On August 12, 2016, the United States District Court for the Northern District of California held that the taxpayer who invested in a group life insurance plan was liable for penalties under section 6707A (listed transaction penalty) for failure to disclose its participation in a group term life insurance transaction for years 2009 through 2011.21 The taxpayer, Interior Glass, filed a refund action seeking the recovery of the section 6707A penalty. Interior Glass argued, in part, that section 6707A is unconstitutionally vague, and therefore void. Taxpayer’s vagueness argument focused on the phrase “substantially similar,” as incorporated into section 6707A. 

Background

In 2006, Interior Glass purchased an insurance product, known as the Insured Security Program (“ISP”), which claimed that the employer could deduct the insurance premium paid on behalf of an employee, while the employee would not have to report any compensation income from the premiums paid on his behalf.22 The ISP was marketed by Lawrence Cronin.

In 2007, the IRS targeted programs similar to the ISP and identified them as “abusive trust arrangements.” To regulate the ISP, the IRS issued Notice 2007-83 providing that abusive trust arrangements are transactions identified as “listed transactions” under the Internal Revenue Code. In response to the notice, Cronin developed a new program that he believed would not be subjected to the disclosure requirements. He founded a tax-exempt business league called the Association for Small Closely-Held Business Enterprises, which offered a group term life insurance plan (“GTLP”) to its membercompanies/employers.23 In 2009, Interior Glass purchased the GTLP and was told that the GTLP was not a “listed transaction” subject to disclosure under Notice 2007-83.24 Thus, Interior Glass did not disclose its participation in the GTLP for the 2009, 2010 and 2011 tax years. In 2012, the IRS imposed penalties under section 6707A because Interior Glass failed to disclose its participation in the GTLP, which the Service determined was a “listed transaction” subject to disclosure under Notice 2007-83. Interior Glass paid the penalty and sought a refund of the tax penalties assessed and collected under section 6707A.25

Interior Glass argued that section 6707A is void as unconstitutionally vague because no reasonable person, including the IRS, could know the meaning of the phrase “substantially similar.” Taxpayer argued that the statute’s vagueness allows “any low level” IRS employee to determine that different policy plans are “substantially similar,” therefore facilitating the imposition of penalties. Taxpayer’s argument was premised on the Fifth Amendment’s Due Process Clause which requires that a penal statute define the criminal offense with sufficient definiteness that ordinary people can understand what conduct is prohibited and in a manner that does not encourage arbitrary and discriminatory enforcement. The government argued that section 6707A is not unconstitutionally vague since Notice 2007-83 describes a “listed transaction” in detail, and explicitly provides for “substantially similar” transactions, incorporating the definition for that phrase in Treasury Reg. 1.6011-4(c)(4).26

Section 6707A Is Not Unconstitutionally Vague

The District Court first looked to the phrase “substantially similar” as it appears in section 6707A(c)(2), which section defines a “listed transaction” as “a reportable transaction which is the same as, or substantially similar to, a transaction specifically identified by the Secretary as a tax avoidance transaction for purposes of section 6011.” By its definition, the court noted that section 6707A must be read in conjunction with Notice 2007-83, because “it is there that the Secretary identified certain trust arrangements claiming to be welfare benefit funds and involving cash value life insurance policies” as “tax avoidance transactions” and “listed transactions for purposes of § 1.6011-4(b)(2) . . . and §§ 6111 and 6112.” 27 Notice 2007-83 defines a “listed transaction” with four specific elements, and provides that “[a]ny transaction that has all of the [] elements, and any transaction that is substantially similar to such a transaction, are identified as ‘listed transactions’ . . .” Notice 2007-83 applies to “listed transactions,” which are defined as:

Any transaction that has all of the following elements, and any transaction that is substantially similar to such a transaction, are identified as “listed transactions” for purposes of section 1.6011-4(b)(2) and sections 6111 and 6112, effective October 17, 2007, the date this notice is released to the public:

1.The transaction involves a trust or other fund described in section 419(e)(3) that is purportedly a welfare benefit fund.

2.For determining the portion of its contributions to the trust or other fund that are currently deductible the employer does not rely on the exception in section 419A(f)(5)(A) (regarding collectively bargained plans).

3.The trust or other fund pays premiums (or amounts that are purported to be premiums) on one or more life insurance policies and, with respect to at least one of the policies, value is accumulated:

4.The employer has taken a deduction for any taxable year for its contributions to the fund with respect to benefits provided under the plan (other than post-retirement medical benefits, post retirement life insurance benefits and child care facilities) that is greater than the sum of the following amounts.

According to the court, because Notice 2007-83 lists specific elements to which an arrangement can be compared to determine whether it is “substantially similar” to a “listed transaction,” section 6707A does not “effectively require[] the taxpayer [to] guess what arguments (and what revised facts) the IRS might come up with in the future to allege that two different items are ‘substantially similar.’”28 Accordingly, the court concluded that the language of section 6707A was sufficient to withstand constitutional scrutiny.29 

Interior Glass also argued that even though section 6707A is silent, it is a penal statute which implies a requirement of mens rea. The Government argued that section 6707A allows for a strict liability penalty, and thus taxpayer’s knowledge or advice provided is irrelevant. The court agreed with the government that section 6707A provided for a strict liability penalty, and distinguished the case law cited by the taxpayer.30 Accordingly, the court concluded that Interior Glass’s state of mind or any advice it received was irrelevant to the imposition of the section 6707A penalty.