Chevron's last hurrah: 5th Circuit signals shift in IRS deference and tax-exempt rules

The recent decision by the United States Court of Appeals for the Fifth Circuit in MHACO v. Commissioner marks the commencement of a significant shift in how courts may approach the interpretation of agency rules that I discussed in my articles, "The Project 2025 Mandate: Implications for the Administrative State and the U.S. Constitution" published on July 19, 2024, and "Navigating uncharted waters: Congress aligns with SCOTUS in reshaping the administrative state," published on Aug. 19, 2024, particularly those promulgated by the Internal Revenue Service (IRS). This decision could have profound implications for entities that have traditionally relied on the Chevron deference doctrine to justify adherence to agency rules.

Background of the case

Memorial Hermann Accountable Care Organization (MHACO) sought tax-exempt status under Internal Revenue Code § 501(c)(4), claiming it operated exclusively for the promotion of social welfare. The IRS denied this status, arguing that MHACO's activities primarily benefited commercial payors and healthcare providers rather than the public. The Tax Court upheld the IRS's decision, and MHACO appealed to the Fifth Circuit.

Key legal issues

The central legal issue in this case was whether the court should defer to the IRS's interpretation of § 501(c)(4) under the Chevron doctrine, which traditionally allowed courts to defer to an agency's interpretation of ambiguous statutory language. However, the Supreme Court's decision in Loper Bright Enterprises v. Raimondo overruled the Chevron doctrine, prompting the Fifth Circuit to reconsider its approach.

Court's analysis and application of Loper Bright

The Fifth Circuit applied the Loper Bright decision to limit the Chevron deference doctrine, stating that it no longer needed to provide deference to the Treasury's interpretation of § 501(c)(4), which had for at least a decade allowed tax practitioners to rely on IRS guidance that the agency would expedite tax-exempt application for organizations where approximately 60% of its operations were devoted to social welfare purposes, by stating:

Importantly, we no longer are required to provide "Chevron deference" to the Treasury's interpretation of § 501(c)(4) (although we can certainly consider it). See Loper Bright Enters. v. Raimondo, 144 S. Ct. 2244, 2273 (2024), overruling Chevron U.S.A. Inc. v. Nat. Res. Def. Council, Inc., 467 U.S. 837 (1984).

Instead, the court independently assessed the statutory language, emphasizing the importance of the text over agency interpretation.

The court also disregarded the IRS's rule at 26 C.F.R. § 1.501(c)(4)-1(a)(2)(i), https://www.ecfr.gov/current/title-26/chapter-I/subchapter-A/part-1/subject-group-ECFR062882ac6495890/section-1.501(c)(4)-1, which had been historically used to determine tax-exempt eligibility for 501(c)(4) social welfare civic organization. However, instead of applying the "primary purpose" test, contained § 1.501(c)(4)-1(a)(2)(i), which MHACO advocated, the court instead used the "substantial nonexempt purpose" test. This test, derived from the Better Business Bureau case, is typically applied to § 501(c)(3) cases and focuses on whether an organization's nonexempt activities are substantial enough to disqualify it from tax exemption. [See https://www.ecfr.gov/current/title-26/chapter-I/subchapter-A/part-1/subject-group-ECFR062882ac6495890/section-1.501(c)(3)-1]

Implications for tax-exempt entities

The Fifth Circuit's decision signals a potential shift in how courts may interpret agency rules, particularly those affecting tax-exempt status. Entities that have relied on Chevron deference to justify compliance with IRS rules may need to reassess their strategies. The court's emphasis on statutory text over agency interpretation could lead to more stringent scrutiny of agency rules and a reevaluation of what constitutes a "substantial nonexempt purpose."

This decision may encourage entities to focus more on the statutory language and legislative intent rather than relying solely on agency guidance. It also underscores the importance of aligning organizational activities with the statutory requirements for tax exemption, as courts may no longer defer to agency interpretations that previously provided a buffer.

Conclusion

The Fifth Circuit's ruling in MHACO v. Commissioner highlights the evolving landscape of administrative law and the diminishing role of Chevron deference. Entities and their counsel must stay informed about these changes and consider their potential impact on compliance and strategic planning. As courts continue to navigate the post-Chevron era, the emphasis on statutory interpretation over agency deference will likely shape future legal and regulatory environments.

Selwyn D. Whitehead is founder of The Law Offices of Selwyn D. Whitehead.