IRS Made “Initial Determination”

The Tax Court held that the IRS could impose the 40% gross-valuation-misstatement penalty on the taxpayers because the IRS examiner had made an initial determination that the penalty applied.

Background

During 2007, Brett and Cindy Legg, through a disregarded entity, donated 80 acres as a conservation easement to the Colorado Natural Land Trust. On their timely filed 2007 federal income tax return, the Leggs valued the donation at $1,418,500 and claimed a charitable contribution deduction. They deducted a portion of the contribution on their 2007 return and carried over to and deducted the rest in 2008, 2009, and 2010.

On examination, the IRS found that the Leggs had indeed been generous with their contribution—to themselves. The IRS examiner determined that the couple did not satisfy the legal requirements for a charitable contribution deduction or, alternatively, that even if they had met the legal requirements, the actual value of the conservation easement donation was zero. As a result, the examination concluded that there was an underpayment of tax for each of the tax years at issue due to a decrease of the charitable contribution deduction for the donated conservation easement. The examiner’s supervisor sent a copy of the examiner’s report to the Leggs.

The IRS examiner determined the Leggs were liable for the 20% accuracy-related penalty under Sec. 6662(a) or, alternatively, they were liable for the 40% accuracy-related penalty for a gross-valuation misstatement under Sec. 6662(h). The examination report stated that the Leggs were “subject to the Accuracy Related Penalty—Gross ­Valuation Misstatement pursuant to IRC Section 6662 for the tax year 2007.” However, the examiner calculated the proposed penalties in the report using the 20% rate. The examiner’s supervisor signed the examination report in writing.

The examiner included the 40% gross-valuation-misstatement penalty analysis as an alternative position because of uncertainty as to whether the IRS could impose that penalty where an underpayment was the consequence of an adjustment not based on valuation. Specifically, at the time the examiner issued the report, it was uncertain whether the IRS could impose a gross-valuation-misstatement penalty on the theory that the Leggs’ donation of the conservation easement did not meet the charitable contribution deduction requirements of Sec. 170, because the adjustment was not based on valuation.

The Leggs appealed the determination administratively, but the Appeals Office sided with the IRS. It agreed with the examiner that the easement had a value of zero, and that the 20% or, alternatively, the 40% penalty should apply. The issue of whether the IRS could apply the 40% penalty in the Leggs’ case by this time had been resolved in the IRS’s favor, so the IRS issued a notice of deficiency with a 40% penalty. After the notice was issued, the two sides eventually stipulated that the value of the easement was only $80,000.

Having stipulated to the main issue, the Leggs marched to the Tax Court to protest the IRS’s imposition of the 40% penalty instead of the 20% penalty. They argued that the 40% penalty should not apply because the IRS examiner made an “initial determination” under Sec. 6751(b) that the 20% penalty applied. Sec. 6751(b)(1) requires that no penalty be assessed “unless the initial determination of such assessment is personally approved (in writing) by the immediate supervisor of the individual making such determination.”

The Tax Court’s Decision

The Tax Court held that the application of the 40% penalty was proper because the IRS examiner had made an initial determination as required by Sec. 6751(b). The court found that the IRS examiner’s report, in which the examiner determined as an alternative position that the Leggs were liable for the 40% penalty, was an initial determination.

The Leggs argued that the IRS’s examiner did not make an “initial determination” that the Sec. 6662(h) 40% penalty applied, because the examination report calculated the penalty adjustments at 20%. They asserted that this calculation suggested that respondent never considered imposing the 40% gross-valuation-misstatement penalty and that consequently the examiner’s immediate supervisor could not have approved, in writing, this penalty.

The IRS argued that the examiner made an “initial determination” that the 40% penalty was appropriate, concluding in the examination report that the Leggs were liable for it. It further contended that the mere fact that the examiner computed the proposed penalty at a rate of 20% did not nullify the fact that the report concluded that the Leggs were liable for the 40% penalty. Because the report was approved, in writing, by the examiner’s immediate supervisor, the Sec. 6751(b) procedural requirements were met.

The Tax Court explained that Congress enacted Sec. 6751(b) to ensure that taxpayers understood the penalties that the IRS imposed upon them. The examination report clearly explained why the Leggs were liable for the gross-valuation-misstatement penalty. The report applied Sec. 6662(h) and the relevant regulations to the Leggs’ specific facts, reaching the conclusion that they were liable for the 40% penalty. According to the court, the Leggs could not contend that they lacked an understanding of the penalty imposed upon them because the IRS posed it as an alternative position. Thus, the court concluded that its determination that the IRS had made an initial determination regarding the 40% penalty comported with congressional intent.

Reflections

The IRS and the Leggs also disputed whether Sec. 6751(b) applied only before the assessment of penalties or before the determination of penalties in a notice of deficiency. However, because the court determined that the IRS examiner had made an initial determination before the notice of deficiency was issued, the Tax Court did not decide this issue.

Legg, 145 T.C. No. 13 (2015)