IRS met written-supervisory-approval requirement for penalty

The Tax Court held that the IRS met the Sec. 6751(b) written–supervisory–approval requirement where an IRS supervisor approved a determination by a revenue agent (RA) of a penalty four times before the penalty was assessed and while the supervisor still had discretion to approve the penalty. The court rejected the taxpayer’s claim that under the Administrative Procedure Act (APA), the supervisor’s approval of the penalty should be set aside as “arbitrary, capricious, an abuse of discretion, or otherwise not in accordance with law” because the supervisor did not use “reasoned decisionmaking” in approving the penalty.

Background

Computer Sciences Corp. (CSC) was the U.S. parent of a group of corporations that engaged in various aspects of the information–technology business. During 2013, CSC sold its credit services business, realizing a large capital gain from the sale.

Related to the sale, CSC undertook a series of transactions known as Project Trinity. The object of Project Trinity was to create a capital loss to offset the gain from the sale of the credit services business.

According to CSC, Project Trinity resulted in a capital loss of more than $650 million. The company reported the loss on its 2013 income tax return, to which it attached a Form 8886, Reportable Transaction Disclosure Statement, in which it allegedly disclosed all relevant facts about Project Trinity and the capital loss deduction.

The IRS examined CSC’s 2013 return. RA Steven Herrera conducted the examination, and Supervisory RA Richard Guastello served as his immediate supervisor. In March 2017, as the examination neared completion, Herrera proposed to disallow CSC’s capital loss deduction and to assert a 20% penalty for an underpayment due to a substantial understatement of income tax. He set forth his recommendation in a Form 5701, Notice of Proposed Adjustment (NOPA). He sent the NOPA to Guastello on March 22, 2017, and Guastello signed it the same day.

Besides approving Herrera’s initial determination to assert the penalty by signing the NOPA, Guastello approved the penalty on three other occasions: first, when he signed on April 1, 2017, a “Substantial Understatement Penalty” worksheet prepared by Herrera; second, by initialing a civil penalty worksheet on April 21, 2017; and third, on May 15, 2017, by signing a Letter 950 (a 30–day letter) that was sent to CSC, which formally communicated to the company that the IRS intended to assert the 20% penalty for an underpayment due to a substantial understatement of income tax.

CSC filed a protest letter to the 30–day letter, seeking review by the IRS Independent Office of Appeals. On Feb. 16, 2021, Appeals issued CSC a notice of deficiency that determined a deficiency of $276,535,161 and a substantial–understatement penalty of $45,584,000. CSC petitioned the Tax Court for a redetermination of the deficiency and the penalty.

In Tax Court, the IRS filed a motion for partial summary judgment seeking a ruling that it had complied with Sec. 6751(b)(1) by securing timely supervisory approval for the penalty. CSC filed a cross–motion for partial summary judgment, arguing that the APA applies to the requirement under Sec. 6751(b) of written supervisory approval and that, under the APA, the IRS supervisor must use reasoned decision–making in approving the determination of a penalty.

CSC asserted that Guastello did not “meaningfully review” Herrera’s penalty recommendation because he did not consider whether the company might have a “reasonable basis” defense to the penalty. As a result, CSC claimed, Guastello’s penalty approval should be set aside under 5 U.S.C. Section 706(2)(A) as an agency action that was “arbitrary, capricious, an abuse of discretion, or otherwise not in accordance with law.”

The Tax Court’s decision

The Tax Court held that the IRS had satisfied the written–supervisory–approval requirement of Sec. 6751(b)(1) because Herrera secured written supervisory approval of his initial determination to assert the penalty against CSC from Guastello before the IRS issued the 30–day letter and the notice of deficiency to the company. The court further held that, for four independently sufficient reasons, the APA did not require an IRS supervisor to use reasoned decision–making in approving a penalty.

Sec. 6751(b)(1), the case law, and application to CSC

Sec. 6751(b)(1) provides, “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.”

Under Tax Court precedent, the “initial determination” of a penalty assessment is typically part of a letter in which the IRS formally notifies the taxpayer that it has made a definite decision to assert penalties (Belair Woods, LLC, 154 T.C. 1 (2020)). No particular form or document is needed for supervisory approval; a writing that manifests the immediate supervisor’s intent to approve the penalty is the only requirement (Tribune Media Co., T.C. Memo. 2020–2).

An appeal of CSC’s case would lie in the Fourth Circuit, which, the Tax Court noted, has not addressed when supervisory approval for a penalty must be secured. However, as the court observed, the Second, Fifth, Ninth, Tenth, and Eleventh Circuits have held that supervisory approval of a penalty is timely if it occurs before the assessment of a penalty or, if earlier, before the relevant supervisor loses discretion to approve the penalty assessment.

