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Pinch-Hitting for the IRS: Second Circuit Adopts Phantom Regulations to Curb a Monster Abuse of Financial Derivatives

In Estate of McKelvey v. Commissioner, the Second Circuit Court of Appeals adopted the IRS’s position that probability analysis should be employed to deter-mine that the taxpayer’s particular performance under the terms of a financial instrument was “virtually certain.” However, the IRS had steadfastly refused to promulgate regulations that, under a statutory delegation of authority to issue regulations to interpret and enforce the statute, could have administratively imposed that out-come. 
 
Instead, by employing what are commonly referred to as “phantom regulations,” the Second Circuit judicially mandated that result. The Panel’s decision effectively bypassed application of the Administrative Procedure Act’s notice and comment requirements. More significantly, it permitted the IRS to avoid its responsibility to issue regulations and, thereby, deprived the public, and the taxpayer, of the expertise and professionalism of the IRS rulemaking process.