Tax Court tackles supervisory approval of penalties

By James A. Beavers, CPA, CGMA, J.D., LL.M.

Under Sec. 6751(b)(1), the IRS cannot assess a penalty "unless the initial determination of such assessment is personally approved (in writing) by the immediate supervisor of the individual making such determination," with exceptions for the penalties for failure to file, failure to pay, or failure to pay estimated tax and any other penalty that is automatically calculated electronically.

In Graev, 149 T.C. 485 (2017), supplementing and overruling in part 147 T.C. 460 (2016), the Tax Court held that Sec. 6751(b)(1) requires written supervisory approval of a penalty "no later than the date the IRS issues the notice of deficiency (or files an answer or amended answer) asserting such penalty." Since that case was decided, penalties have frequently been challenged in Tax Court over whether they were approved in writing by a supervisor, and many penalties have been overturned by the court because that requirement was not satisfied.

However, questions remain about the scope of the requirement, and the Tax Court recently issued opinions in three cases that address specific issues regarding the determination of whether a penalty satisfies Sec. 6751(b)(1). The ­issues resolved included whether the IRS has made an initial determination of a penalty; when the burden of production shifts to the taxpayer in a dispute over whether the IRS has satisfied the requirements of Sec. 6751(b)(1); and which supervisor must approve a penalty for Sec. 6751(b)(1) purposes.

Initial determination of a penalty


In the first case, the Tax Court held that the issuance of Letter 1807 and a summary report setting forth the IRS's tentative proposed adjustments resulting from an audit and inviting the taxpayer to a conference to discuss them was not an initial determination of a penalty for purposes of the written supervisory approval requirement in Sec. 6751(b)(1).

Background

Belair Woods LLC (Belair) claimed a charitable contribution deduction for a conservation easement on its 2019 return. The IRS audited the 2019 return, and the revenue agent (RA) assigned to the audit had an IRS engineer value the easement. The engineer found that Belair had substantially overvalued the easement.

Upon completing her examination, the RA sent Belair's tax matters partner (TMP) a Letter 1807 and summary report of her proposed adjustments. The letter invited the TMP to a closing conference to discuss the IRS's tentative proposed adjustments, which included disallowing the charitable contribution deduction and the imposition of alternative penalties under Secs. 6662(c), (d), and (h). The Letter 1807 explained that all the proposed adjustments would be discussed at the conference.

The IRS held two conferences with Belair representatives, but no agreement was reached. The RA then finalized a Civil Penalty Approval Form that stated the IRS intended to assert alternative penalties under Secs. 6662(c), (d), and (h). The RA's immediate supervisor signed that form, approving assertion of those three penalties.

The IRS subsequently issued a 60-day letter to Belair disallowing the charitable contribution deduction and asserting the three penalties set forth in the Civil Penalty Approval Form. The 60-day letter offered Belair's TMP the opportunity to appeal these determinations administratively, which the TMP did unsuccessfully. The IRS then issued the TMP a Final Partnership Administrative Adjustment (FPAA) asserting alternative penalties under Secs. 6662(c), (d), and (h), as set forth in the 60-day letter, and a fourth penalty under Sec. 6662(e). The RA did not obtain supervisory approval for the fourth penalty before issuing the FPAA.

The Tax Court's decision

The Tax Court held that the Letter 1807 and summary report, setting forth the Examination Division's tentative proposed adjustments and inviting Belair's TMP to a conference to discuss them, was not the initial determination of a penalty that required prior supervisory approval under Sec. 6751(b)(1). It held that the 60-day letter was the initial determination of the penalties imposed against Belair for Sec. 6751(b)(1) purposes, and the IRS satisfied Sec. 6751(b)(1) for the first three penalties because the RA secured written supervisory approval for the penalties on a Civil Penalty Approval Form before the 60-day letter was issued to Belair's TMP. However, the court further held that the IRS did not meet the statutory requirements for the fourth penalty because it did not show the RA obtained timely supervisory approval of that penalty.

In Graev, the Tax Court held that Sec. 6751(b)(1) requires supervisory approval of a penalty "no later than the date the IRS issues the notice of deficiency (or files an answer or amended answer) asserting such penalty." In Clay, 152 T.C. 223 (2019), the Tax Court further held that Sec. 6751(b)(1) requires written supervisory approval of the initial determination no later than the earlier of (1) when it is communicated to the taxpayer in the form of a notice of deficiency or (2) when another form of formal communication is sent to the taxpayer that both advises it that penalties were determined and gives the taxpayer the opportunity to appeal that determination.

