IRS penalty relief available when approvals not timely

Editor: Valrie Chambers, CPA, Ph.D.

A recent series of taxpayer victories in Tax Court signals an avenue that may be available to eliminate penalties assessed by the IRS. This relief may be available for field exams as well as for office exams, correspondence exams, and CP-2000 notices, even when all changes the IRS proposed on the CP-2000 are correct.

The basis for the relief is Sec. 6751(b)(1), which was enacted as part of the IRS Restructuring and Reform Act (RRA) of 1998, P.L. 105-206. Sec. 6751(b)(1) states:

No penalty under this title shall be assessed unless the initial determination of such assessment is personally approved (in writing) by the immediate supervisor of the individual making such determination.

Importantly, this relief applies to accuracy, negligence, and fraud penalties for both individual taxpayers and partnerships subject to the provisions of the Tax Equity and Fiscal Responsibility Act (TEFRA), P.L. 97-248. It does not apply to underpayment, failure-to-file, or failure-to-pay penalties or any other penalty calculated by electronic means, but it appears that it also applies to the responsible-person penalty.

Beginning in 2017, cases began to emerge interpreting how this relief may be available and how to request abatements for taxpayers. In Chai,851 F.3d 190 (2d Cir. 2017), the Second Circuit reviewed the Tax Court’s decision not to abate an accuracy-related penalty. The taxpayer argued that the IRS had not established that an IRS supervisor had approved the assertion of the penalty as required by Sec. 6751(b)(1). The Second Circuit considered another provision inserted into the Code by the RRA, Sec. 7491(c), which says, “the Secretary shall have the burden of production in any court proceeding with respect to the liability of any individual for any penalty.” Accordingly, the court held that documentation of the supervisory approval was part of the IRS’s burden of proof for those penalties. The court noted that the correct time for obtaining approval is no later than the date the IRS issues the notice of deficiency. (See Beavers, “Tax Trends,” 51 The Tax Adviser 212 (March 2020), for a discussion of several cases that address various aspects of the supervisory approval that is required for the IRS to properly assert certain penalties.)

Following the Second Circuit’s Chai decision, the Tax Court in Graev, 149 T.C. 485 (2017), supplementing and overruling in part 147 T.C. 460 (2016), reversed its earlier position and held that the IRS must provide written proof of supervisory approval of penalties prior to the initial assertion of those penalties. Another case also found that the same rationale applied to partnerships that receive a notice of Final Partnership Administrative Adjustment (FPAA). In Endeavor Partners Fund, LLC, T.C. Memo. 2018-96, the judge wrote that “[a]lthough the partnerships’ conduct is plainly deserving of penalty, respondent has conceded that the IRS did not secure, prior to the issuance of the FPAAs, written supervisory approval of the penalties as required by section 6751(b)(1).”

In April 2019, the Tax Court held in Clay, 152 T.C. No. 13 (2019), that the term “initial determination of the penalty” could be deemed to be earlier than the date of the notice of deficiency. Here, the court held that the approval date could also be at a time when another form of formal communication is sent to the taxpayer that advises it that penalties were determined and gives the taxpayer the opportunity to appeal that determination. Since the IRS had sent a Notice of Proposed Adjustment that included penalties and also allowed for appeal rights, the supervisory approval rule was met with the mailing of the notice. Since the Service could not produce the approval record, the penalties were removed.

In early January 2020, the Tax Court narrowed the construction of when “initial determinations” were made, ruling that verbal discussions or draft proposed reports do not constitute a “determination” and that “[S]ec. 6751(b)(1) does not require written supervisory approval of penalties until the first formal communication to the taxpayer that the Commissioner has determined a penalty” (Tribune Media Co.,T.C. Memo. 2020-2).

The IRS also updated Internal Revenue Manual (IRM) Section 4.19.13.6.2 in February 2018 to address this procedural issue. The IRM now clearly indicates that managerial approval is required when a notice of deficiency or an FPAA is sent out.

Interestingly, the IRM provides an opportunity for taxpayers undergoing correspondence exams where the substantial-understatement penalty is automatically included with the notice. Here the IRM indicates that if the taxpayer submits a protest, written or otherwise, that challenges the penalty or the amount of the tax increase, then the immediate supervisor of the IRS employee considering the response must review and approve the penalty before a notice of deficiency with the penalty is issued. However, this managerial approval may not have occurred in practice, perhaps because the enforcement of the applicable Code sections refers to court procedures. Even so, asserting improper authorization of penalties would arguably constitute a litigation strategy when appealing a potentially qualifying taxpayer penalty.

Accordingly, even when a correspondence notice (CP-2000) correctly increases a taxpayer’s liability, a protest letter requesting abatement of the automatically generated accuracy penalty will often succeed.

Further, because the court cases apply to penalties asserted in prior years, practitioners may be able to request abatement for cases already decided and paid. Practitioners can file a Freedom of Information Act request to obtain a copy of the IRS audit file related to a client. The audit file should contain the supervisor’s written authorization for a penalty. If it does not, the practitioner might file Form 843, Claim for Refund and Request for Abatement, arguing that the penalties are invalid. For amounts already paid, such a request must be made within two years of the time the tax was paid or three years from when the return was filed.

Tax practitioners should review recent client controversy files to determine if such an abatement is possible, which may result in a victory when it appeared that all was lost.