Challenge to Circular 230's Limitation on Contingent Fee Arrangements Dismissed
(Parker's Federal Tax Bulletin: April 12, 2013)

A tax services firm and its founder, as well as another firm employee, challenged Circular 230's limitation on contingent fees before the district court in Washington, D.C. In particular, they claimed that Circular 230's restrictions on the use of contingent fee arrangements for ordinary refund claims violated their First and Fifth Amendment rights and asked for a permanent injunction barring the enforcement of those restrictions.

The taxpayers may have thought they were in friendly territory since the same court recently invalidated the IRS's registered tax return preparer rules (see ¶271,127). However, while the court in Ryan, LLC v. Lew, 2013 PTC 43 (D. D.C. 3/29/13) concluded that the firm, but not its founder, had standing to take its arguments before the court, the court ultimately held that the tax services firm failed to state a plausible claim for relief. As a result, the court granted the IRS's motion to dismiss their claims.

Observation: A separate claim filed under the Administrative Procedure Act was not included in the IRS's motion to dismiss. As a result, the court allowed that claim to go forward.

Background

Ryan, LLC, is a global tax services firm. Along with its founder, G. Ryan, and Gerald Lee Ridgely, Ryan, LLC filed a suit in the U.S. District Court for the District of Columbia challenging certain provisions of Circular 230. In particular, they challenged the limitation on the use of contingent fee arrangements in connection with the preparation and filing of refund claims with the IRS. Their arguments against Circular 230 were as follows:

(1) Ryan, LLC and G. Ryan argued that Circular 230 violated taxpayers' rights under the Petition Clause of the First Amendment (Count I);

(2) G. Ryan argued that Circular 230 violated his Fifth Amendment Due Process Rights (Count II); and

(3) Gerald Lee Ridgely, in a suit under the Administrative Procedure Act, argued that the IRS had exceeded its statutory authority in promulgating Circular 230 (Count III).

Observation: The Petition Clause of the First Amendment allows a taxpayer to state a grievance and request relief from a court or other ruling authority. It provides a taxpayer with a means to institute a nonfrivolous lawsuit and mobilize popular support to change existing law. The Administrative Procedure Act governs the way in which administrative agencies of the federal government may propose and establish regulations.

The taxpayers were seeking a declaratory judgment that Circular 230's restrictions on contingent fee arrangements in the context of ordinary refund claims was unconstitutional and exceeded the scope of the IRS's authority. They asked for a permanent injunction barring the enforcement of Circular 230's restrictions on the use of contingent fee arrangements for ordinary refund claims. The IRS filed a motion to dismiss Counts I and II.

Contingent Fee Rules

Beginning in 1994, Circular 230 restricted the use of contingent fee arrangements for preparing original income tax returns. However, the regulations allowed the use of contingent fee arrangements for the preparation and filing of amended returns and/or refund claims, so long as the practitioner reasonably anticipated at the time the fee arrangement was entered into that the amended return or refund claim would receive substantive review by the IRS. In issuing the regulations, the IRS explained that a rule restricting contingent fees for preparing tax returns supports voluntary compliance with the tax laws by discouraging return positions that exploit the audit selection process.

In September 2007, however, the IRS issued final regulations expanding the Circular 230 limitations on the use of contingent fee arrangements. In response to public comments, the IRS repeated its prior stance that a rule restricting contingent fees for preparing tax returns supports voluntary compliance with the federal tax laws by discouraging return positions that exploit the audit selection process. Circular 230, Section 10.27(b)(1), now provides that, in most circumstances, a practitioner may not charge a contingent fee for services rendered in connection with any matter before the IRS. However, Circular 230, Section 10.27(b)(3) and (4), does allow for some exceptions to this limitation for services rendered in connection with the IRS's examination of, or challenge to: (1) an original tax return; or (2) an amended return or claim for refund or credit where the amended return or claim for refund or credit is filed within 120 days of the taxpayer receiving a written notice of the examination of, or a written challenge to, the original tax return. Additionally, a practitioner may properly charge a contingent fee for services rendered in connection with a claim for credit or refund filed solely in connection with the determination of statutory interest or penalties assessed by the IRS or for services rendered in connection with any judicial proceeding arising under the Internal Revenue Code.

The term contingent fee is defined as any fee that is based, in whole or in part, on whether or not a position taken on a tax return or other filing avoids challenge by the IRS or is sustained either by the IRS or in litigation, and also includes a fee that is based on a percentage of the refund reported on a return, that is based on a percentage of the taxes saved, or that otherwise depends on the specific result attained.