The IRS argued that the supervisory approval required by Sec. 6751(b)(1) must only be obtained before the IRS sends a 60-day letter that formally communicates its definite decision to assert penalties against the taxpayer. Belair argued that the supervisory approval required by Sec. 6751(b)(1) was required before the IRS sent Belair the Letter 1807 and the summary report.

The Tax Court sided with the IRS. It found that "[t]he statute requires approval for the initial determination of a penalty assessment, not for a tentative proposal or hypothesis" (emphasis in the original). It further stated that, as in the determination in Clay, the initial determination "of a penalty assessment will be embodied in a formal written communication to the taxpayer, notifying him that the Examination Division has completed its work and has made a definite decision to assert penalties."

According to the court, the Letter 1807 and the summary report did not set out the IRS's definite decision about the penalties and instead only set out the IRS Examination team's tentative proposals and invited Belair's partners to a conference to discuss them. While the documents advised Belair that penalties might be proposed, they were not an unequivocal communication that advised Belair that penalties would be proposed. When they were sent, whether a penalty would be asserted depended on further input from Belair, which had the opportunity to submit information about the propriety of penalties. The court further explained that the letter and report were part of the RA's attempt to learn the facts of the case and that taking "exploratory steps to gather the pertinent facts" did not require statutory approval.

On the other hand, the Tax Court found that in the 60-day letter, the IRS formally notified Belair that the Service had completed its work on the audit and, after considering Belair's arguments, had made a definite decision to assert penalties. Based on the text of Sec. 6751(b)(1), Tax Court precedent, and terminology used elsewhere in the Code, the court concluded that the initial determination of the penalty assessment against Belair was embodied in the 60-day letter. Because the RA had obtained supervisory approval for the three penalties under Secs. 6662(c), (d), and (h) before the 60-day letter was issued, the IRS had complied with Sec. 6751(b)(1) for those penalties. Because it had not done so for the fourth penalty under Sec. 6662(e), the IRS had not complied with Sec. 6751(b)(1) for that penalty.

Reflections

According to the legislative history, Congress enacted Sec. 6751(b)(1) to prevent the IRS from using penalties as bargaining chips in negotiating settlements in tax cases. A dissent to the majority's opinion argued that this intent can only be achieved by requiring supervisory approval at the beginning of the penalty process, when the IRS first proposes a penalty in a written communication with a taxpayer, rather than at the end, when it makes its final determination of the penalty.

—Belair Woods, LLC, 154 T.C. No. 1 (2020)

Burden of production for Sec. 6751(b)(1)


In another case involving supervisory approval of penalties, the Tax Court addressed when the burden of production shifts to the taxpayer in a dispute over whether the IRS satisfied the requirements of Sec. 6751(b)(1) for imposing a penalty.

Background

Charles Frost was a traveling insurance agent. In 2010, 2011, and 2012 he deducted travel expenses and, in 2011, losses from a limited liability company (LLC) in which he held an 80% interest. The IRS audited his returns for 2010-2012 and issued a notice of deficiency that reduced the travel expenses, disallowed the 2011 loss from the LLC entirely, and imposed accuracy-related penalties for all three years.

The revenue agent conducting Frost's exam got his manager to sign a Civil Penalty Approval Form listing the 2012 penalty a year before the deficiency notice was issued; however, no written approval was obtained for the penalties for the other years. In Tax Court, Frost argued that he was not liable for the penalties because the IRS had not complied with Sec. 6751(b)(1).

The applicable law

Sec. 7491(c) states: "Notwithstanding any other provision of this title, the [IRS] shall have the burden of production in any court proceeding with respect to the liability of any individual for any penalty, addition to tax, or additional amount imposed by this title." Following its decisions in Higbee, 116 T.C. 438 (2001), and Wheeler, 127 T.C. 200 (2006), aff'd, 521 F.3d 1289 (10th Cir. 2008), the Tax Court held that if the taxpayer challenges the IRS's penalty determinations, the IRS must come forward with sufficient evidence of the approval of each penalty imposed as part of its initial burden of production under Sec. 7491(c). After the Service makes that showing, the taxpayer must come forward with contrary evidence.

