March 31, 2015
By Jeffrey Birdsong, Senior Associate
The United States Court of Appeals for the Second Circuit faced a conflict between the principles of administrative and tax law in the 2013 case of IRS v. WorldCom. In WorldCom, the status of revenue rulings as non-binding guidance documents clashed with the duty of consistency in IRS tax application. WorldCom offered the perfect opportunity for the United States Supreme Court to resolve this ambiguity and a circuit split, but the Court denied certiorari.
In 2003, the IRS applied a tax on landline telephone use to WorldCom, the bankrupt telecommunications company acquired by Verizon. WorldCom challenged the tax application, claiming that the relevant product did not meet the criteria of the tax statute. WorldCom acted as an intermediary in the back-end infrastructure of the Internet, receiving user data from local phone companies and transmitting it to a centralized internet access point. In effect, WorldCom purchased access to the customer’s data from local phone companies, as opposed to traditional phone service.
The landline telephone tax applies when a customer purchases a product that offers the “privilege of telephonic quality communication.” The case hinged on the interpretation of that definition because WorldCom was not a typical telephone service user; rather, WorldCom purchased access to a customer’s Internet data. The Second Circuit found that the phrase “telephonic quality” as used in the statute referred to the technological capacity of the channel to transmit voice signals regardless of whether the channel was used for voice communications. Because the specific type of cable used in the product could maintain vocal communication as well as data, the product offered “telephonic quality communications,” and WorldCom was subject to the tax. In WorldCom, the IRS applied the tax counter to their existing position in Revenue Ruling 79-245.
I. Tax Law
Rulemaking is a function of administrative agencies such as the IRS. Tasked by Congress with fleshing out the details of statutes through regulations, the IRS creates publications to inform the public. Revenue rulings, a specific type of IRS publication, are “an official interpretation by the [IRS] of the internal revenue laws and related statutes . . . published for the information and guidance of taxpayers.” They are issued upon the request of a taxpayer, and the IRS applies the law to a generic version of that taxpayer’s situation. Though published, revenue rulings lack the legal force of a regulation; however, they do reflect the current IRS position on any number of matters.
Revenue Ruling 79-245 provides guidance to WorldCom and similar issues. In the IRS ruling, a taxpayer purchased a teleprocessing system to verify credit cards. The issue was whether the ancillary equipment used—e.g., computers, modems, etc.—qualified for the landline telephone tax. The IRS stated that the use of the equipment was not taxable but that the use of the phone line qualified as “the privilege of telephonic communication.” In its analysis, the IRS noted that, though the line was not used for phone calls, the modem could be unplugged and swapped with a telephone. In other words, it was wholly up to the consumer whether they would plug in a modem or a telephone. Accordingly, the IRS said that because the privilege was available, “it is immaterial whether the subscriber exercises the privilege.” Revenue Ruling 79-245 stands for the proposition that if a taxpayer purchases a service that allows phone calls, it is subject to the landline telephone tax.
The IRS may change its policy over time; however, the duty of consistency prevents the IRS from applying that new position until it is announced. In theory, a taxpayer should not be taxed for behavior before the announced revision. Historically, the IRS applied the duty against taxpayers. That is, a taxpayer could not change the classification of property year to year in an attempt to circumvent IRS regulations. Eventually, courts inverted the duty and began applying it to the IRS.
The official position of the IRS is that “taxpayers generally may rely upon revenue rulings . . . in determining the tax treatment of their own transactions.” From this pronouncement, courts began to hold that “taxpayer[s] may rely on the legal standard implied by the revenue ruling.” Part of the confusion regarding the doctrine is that it has not been applied uniformly. The Supreme Court has never spoken on the application of the duty of consistency to the IRS, though several circuits have adopted its use.
Pursuant to Revenue Ruling 79-245, the product WorldCom purchased from the local phone companies was ineligible for the tax. WorldCom purchased back-end connectivity to end-user’s computers, and WorldCom could not plug in a telephone to make voice calls.
In WorldCom, the IRS amended their position from the earlier revenue ruling. Nevertheless, they announced the new policy only by alerting WorldCom to the company’s tax deficiency, violating the duty of consistency. The duty should forbid such a retroactive application of new policy; however, this tax law duty of consistency does not comport with administrative law standards governing the nature of guidance documents.
II. Administrative Law
Administrative agencies execute laws passed by Congress. One aspect of this execution is rulemaking, interpreting statutes and promulgating rules that give effect to the intentions of Congress. In this process, agencies publish rules that carry the force of law and are binding on the agency and the public. These rules are subject to a strict procedural framework. The agency must announce to the public that a rule is being created, seek input on the content of the proposed rule, and publish the final rule in the Federal Register.