Ryan LLC's Argument

According to Ryan, LLC, an integral part of its business has historically been the representation of clients on a contingent fee basis in the preparing and filing of ordinary tax refund claims. The firm asserted that the ordinary refund claims it has prepared and filed on behalf of its clients typically have not involved complex legal issues, or in many cases, any legal disputes at all. Instead, these refund claims have usually been extremely fact intensive inquiries that required an enormous outlay of time, energy, and resources. The firm stated that its efforts in compiling, organizing, preparing, and analyzing the volumes of data necessary to establish the validity of such claims results in substantial expenses being incurred up front, in the preparation of the claim. Given this, Ryan, LLC alleged that its clients have preferred the use of contingent fee arrangements when pursuing these claims. Ryan, LLC argued that it has lost clients and substantial revenue due to the Circular 230 prohibition on the use of contingent fee arrangements for services rendered in connection with preparing and filing of ordinary refund claims. Through the suit, Ryan, LLC asserted that Circular 230's restrictions infringed upon the First Amendment right to petition the Government for a redress of grievances, through the filing of ordinary refund claims.

According to Ryan, LLC, its clients' interest in upending Circular 230 is to reduce the initial outlay of cost in pursuing ordinary refund claims by enabling them to share the expenses associated with the preparation and filing of these claims through contingency fee payments. Ryan, LLC stated that it wanted to set aside Circular 230's contingent fee prohibition so that it can resume contingent compensation agreements with its clients and can benefit from the renewed business opportunities and increased revenues that would result. According to Ryan, LLC, its clients' interest in upending Circular 230 is to reduce the initial outlay of cost in pursuing ordinary refund claims by enabling them to share the expenses associated with the preparation and filing of these claims through contingency fee payments.

G. Ryan's Arguments

G. Ryan, as founder and chairman of Ryan, LLC, argued that because of Circular 230's prohibition on the use of contingent fee arrangements, he was unable to retain a practitioner on a contingent fee basis to prepare and file an ordinary refund claim on his behalf. He alleged that Circular 230 violated his rights under the Petition Clause of the First Amendment, and also claimed that Circular 230 violated his Fifth Amendment due process rights by depriving him of the ability to obtain a refund for an overpayment of tax.

IRS Argument

According to the IRS, Circular 230's impact on taxpayers' ability to file refund claims with the IRS, if any, falls well within the permissible bounds of the government's ability to regulate potential First Amendment conduct. Under the revised regulations of Circular 230, the IRS said, taxpayers remain free to file ordinary refund claims with the IRS. The IRS stated that taxpayers remain free to retain a tax practitioner to assist them in the preparation and filing of such claims and taxpayers also remain free to compensate tax practitioners for such claims. The only limitation that Circular 230's revised regulations place on taxpayers, the IRS observed is if taxpayers choose to file an ordinary refund claim, and if taxpayers choose to retain a tax practitioner to assist them in the preparation and filing of such a claim, then they cannot compensate the practitioner on a contingency fee basis.

District Court's Opinion

The question before the district court was whether Ryan, LLC, or G. Ryan, individually, had standing to contest the Circular 230 limitation on contingent fee arrangements. The district court found that Ryan, LLC had standing to pursue its claim on behalf of its third-party taxpayer clients. However, with respect to G. Ryan, the court concluded that he failed to allege an injury consistent with this theory. Stated another way, the court said that, despite the supposedly complex and costly nature of ordinary refund claims, G. Ryan did not assert that his inability to retain a practitioner on a contingent fee basis had deprived him of the right or ability to pursue such a claim. In fact, the court pointed out, his allegations confirmed precisely the opposite because he stated that he had filed an ordinary refund claim since the effective date of the 2007 revisions to Circular 230. In sum, because G. Ryan failed to allege a sufficiently concrete and particularized injury that comported with his constitutional due process theory, the district court held that he lacked standing to pursue his claim.

The court then reviewed the crux of Ryan LLC's claim under the Petition Clause, which was that, given the technical complexities of the tax laws, the requirements imposed by the IRS on the content of refund claims and the enormous amount of time and effort necessary to prepare a proper refund claim, the prohibition on the use of contingent fee arrangements impairs and, in some cases, may extinguish, the ability of taxpayers to effectively petition the IRS for a refund of taxes that have been overpaid.

The court found dubious the IRS's argument that the Petition Clause does not protect a taxpayer's right to file an administrative claim for refund with the IRS. Not only has the Supreme Court explicitly held that Petition Clause guarantees citizens the ability to seek relief with courts, the district court noted, but it has also made clear that these protections extend to other forums established by the government for the resolution of legal disputes.

In the end, however, the district court agreed with the IRS that the minor limitation on proceedings before the IRS as put forth in Circular 230's limitation on contingent fee arrangements, does not run afoul of the Petition clause. The court concluded that, even accepting as true the well-pleaded allegations of Ryan LLC's complaint, the firm had failed to state a plausible claim for relief under the First Amendment's Petition Clause.

Finally, the court stated that Gerald Lee Ridgely's claim under the Administrative Procedure Act (Count III), which was not included in the IRS's motion to dismiss, would be allowed to proceed.

Staff Editor Parker Tax Publishing

Don't miss our Complimentary Federal Tax Bulletin: March 27, 2013.

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