The Tax Court's decision

The Tax Court held that the IRS's providing the Civil Penalty Approval Form, which listed the 2012 penalty, was sufficient to meet the IRS's burden of production on the written supervisory approval issue for that penalty. Therefore, the burden of production shifted to Frost on the issue of the 2012 penalty, requiring him to offer evidence suggesting that the approval was untimely, e.g., that there was a formal communication of the penalty before the approval. Frost did not do so, so the court held that the IRS had met the Sec. 6751(b)(1) requirements with respect to the 2012 penalty.

For the 2010 and 2011 penalties, however, the Tax Court found the IRS had not met its burden of production because the Civil Penalty Approval Form it produced only listed the 2012 penalty. Therefore, the court held Frost was not liable for penalties for those years.

Reflections

While the Tax Court addressed the burden of production in this case, it did not address which party had the burden of proof regarding Sec. 6751(b)(1) because it would not have changed the outcome.

—Frost, 154 T.C. No. 2 (2020)

Who must approve the penalty under Sec. 6751(b)(1)


In a third case involving supervisory approval of penalties, the Tax Court addressed which supervisor must approve a penalty for Sec. 6751(b)(1) purposes.

Background

The IRS audited the tax returns of Tribune Media Company (Tribune) and the Chicago Baseball Holdings LLC (CBH) for 2009, in part regarding the formation of CBH by Tribune as part of its sale of the Chicago Cubs. The IRS claimed the formation of CBH was a disguised sale and determined a deficiency for both Tribune and CBH for 2009.

The notice of deficiency sent to Tribune and the Final Partnership Administrative Adjustment (FPAA) sent to CBH also imposed a 40% gross-valuation-misstatement penalty under Secs. 6662(a), (b)(3), (e), and (h), or, in the alternative, one of the 20% penalties for negligence, disregard of rules or regulations, a substantial understatement of income tax, or a substantial-valuation misstatement under Sec. 6662(a), (b)(1), (2), or (3), (c), (d), or (e) (20% penalties). The parties agreed that the person making the determination of the various 20% penalties was the revenue agent (RA) in charge of the audit of Tribune and CBH and that the 40% gross-valuation-misstatement penalties were determined by an attorney in the Chief Counsel's Office who was assisting the RA. While it was unclear from the record whether the RA's supervisor had approved the application of the various 20% penalties in writing before the notice of deficiency and FPAA were sent, it was clear that the attorney's supervisor had approved the imposition of both the various 20% penalties and the 40% penalty in writing before the documents were sent.

The Tax Court's decision

In response to cross-motions for summary judgment, the Tax Court first held, consistent with the Belair decision,that written supervisory approval must have occurred before the notice of deficiency to Tribune and the FPAA to CBH that imposed the penalties were sent out. This left the court with the question of whether the right person had provided the approval.

The Tax Court held that the IRS had proved that the 40% penalties were approved by the correct person, while it failed to prove that the various 20% penalties were. Sec. 6751(b)(1) states that the initial determination of the penalty must be "personally approved (in writing) by the immediate supervisor of the individual making such determination." The court, following the plain language of the statute, considered whether the written approval of the imposition of the penalties came from the immediate supervisor of the person who determined the penalties. Documents in evidence showed the attorney's immediate supervisor had approved the 40% penalties in writing before the notice of deficiency and FPAA were sent, so they satisfied the Sec. 6751(b)(1) requirement.

Although the attorney's supervisor also approved the various 20% penalties, and she was clearly higher up in the IRS than the RA, she was not the RA's immediate supervisor, so the court found that her approval of the penalties did not satisfy Sec. 6751(b)(1). Rather, the written supervisory approval requirement could be satisfied only if the RA's immediate supervisor provided the approval. It was unclear from the record whether the RA's immediate supervisor had approved those penalties, so the court held the IRS had not proved that the written supervisory approval requirement was met.

Reflections

In Graev, 149 T.C. 485 (2017), the taxpayer argued that an attorney from the Chief Counsel's Office could not make an initial determination of a penalty for Sec. 6751(b)(1) purposes because the attorney served in only an advisory capacity. The majority in that case held that an attorney could make the initial determination, but it was a contentious issue, and several judges dissented from the majority's holding on it. However, in this case, the parties stipulated that the attorney had made the initial determination of the 40% gross-valuation-misstatement penalties.

—Tribune Media Co., T.C. Memo. 2020-2   

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