IRS sanctioned in penalty case

The Tax Court vacated its earlier order in a partnership case granting the IRS partial summary judgment on whether it complied with the Sec. 6751(b) written supervisory approval requirement, after new evidence revealed that the Service had misled the court and there was a genuine dispute concerning whether it had met the requirement. The court also approved monetary sanctions against the IRS under Sec. 6673(a)(2) for misconduct of its legal counsel but deferred its ruling on the IRS’s liability until after trial.

Background

LakePoint Land II LLC is a limited liability company (LLC) treated as a partnership. The IRS decided to examine LakePoint’s partnership returns for its fiscal tax year ending Nov. 15, 2013, the short tax year ending Dec. 31, 2013, and the calendar tax year ending Dec. 31, 2014. Revenue Agent Pamela Stafford was assigned as the examiner, and Revenue Agent Catherine Brooks was Stafford’s immediate supervisor for the examination.

In May 2016, Stafford corresponded with a LakePoint representative to review proposed adjustments and penalties and to potentially resolve the examination. LakePoint requested that Stafford provide the LLC the IRS’s “determination” of penalties. Stafford, in response, provided a list of “proposed adjustments,” including penalties, to LakePoint. No settlement was reached between LakePoint and the IRS.

On July 15, 2016, Stafford prepared a penalty consideration lead sheet ( July lead sheet). Purportedly, Brooks personally approved Stafford’s initial determination of the penalties in writing by electronically signing the July lead sheet on July 16, 2016, and this July lead sheet asserted all the penalties that were eventually determined in LakePoint’s final partnership administrative adjustment (FPAA).

On March 27, 2017, the IRS issued the FPAA to LakePoint. For the 2013 tax year, the FPAA determined a Sec. 6662(a) underpayment penalty based on negligence or disregard of rules or regulations, a substantial understatement of income tax, and a substantial valuation misstatement. It also determined an increase to the Sec. 6662(a) penalty from 20% to 40% for a gross valuation misstatement under Sec. 6662(h).

For the 2014 tax year, the FPAA determined a Sec. 6662(a) underpayment penalty based on negligence or disregard of rules or regulations and a substantial understatement of income tax.

LakePoint timely filed a petition with the Tax Court disputing the FPAA and seeking readjustments of partnership items under Sec. 6226. In August 2022, the IRS filed a motion for partial summary judgment in which it asked the court to rule that, based on the July lead sheet signed by Brooks, it had complied with the written supervisory approval requirement of Sec. 6751(b)(1) for the Sec. 6662 penalties asserted in the FPAA.

It turned out, however, that different versions of this July lead sheet existed. These included a version signed by Brooks on Nov. 29, 2016 (November lead sheet), as well as a Form 5701, Notice of Proposed Adjustment (NOPA), signed by Brooks on July 21, 2016. In addition, the July lead sheet was amended by Stafford in February 2017 to include additional penalties recommended by IRS counsel, and it was signed by Brooks on Feb. 10, 2017, with Brooks backdating her signature on the document by writing in a date of July 16, 2016.

In December 2022, the IRS filed a supplement to its motion for partial summary judgment in which it argued that the “complaints petitioner asserts with respect to the Penalty Consideration Lead Sheets signed on July 16 and November 29, 2016, are absent from the penalty-approval NOPA.” In the supplemental filing, the IRS did not admit to the court that the July lead sheet was signed by Brooks on Feb. 10, 2017, and continued to claim that Brooks had signed it on July 16, 2016.

In January 2023, LakePoint filed its opposition to the IRS’s motion for partial summary judgment. The Tax Court, believing the IRS’s claims about the July lead sheet, issued an order in March 2023 granting the IRS’s motion. After the Tax Court granted the motion, the IRS’s signing inconsistencies came to light. Based on the new evidence about the lead sheets, both LakePoint and the IRS sought reconsideration of the court’s March order, and LakePoint made a motion to have sanctions imposed on the IRS for its actions.

LakePoint contended that reconsideration was appropriate for three reasons. The first was that the Tax Court relied on the IRS’s false declaration and backdated document for its order. Second, LakePoint asserted that the IRS’s reliance on the July 21, 2016, NOPA as a valid Sec. 6751(b) approval was misplaced and that the IRS never disclaimed the July lead sheet, which the court had relied upon. Third, Lake- Point asserted that the November lead sheet also likely was invalid and did not approve the substantial-valuation or gross-misstatement penalties.