The Tax Court determined that as of the date the IRS mailed the 30–day letter and almost four years later, when it mailed CSC a notice of deficiency, the IRS’s examination remained at a stage where Guastello, as Herrera’s supervisor, had discretion to approve or disapprove Herrera’s penalty recommendation. The court therefore found that “under a reading of the appellate case law most favorable to [CSC], the IRS complied with section 6751(b)(1) because Mr. Guastello timely approved the substantial understatement penalty and did so in writing.”

CSC, conceding the timeliness of Guastello’s approvals, instead argued that the form of the approvals (the bare signatures of an IRS employee) did not satisfy Sec. 6751(b)(1)’s requirements. Despite Guastello’s four written approvals of Herrera’s penalty recommendation on four documents, according to CSC, Sec. 6751(b)(1) was not satisfied because Guastello did not conduct a meaningful review of Herrera’s penalty recommendations. In CSC’s view, Guastello did not conduct a meaningful review because he did not evaluate or even consider whether CSC had a reasonable–basis defense.

As CSC noted, one definition of “approve” is “to sanction officially” or “to give formal or official sanction.” Based on this definition, CSC argued that to officially sanction the penalty determination, the relevant IRS supervisor’s personal written approval requires a reasoned decision regarding the facts of a particular taxpayer. This, according to CSC, also requires the supervisor to provide a narrative explanation for his or her approval of the penalty.

CSC conceded that no Tax Court precedent supported this argument. As the court stated, it had repeatedly refused to read into Sec. 6751(b)(1) a subtextual requirement that the IRS must demonstrate the depth or comprehensiveness of the supervisor’s review (Belair Woods, 154 T.C. at 17). It also found that Sec. 6751(b)(1) does not inquire into the time or effort the supervisor devotes to the task. Rather, as the court had previously expressed, “The written supervisory approval requirement … requires just that: written supervisory approval” (Pickens Decorative Stone, LLC, T.C. Memo. 2022–22).

The Tax Court likewise found nothing in the statute supporting CSC’s position that a supervisor, when approving a penalty, must provide “a reasoned decision regarding the facts of [the] particular taxpayer.” According to the court, Sec. 6751(b)(1) requires only that the penalty be “personally approved” by the supervisor and that the approval be “in writing.” As the court had noted earlier, CSC itself defined “approve” as meaning “to give formal or official sanction.” Thus, it concluded that by affixing his signature to an official IRS document, accompanied by a representation that he reviewed and approved Herrera’s recommendation, Guastello “gave formal or official sanction” to the initial determination to assert the penalty.

As the Tax Court explained, appellate courts facing this issue have held that supervisory approval must be meaningful from a temporal standpoint. For a supervisor’s approval to be meaningful, it must come before the supervisor has lost discretion to approve or disapprove a penalty so that the approval is not “so late as to be a vain act.” However, the court stated, “No court has ever held that section 6751(b)(1) requires a supervisor to supply — in addition to timely written approval — any particular level of substantive review.”

CSC’s APA argument

CSC also argued that the APA, rather than Sec. 6751(b)(1) itself, requires the IRS supervisor to use reasoned decision–making in approving the determination of a penalty. Specifically, the company relied on 5 U.S.C. Section 706(2)(A), which directs a reviewing court to “hold unlawful and set aside agency action, findings, and conclusions found to be … arbitrary, capricious, an abuse of discretion, or otherwise not in accordance with law.”

The court concluded that this argument failed for four independently sufficient reasons. First, the court noted that it was reviewing whether a penalty was properly imposed in a deficiency case, and the APA’s judicial review provisions do not apply to Tax Court deficiency proceedings. Second, the court found a supervisor’s approval to assert a penalty does not constitute “final agency action” reviewable under 5 U.S.C. Sections 704 and 706(2)(A). Third, even if Guastello’s approval of the penalty had constituted a final agency action, the court determined that it would not be subject to distinct judicial review under 5 U.S.C. Section 704 because the court’s review in CSC’s deficiency case gave the company an “adequate remedy in a court.” Finally, the court found that even if the APA’s requirement of reasoned decision–making were deemed to apply, review of that question would be on the administrative record, and the examination case file showed that Guastello satisfied this requirement.

Reflections

In T.D. 10017 (89 Fed. Reg. 104419 (Dec. 23, 2024)) the IRS issued regulations to clarify the application of the written–supervisory–

approval requirement. Under Regs. Sec. 301.6751(b)-1(c), Sec. 6751(b)(1) is satisfied “for a penalty that is included in a pre–assessment notice that provides a basis for Tax Court jurisdiction upon timely petition if the immediate supervisor of the individual who first proposed the penalty personally approves the penalty in writing on or before the date the notice is mailed.” This regulation is effective for all penalties assessed on or after Dec. 23, 2024.

Computer Sciences Corp., 165 T.C. No. 8 (2025)

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.