Often, agencies publish documents that are not in furtherance of a congressional statute and are not supported by the force of law. Administrative agencies publish documents that detail the general purpose of the agency’s actions, clarify agency interpretations and litigation positions, or establish internal procedures. Though useful to the agency and the public, these guidance documents are not created with heightened scrutiny and are not binding on the agency.
An IRS revenue ruling is precisely this type of document. Taxpayers have the right to ask the IRS to explain the effect of a particular statute on the individual taxpayer. The IRS then issues a revenue ruling presenting the taxpayer’s issue in generic terms and applies the law to that particular issue. Because these documents are not rules created to further the statutory intent of Congress, they are not subject to notice and comment. These individual applications of the law are not binding on the agency or any future taxpayer.
Given the nonbinding nature of guidance documents—e.g., revenue rulings—the IRS’ adoption of a new policy without alerting taxpayers is permissible. WorldCom illustrates this reality. According to the IRS policy in Revenue Ruling 79-245, the product WorldCom purchased was not taxable as a telephone service. The IRS shifted from that stated policy when it applied this tax to WorldCom. Though permissible under administrative law, application of the new policy to behavior that took place before the announced change appears to violate the duty of consistency.
If tax law doctrine requires the IRS to apply their stated position as it stood the day of the behavior, then retroactively applying new law is impermissible. If administrative law holds that by their nature guidance documents—such as revenue rulings—are not binding, then the duty of consistency is a fallacy. Though WorldCom displayed this dichotomy, the Second Circuit did not analyze the applicability of the duty of consistency. The circuit found for the IRS, subjected WorldCom to the tax, and skewered the duty of consistency. It is unclear how these doctrines interact, and the Supreme Court failed to seize the opportunity to provide the necessary clarity.
It is possible that the Court denied certiorari because they disapproved of the duty of consistency or wanted to let the duty further percolate at the appellate level, regardless of the Second Circuit’s treatment of the issue. In the face of a growing docket, the Supreme Court might have denied certiorari because the stakes were relatively low—$26 million—and because these facts are unlikely to appear again before the Court. The product in WorldCom has been obsolete for years, and the case only arose in the process of WorldCom’s bankruptcy.
Regardless of the non-prospective nature of the facts, the Supreme Court may still grant certiorari to settle doctrinal disputes like this one. The Supreme Court should have resolved this fundamental discrepancy between tax and administrative law, but their silence leaves this inquiry unresolved.
 IRS v. WorldCom, Inc., 723 F.3d 346 (2d Cir. 2013).
 See WorldCom, Inc., v. IRS, 135 S. Ct. 56 (2014). The case created a circuit split between the Federal Circuit and the Second Circuit. See USA Choice Internet Servs., LLC v. United States, 522 F.3d 1332 (Fed. Cir. 2008). At issue was the IRS’ method of analyzing how a taxpayer structured its transactions. Specifically, whether the IRS should focus on products the taxpayer purchased, as opposed to products the taxpayer could have purchased.
 See 26 U.S.C. § 4251 (2012).
 26 U.S.C. § 4251 (2012).
 26 U.S.C. § 4252(a) (2012).
 WorldCom, 723 F.3d at 355.
 Rev. Rul. 79-245, 1979-2 C.B. 380.
 See Leandra Lederman, The Fight Over “Fighting Regs” and Judicial Deference in Tax Litigation, 92 B.U. L. Rev. 643 (2012).
 Rev. Proc. 89-14, 1989-1 C.B. 814.
 Treas. Reg. § 601.601(d)(2)(i)(a) (2010).
 Rev. Rul. 79-245, 1979-2 C.B. 380.
 See Stephanie Hoffer, Hobgoblin of Little Minds No More: Justice Requires an IRS Duty of Consistency, 2006 Utah L. Rev. 317 (2006).
 See Estate of McLendon v. Comm’r, 135 F.3d 1017 (5th Cir. 1998).
 Rev. Proc. 89-14, 1989-8 I.R.B. 20.
 Hoffer, supra note 15, at 337.
 Steve R. Johnson, Reasoned Explanation and IRS Adjudication, 63 Duke L.J.1771, 1804–05 (2014).
 See id.
 5 U.S.C. § 553 (2012).
 Rev. Proc. 89-14, 1989-1 C.B. 814
 Rev. Rul. 79-245, 1979-2 C.B. 380.
 See IRS v. WorldCom, Inc., 723 F.3d 346 (2d Cir. 2013).