With respect to its motion for sanctions, LakePoint contended that, based on the false evidence presented and the IRS counsel’s conduct, sanctions against the IRS were warranted under Rule 123 of the Tax Court Rules of Practice and Procedure, Sec. 6673(a) (2), and the court’s inherent authority to supervise its proceedings.

With respect to reconsideration of the Tax Court’s earlier order, the IRS acknowledged that Brooks did not execute the July 2016 lead sheet until Feb. 10, 2017. The IRS argued that its approval of the penalties nonetheless was made timely under the requirements of Sec. 6751(b) according to Eleventh Circuit precedent (the circuit to which an appeal of the case would lie) and that it had met the written supervisory approval requirement.

In response to the motion for sanctions, the IRS acknowledged its improper actions and those of its counsel but contended that those actions did not rise to the level of fraud or bad faith and therefore did not warrant the imposition of any sanctions. The Service argued that its counsel complied with American Bar Association Model Rules 3.3(a)(1) and (3) and with Tax Court Rule 201 requiring candor to the court. The IRS also argued that prior to filing for partial summary judgment, its counsel made a reasonable inquiry and properly determined that the relief it sought was grounded in fact, as required by Tax Court Rules 33(a) and 50(a).

In addition, the IRS contended that the first declaration by Brooks was not submitted in bad faith or solely for delay and that its actions did not warrant LakePoint’s requested relief under Tax Court Rule 123 (discussed below). Moreover, the IRS maintained that its actions and those of its counsel had not multiplied the Tax Court proceedings and that its counsel had not otherwise acted recklessly or in bad faith such that the IRS should be subject to sanctions under Sec. 6673(a)(2) or the court’s inherent powers.

The Tax Court’s decision

The Tax Court granted LakePoint’s motion for reconsideration and vacated its March 2023 order for partial summary judgment. It also imposed sanctions on the IRS under Sec. 6673(a)(2) as LakePoint had requested but refused to impose sanctions under Tax Court Rule 123.

The motions for reconsideration: The Tax Court explained that the IRS’s arguments on reconsideration with respect to its motion for partial summary judgment were different from those initially included in the motion. Originally, and on the basis of Brooks’s declaration dated Aug. 9, 2022, the IRS contended that Brooks personally approved, in writing, Stafford’s initial determination of penalties by “signing the Penalty Consideration Lead Sheet on July 16, 2016.” Alternatively, in its supplemental filing, the IRS argued that Brooks’s signature on the July 21, 2016, NOPA satisfied Sec. 6751(b)(1) for all penalties at issue. However, despite this secondary argument, the IRS continued in the supplemental filing to represent to the court that Brooks had executed the July lead sheet on July 16, 2016.

Addressing the IRS’s motion for reconsideration, the court stated that reconsideration under Tax Court Rule 161 is intended to correct substantial error either of fact or law and facilitates the introduction of new evidence the moving party could not have previously introduced with due diligence. However, it further expressed that “reconsideration is not the appropriate forum for rehashing previously rejected legal arguments or for tendering new legal theories to reach the end result desired by the moving party,” citing Estate of Quick, 110 T.C. 440, 441 (1998), supplementing 110 T.C. 172 (1998). The court found that it had already considered the IRS’s arguments made in its motion for reconsideration previously in the Service’s supplemented motion for partial summary judgment, and the subsequent motion raised no new arguments meriting reconsideration. Therefore, it denied the IRS’s motion for reconsideration.

With regard to LakePoint’s motion for reconsideration, the Tax Court found that new evidence of the IRS’s actions that had previously been unavailable to LakePoint refuted the factual representations the IRS made in Brooks’s Aug. 9, 2022, declaration. Thus, based on the new evidence, it was apparent to the court that its ruling in its March order was based on facts that were not true. Accordingly, it granted LakePoint’s motion for reconsideration.

