on the ground that Congress delegated to the Commissioner in section 7805(a) the power to write “all needful rules and regulations”:
But we do not sit as a committee of revision to perfect the administration of the tax laws. Congress has delegated to the Commissioner, not to the courts, the task of prescribing “all needful rules and regulations” of the Internal Revenue Code. 26 U.S. [section]7805(a). In this area of limitless factual variations, “it is the province of Congress and the Commissioner, not the courts, to make the appropriate adjustements.” (4) United States v. Correll, 389 U.S. 299, 309 (1967).
In addition to section 7805(a), a related source of congressional deference is inherent in each specific congressional request for a legislative regulation. Thus, each time Congress states a rule, followed by “except as provided by regulations,” (5) Congress is investing the regulation writers with special powers to fill-in the details in a reasonable manner, consistent with the statutory design.
6. Critique of the Origins
Judicial deference is a concept of critical importance today. Randolph Paul expressed great anxiety over the doctrine in his 1940 article. He lamented about the “bulk of administrative regulations” and the fact that “the current income tax regulations alone run to 358 pages.” Today, some single regulation projects approach 300 (typed) pages in length, and the complete set of the income tax regulations (including proposed and temporary) consume five volumes of CCH, each running more than a thousand pages! If the deference concept were really meaningful, the early court decisions — perhaps unlawfully — delegated much of their jurisdiction to the executive branch. Except for a modified version of the legislative reenactment doctrine, however, none of the origins seems very persuasive today.
a. Masters of the Subject. A crucial foundation for the doctrine — the linkage between writing the law and issuing a contemporaneous regulation — has serious cracks. Constrast the 1960s with the 1980s:
* In the 1960s, Treasury normally proposed the legislation in a message from the President, wrote detailed position papers presented by the Secretary of the Treasury in connection with such proposals, fully participated in all committee hearings and mark-up sessions, prepared the initial statutory draft language, sat in on every drafting session and prepared the first draft of the technical explanation of the committee reports. It the prepared the first draft of the regulations. Armed with immense knowledge of the history and purpose of the legislative words, it was committed to write regulations which made sense out of the statute. Sometimes words were stretched in favor of the taxpayer or the government, but so be it — Treasury knew it was the right thing to do.
* In the 1980s, Treasury had far less impact on the legislative process. The starting point usually was not the President’s tax message but the marke of Chairman Rostenkowski; and the Treasury technicians at times were excluded from certain key committee mark-up sessions. Finally, the Hill staffs wrote the drafts of the statutes and the reports and kept control of the final language, although Treasury did review the language and suggested changes.
As more judges become aware of the reality of the current legislative process, it would not be surprising if the deference to regulations concept began to soften. Indeed, some jurists are calling into question the weight to be accorded legislative history, including Supreme Court Justice Scalia, who wrote the following in a separate opinion in Blanchard v. Bergeron, 109 S.Ct. 939, 947 (1989):
I decline to participate in this process. It is neither compatible with our judicial responsibility of assuring reasoned, consistent and effective application of the statutes of the United States, nor conducive to a genuine effectuation of congressional intent, to give legislative force to each snippet of analysis, and even every case citation, in committee reports that are increasingly unreliable evidence of what the voting Member os Congress actually had in mind. (6)
Assuming the Court systematically erodes the deference to legislative history, isn’t judicial deference to regulations an a fortiori case?
b. Complexity. The deference for complexity is an unacceptable give-away of power. Congress almost always writes very complex laws today and this is no excuse to delegate the interpretation of the Code to the administrators. Indeed, complex laws are often a product of detailed statutory language covering many points heretofore left out of the statutes; the more verbiage, the less need to rely on IRS rules and regulations.
Finally, since almost 80 percent (22/28) of the current judges on the Tax Court have worked for the government in various departments with experience ranging from Capitol Hill, to the Treasury’s Office of Tax Legislative Department, does it make any sense to assume they are not capable of sorting out a complex issue?
c. Stability. This source also seems very weak since (i) the “mischief” referred to by the courts is too vague a concern and (ii) stability hardly is relevant with respect to a Code undergoing significant annual revisions.
d. Variations. The deference to the IRS to “make appropriate adjustments” has a soft underpinning requiring further analysis.
Section 7805(a) has a rich but puzzling history. An unsuccessful attempt to adopt the predecessor of such rule was made in 1921. The apparent reason for the proposal was to obviate the need for a number of specific “legislative” delegations that first appeared in the 1921 Act:
In more than 20 places in the bill the commissioner is given flexible authority for the first time. That is a great departure from previous tax legislation. Such a system is said to have worked very satisfactorily in Great Britain and other countries where flexible authority has been given; but it is the first departure in this county from the rule of defining accurately and in detail the tax law. In this bill in very many instances great power is given to the commissioner, as well as great discretion, in the interpretation of the law. Statement by Congressman Walsh, Seidman’s Legislative History of Federal Income Tax Laws (1938-1861), at 883 (emphasis supplied).
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