Daines v. IRS, No. 24-CV-1057 (E.D. Wis. May 4, 2026)

The dispute in this case centered around the implementation and operation of an employee stock ownership plan (ESOP). The individual plaintiffs, Jeffrey and Elisha Daines and Jeffrey and Stephanie Federwitz, alongside their corporate entities Solid Ground Inc. and Solid Ground Transportation, Inc., sought to establish an ESOP to take advantage of specific tax benefits. To execute this strategy, the taxpayers enlisted Lex J. Byers and his company, who aggressively marketed "a proprietary system that would afford certain tax benefits". This arrangement created the seventh plaintiff in the case, the Solid Ground Transportation Inc. Employee Stock Ownership Plan.

For years, the ESOP operated without interference, and the plaintiffs believed they were in compliance. However, the IRS subsequently initiated an examination into the methodologies employed by Mr. Byers for the plaintiffs and other clients. Upon review, the IRS disqualified the ESOP and issued an Information Document Request (IDR) using IRS Form 4564. The IDR explicitly stated:

"As you have been informed through the Revenue Agent Report (F-886-A), the Service concluded that Solid Ground Transportation, Inc. Employee Stock Ownership and Profit-Sharing Plan is not qualified in operation under IRC Section 401 (a) and the Trust is no longer exempt under IRC section 501(a) for the plan year ending December 31, 2013, and subsequent plan years. Once the plan is disqualified, the earnings that the Trust assets’ realized are taxable each year the plan is not qualified. Trust earnings must be reported and filed on Form 1041 for all open years. Please provide Form 1041 for plan years 2018, 2019, 2020 and 2021".

Taxpayers' Request for Relief

While the taxpayers challenged the substantive disqualification of the ESOP in a separate proceeding before the United States Tax Court, they brought this specific action in the United States District Court for the Eastern District of Wisconsin under the Administrative Procedure Act (APA).

The taxpayers' core request for relief sought to invalidate the IRS's actions on procedural grounds. They alleged that the issuance of the IDR requiring a Form 1041 represented a new legislative rule—which they dubbed "the Byers Rule"—created by the IRS. The taxpayers argued that because "no provision of §4975, §4979A, or any other IRC section requires Form 1041 from a qualified ESOP trust," the IRS's actions constituted formal legislative rulemaking. Consequently, they requested the court rule that the IRS violated the APA by failing to follow mandatory notice-and-comment procedures and by bypassing the Congressional Review Act.

Analysis of the Law

The court’s analysis relied heavily on distinguishing between "rulemaking" and "adjudication" under the APA. Under 5 U.S.C. § 551(4), a "rule" is defined as "the whole or a part of an agency statement of general or particular applicability and future effect designed to implement, interpret, or prescribe law or policy". Conversely, an "order" constitutes "the whole or a part of a final disposition, whether affirmative, negative, injunctive, or declaratory in form, of an agency in a matter other than rule making but including licensing".

The court emphasized that rules are informally separated into legislative (substantive) rules, which require public notice and comment, and non-legislative rules. Citing Perez v. Mortg. Bankers Ass’n, 575 U.S. 92, 96 (2015) and 5 U.S.C. § 553(b), the court noted that the APA defines legislative rules in the negative; they are rules that are not "interpretative rules, general statements of policy, or rules of agency organization, procedure, or practice". A legislative rule issued without proper notice and comment is invalid, as established in Hoctor v. United States Dep’t of Agric., 82 F.3d 165, 167 (7th Cir. 1996).

Furthermore, the court analyzed the jurisdictional limits set forth by the APA, specifically 5 U.S.C. § 704, which permits judicial review only where there is "no other adequate remedy in a court".

Application of the Law to the Facts

The court decisively rejected the taxpayers' characterization of the IDR as a legislative rule. The court pointed out that the taxpayers' argument was "inconsistent with the plain language of the IDR and the premise for the request". The IDR did not create a new rule that an exempt ESOP trust must file a Form 1041; rather, it concluded that the specific trust in question was no longer exempt. Thus, "Requiring a non-exempt entity to submit a 1041 does not constitute a new rule; it is a conclusion that follows a finding that an entity was not exempt".

The court determined that the IRS’s action was an adjudication—the direct application of tax law to the taxpayers' specific facts. The court emphasized that the necessity for the IRS to interpret the law to arrive at an adjudicative decision does not magically transform the audit outcome into a legislative rule. Furthermore, the court dismissed the taxpayers' argument that the IRS's top-down enforcement against all clients using the "Byers Proprietary ESOP System" constituted rulemaking. Drawing on NLRB v. Wyman, 394 U.S. 759, 765-66 (1969), the court stated that adjudicative matters frequently have broader effects and serve as precedents, but this does not transform them into legislative rules requiring notice and comment.

Addressing the taxpayers' argument that the IRS's sudden enforcement action after years of silence was an implicit rule change, the court cited United States v. Bisceglia, 420 U.S. 141, 145 (1975) to remind the plaintiffs that the U.S. tax system relies heavily on self-reporting. The IRS cannot police every transaction simultaneously, and its failure to audit or challenge a position in previous years does not estop the agency from enforcing the law later.

Finally, applying 5 U.S.C. § 704, the court noted that the taxpayers possessed an adequate remedy in another court. The taxpayers' core dispute—whether the ESOP was legally qualified and whether taxes and penalties were properly assessed—was already the subject of pending Tax Court proceedings under 26 U.S.C. § 6213 and 26 U.S.C. § 7476.

Conclusions of the Court

The court concluded that the taxpayers failed to plausibly allege the existence of a legislative rule. Summarizing the procedural maneuvering of the plaintiffs, Judge Conway noted, "The plaintiffs’ amended complaint again leaves the court with the impression they are trying to fit the square peg of a routine administrative enforcement action into a round hole of a rulemaking under the APA".

Because the IDR and subsequent disqualification were adjudicative actions rather than legislative rulemaking subject to APA notice-and-comment restrictions, the court granted the IRS's motion to dismiss the amended complaint. Finding that further amendment would not cure the fundamental defects in the taxpayers' legal theory, the court dismissed the action with prejudice.

Prepared with assistance from NotebookLM.