The Tax Court’s reconsideration: Reconsidering the March order, the Tax Court noted that the IRS had now abandoned the argument that the initial determination and supervisory approval for all penalties at issue occurred on July 16, 2016. Instead, the IRS now contended that penalty approval occurred before the issuance of the FPAA, when, on July 12, 2016, Brooks reviewed and edited a Form 886-A, Explanation of Items, that had been created earlier by Stafford, signed the NOPA on July 21, 2016, and then approved the July lead sheet on Nov. 29, 2016.

LakePoint countered that the NOPA was not a valid Sec. 6751(b) penalty approval and that underlying disputes of fact remained with respect to the July lead sheet. The court, agreeing with LakePoint, concluded that genuine disputes of material fact existed that precluded it from finding that the IRS had complied with the written supervisory approval requirements of Sec. 6751(b)(1). Consequently, the court vacated its March order granting the IRS partial summary judgment.

Motion for sanctions: LakePoint argued that sanctions were appropriate because Brooks provided a false declaration to the court and attached the backdated July lead sheet to that declaration. Also, the LLC asserted that the IRS’s counsel knew or should have known of the false declaration. LakePoint requested under Tax Court Rule 123 that the Tax Court sanction the IRS by deciding the written supervisory approval issue against the IRS and under Sec. 6673(a)(2) by awarding it reasonable expenses, including the attorneys’ fees it incurred as a result of the IRS’s misconduct.

Reviewing the facts of the case, the Tax Court found that the IRS’s counsel failed to timely advise the court of Brooks’s erroneous declaration. The court also concluded that the actions of the IRS’s counsel were objectively in bad faith and had “multiplied the proceedings” “unreasonably and vexatiously” (Sec. 6673(a)(2)). It noted that the IRS’s counsel’s actions had, among other things, resulted in LakePoint’s retaining additional counsel to elicit the truth regarding the Sec. 6751(b) issues and substantially increased the discovery and motion practice required.

The Tax Court then considered LakePoint’s request for relief under Tax Court Rule 123(b) in the form of an adverse ruling on the IRS’s compliance with the written supervisory approval requirement. While disagreeing with the IRS’s contention that sanctions were inappropriate because its counsel’s actions were “at most an unintentional and unknowing violation of the duty of candor,” the court found that the extreme sanction of granting an adverse ruling would be inappropriate.

The court then addressed sanctions under Sec. 6673(a)(2), under which a government attorney who unreasonably and vexatiously multiplies Tax Court proceedings subjects the United States to liability for the costs, expenses, and fees attributable to the services of the taxpayer’s attorney. Under Eleventh Circuit precedent, the court found that the proper standard for granting an award of attorneys’ fees was conduct that was tantamount to bad faith. As the court already had determined that the IRS’s counsel had acted in bad faith and multiplied the proceedings unreasonably and vexatiously, the court determined that sanctions under Sec. 6673(a)(2) were warranted.

Under 6673(a)(2)(A), the fees that can be awarded are the “excess costs, expenses, and attorneys’ fees reasonably incurred” because of the government attorney’s conduct, which the Tax Court found means the costs, expenses, and fees associated with only the multiplied proceedings and not the total cost of the litigation. The court concluded that, based on the record, it would be premature to award costs and fees to LakePoint because no evidence of the excess costs and fees incurred had been submitted to the court; rather, it should make such a determination after trial. Thus, it granted in part LakePoint’s motion to impose sanctions under Sec. 6673(a)(2), reserving its ruling on the IRS’s liability for excess costs.

Reflections

The IRS’s counsel’s handling of this case provides a stark lesson for all tax practitioners. Not only was the counsel’s failure to immediately inform the court and LakePoint about the existence of multiple lead sheets unethical and a violation of the rule of candor, it was also entirely foreseeable that the cover-up of their existence eventually would come to light.

Dishonesty and dealings in bad faith potentially can cause serious harm to a practitioner’s career, whether they are a lawyer or a CPA, so practitioners should always make sure the zealous pursuit of a win for their client or employer does not include actions that fall outside the boundaries of proper conduct.

LakePoint Land II, LLC, T.C. Memo. 2023-111

Contributor

James A. Beavers, CPA, CGMA, J.D., LL.M., is The Tax Adviser’s tax technical content manager. For more information about this column, contact thetaxadviser@aicpa.org.