On September 24, 2020, in Scholl v. Mnuchin,[1] the district court for the Northern District of California issued an order enjoining the IRS from withholding economic-impact payments provided under the CARES Act from prisoners in accordance with FAQs issued by the IRS, finding that the FAQs were contrary to law and exceeded the IRS’s statutory authority. On October 14, 2020, the court granted the plaintiffs’ motion for summary judgment on the APA claims and converted the earlier preliminary injunction into a permanent one.[2] The decision could have far-reaching implications and require the IRS to provide an explanation and basis for its substantive conclusions reflected in future FAQs.

FACTUAL BACKGROUND

The plaintiffs filed a complaint in a putative class action asserting three causes of action: (i) violation of the Administrative Procedure Act (“APA”), 5 U.S.C. § 706(1); (ii) violation of the APA, 5 U.S.C. §§ 702, 706(2); and (iii) violation of the Coronavirus Aid, Relief, and Economic Security Act  (“CARES Act”)[3] and the Little Tucker Act, 28 U.S.C. § 1346(a)(2). The defendants included the Secretary of the Treasury and the Commissioner of the Internal Revenue Service.

The defendants were tasked with administering economic-impact payments (“EIPs”) to eligible individuals pursuant to the CARES Act, which was signed into law on March 27, 2020. The plaintiffs are incarcerated and formerly incarcerated individuals who did not receive payments, and members of the class are all similarly situated persons who are or were incarcerated and otherwise meet the criteria to receive an EIP under the CARES Act, but did not receive an EIP. The plaintiffs filed a motion for preliminary injunction and motion for class certification. The plaintiffs sought to certify a class of all individuals who were incarcerated across the United States since March 27, 2020, and meet the eligibility requirements described in the CARES Act.

CARES ACT

The CARES Act, codified in part at § 6428 of the Internal Revenue Code, established a tax credit for eligible individuals of $1,200 ($2,400 if filing a joint return), plus $500 multiplied by the number of qualifying children.[4]  Under the Act, an eligible individual is defined as “any individual” other than (i) any nonresident alien individual, (ii) any individual who is allowed as a dependent deduction on another taxpayer’s return, and (iii) an estate or trust.[5] The EIP is an advance refund of the subsection (a) tax credit, and subsection (f) describes the mechanism for implementing the advance refund. Paragraph (3) of subsection (f) requires the IRS to “refund or credit any overpayment attributable to this section as rapidly as possible.”[6]   

On May 6, 2020, the IRS published responses to frequently asked questions (“FAQs”) on the IRS.gov website. Question 15 asked, “Does someone who is incarcerated qualify for the Payment [i.e., an EIP]?” The IRS responded,

A15. No. A Payment made to someone who is incarcerated should be returned to the IRS by following the instructions about repayments. A person is incarcerated if he or she is described in one or more of clauses (i) through (v) of Section 202(x)(1)(A) of the Social Security Act (42 U.S.C. § 402 (x)(1)(A)(i) through (v)). For a Payment made with respect to a joint return where only one spouse is incarcerated, you only need to return the portion of the Payment made on account of the incarcerated spouse. This amount will be $1,200 unless adjusted gross income exceeded $150,000.

On June 18, 2020, the IRS updated its internal-procedures manual to reflect the policy stated in response to the FAQ.

The Treasury Inspector General for Tax Administration (“TIGTA”) calculated that initial CARES Act disbursements were sent to 84,861 incarcerated individuals. In response to these already issued payments, the IRS issued guidance, as reflected in the FAQ, that individuals who received a direct-deposit payment in error should repay the advance refund by submitting a personal check or money order to the IRS. Individuals who received a paper EIP check were instructed to return the voided check to the IRS. Further, the plaintiffs cited news stories reporting that the IRS took proactive steps to intercept and retrieve the EIP payments such as directing state corrections departments to intercept payments made to incarcerated individuals and return them to the IRS.

The plaintiffs’ complaint asserted that the IRS’s policy of withholding EIP benefits from prisoners based solely on their status as incarcerated people exceeded the agency’s statutory authority under the CARES Act, was contrary to law, and was arbitrary and capricious under the APA. Defendants argued that the court lacked subject matter jurisdiction, arguing standing, ripeness, and sovereign immunity.

ANALYSIS

Agreeing with the plaintiffs’ arguments on standing and ripeness, the court rejected the Justice Department’s position that the lawsuit was not reviewable under the APA because a . According to the court,

[T]he government was mischaracterizing the nature of the plaintiffs’ lawsuit because plaintiffs were not challenging an erroneously assessed or collected tax or penalty; rather, they were questioning the administrative procedures by which the IRS arrived at its decision and whether that decision was lawful. According to the court, the advance refund (EIP) is a grant of money, and the denial of the advance refund was an agency action.

The remaining issue was whether the IRS’s action was final and reviewable. The court rejected the government’s contention that the FAQ was not a final agency action for APA purposes. The government argued that the IRS’s policy denying EIPs to prisoners was not the consummation of a decision-making process, but rather a response to a rapidly developing situation following enactment of the CARES Act. But the court concluded that the FAQ represented a final agency action because the IRS took the unequivocal position that prisoners were ineligible to receive EIPs and showed no indication that it intended to change its position.

On the substantive APA claims, the court held that the FAQ was contrary to law and exceeded the IRS’s statutory authority because incarcerated individuals are not excludable as “eligible individuals” under the CARES Act. In addition, the court held that the FAQ was arbitrary and capricious because the IRS did not provide “any reason for the decision to exclude payments to incarcerated individuals, much less an adequate one.” 

CONCLUSION

The decision in Scholl is significant because it will require the IRS provide an explanation for any substantive conclusion reflected in a FAQ, and prove that the FAQ is not arbitrary and capricious. This may hinder the future issuance of FAQs by the IRS because they will require additional thought or effort by the IRS. This could also have a negative effect on taxpayers who are looking for informal guidance from the IRS on recent legislation, such as what we witnessed with the passage of the CARES Act.