By Richard Rubin and Brent Kendall 

WASHINGTON -- Supreme Court justices sharply questioned arguments by the federal government that certain tax regulations can't be challenged in court before they are enforced.

Justices across the ideological spectrum, including Samuel Alito, Stephen Breyer, Elena Kagan and Neil Gorsuch, expressed skepticism about the government's position during an hour-long oral argument Tuesday. A ruling against the government would make it harder for the Internal Revenue Service to demand and collect information that it uses to police tax shelters and could invite more-frequent legal challenges.

The case involves a requirement that taxpayers and their advisers disclose certain questionable transactions when they file their returns. They face tax penalties if they don't comply. That disclosure effectively attaches a red flag to those tax returns, letting the IRS more easily identify which ones to audit.

The taxpayer in question, CIC Services LLC, helps companies create what are known as captive insurers, subsidiaries that can get favorable tax treatment. For several years, the IRS has been questioning many captive-insurance arrangements, warning that they can be abusive tax shelters if they move money to a tax-favored entity without insuring genuine risks. In 2016, the agency issued a notice requiring disclosure of certain captive-insurance transactions.

The court isn't considering the merits of captive insurance but instead is examining the ways taxpayers can fight the IRS in court.

Generally, taxpayers trying to challenge the IRS have two paths. They can wait for an IRS assessment, refuse to pay and then go to the U.S. Tax Court. Or they can pay taxes and then sue in federal district court for a refund.

But they have less leeway to challenge regulations before the IRS enforces them because of the Anti-Injunction Act, a longstanding statute that bars lawsuits that attempt to prevent the assessment or collection of taxes. The idea is that taxpayers shouldn't be able to frustrate the important work of tax collection by filing lawsuits.

The act and Supreme Court precedent "make clear that a suit cannot proceed if the relief it seeks would legally bar the IRS from collecting a tax," Justice Department lawyer Jonathan Bond said.

CIC argued that the Anti-Injunction Act shouldn't apply in this regard because there is no assessment or collection that is part of the disclosure requirement.

Justice Kagan suggested that she agreed with CIC's position, saying the point of the company's lawsuit wasn't to avoid the tax penalty that stems from noncompliance but to challenge the requirement itself.

"They're trying to invalidate a demand that they disclose information," she said.

The company's lawyer, Cameron Norris, argued that the government's stance would require CIC to willfully violate the law to challenge it, subjecting itself to penalties or even prosecution. CIC has been following the requirements and hasn't been penalized.

"This is, 'violate the tax code now, risk jail time and your professional license, and if the IRS agreed to give you a penalty, then litigate later,'" he said as part of his argument.

Justice Alito voiced agreement. "I really don't see how they can get review without committing a crime," he said.

The government argued that Congress expressly determined that the penalty for violating the disclosure requirement would be a tax and that lawsuits before enforcement aren't allowed. In the government's view, the Anti-Injunction Act applies and CIC shouldn't be able to sue unless it faces a penalty for noncompliance.

"It would seem to me that if a lawsuit stops the IRS from collecting taxes from you, that that's exactly what the Anti-Injunction Act was intended to prohibit," said Justice Sonia Sotomayor.

Mr. Bond said CIC wouldn't face criminal prosecution if it filed tax returns that omitted the required information and stated clearly that it was seeking to challenge the regulations as invalid.

"The court can avoid any doubt on that score by saying as much in its opinion," he said.

A decision is expected by June.

Write to Richard Rubin at richard.rubin@wsj.com and Brent Kendall at brent.kendall@wsj.com

(END) Dow Jones Newswires

December 01, 2020 17:22 ET (22:22 GMT)

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