Ford v. Commissioner: A step forward in the shadow of Graev III

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We welcome back guest blogger Professor Erin Stearns who directs the low income taxpayer clinic at the University of Denver Sturm College of Law, Graduate Tax Program. She writes today about more fallout from Graev III. Professor Stearns co-authored the Penalty chapter in the forthcoming (hopefully next month) Seventh Edition of Effectively Representing Your Client before the IRS. The case she discusses today takes a taxpayer favorable position on proof of the necessary penalty approval. For a discussion of the case that focuses on the substantive law at issue, see the blog post by Professor Bryan Camp. Keith

The Tax Court published the Ford v. Commissioner memorandum decision on January 25, 2018. See T.C. Memo. 2018-8. It is significant not only because the petitioner is a legendary mover and shaker on Nashville’s country music scene, but because it demonstrates how the Tax Court may handle penalty disputes involving I.R.C. § 6751 after Graev v. Commissioner, 149 T.C. No. 23 (Dec. 20, 2017) (“Graev III”).

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I.R.C. § 6751 states that no penalty 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 or such higher level official as the Secretary may designate.” Exceptions from the requirement of supervisory approval are for penalties under § 6651 (failure to pay and file) and §§ 6654 and 6655 (failure to make estimated tax penalties by individuals and corporations). See I.R.C. § 6751(b)(2).

Ford v. Commissioner involves the petitioner, Mrs. Joy Ford, who with her deceased husband, Mr. Sherman Ford, formed a country music label called Country International Records in 1974. They also started the Bell Cove Club in Hendersonville, Tennessee, just outside Nashville, in the late 1980’s. Bell Cove – still in operation – has been an important venue for up and coming country music stars to take the stage and perform before talent scouts and agents in the competitive Nashville music scene.

In each of 2012, 2013, and 2014, Bell Cove sustained significant losses which appear to have been reported on Schedule C of Mrs. Ford’s Form 1040 and which offset her income from other sources. The IRS audited Mrs. Ford’s individual income tax returns and proposed to deny the losses, arguing that Bell Cove was not an activity engaged in for profit under I.R.C. § 183, but rather a hobby for Mrs. Ford. The IRS also sought to deny NOL deductions on two years of tax returns. Finally, it proposed an accuracy-related penalty for negligence under I.R.C. § 6662. Mrs. Ford’s case went to trial before Judge Foley in May 2017.

The seven-page memorandum decision addresses three issues. The first was whether the Bell Cove was an activity engaged in for profit or a hobby in 2012, 2013, and 2014, and the second was whether Mrs. Ford was entitled to net operating losses (NOL) deductions from earlier years. In the decision, Judge Foley quickly disposed of the first two issues. Albeit with an approving nod to the mission and contributions of Bell Cove to the Nashville music scene, he determined that the operation of Bell Cove was “primarily motivated by personal pleasure, not profit, and simply used the club’s losses to offset her [other] income.” T.C. Memo. 2018-8, Slip Op. at 6. He noted that the handwritten ledger did not match business expenses reported on the returns, that Mrs. Ford frequently used her personal bank account to pay Bell Cove’s expenses, and that the amount paid to performers generally exceeded the revenue from ticket sales. Judge Foley also sustained the respondent’s disallowance of NOL deductions for lack of substantiation.

The remaining issue, and the one relevant here, concerns the accuracy-related penalty. The decision states:

We do not, however, sustain the section 6662(a) accuracy-related penalties relating to negligence for the years in issue. Respondent failed to present any evidence that the penalties were “personally approved (in writing) by the immediate supervisor of the individual making such determination.”… Accordingly, he did not meet his burden of production, and petitioner is not liable for the determined penalties.

The IRS has the burden of production under § 7491(c) for certain penalties in a deficiency case, including showing compliance with the requirements of § 6751(b). See Graev III. The penalty at issue in Ford, and a common penalty for many petitioners, is the accuracy-related penalty under § 6662(a).

Over the last year, the Tax Court and Second Circuit Court of Appeals have sought to define what the IRS must show in order to prove the petitioner is liable for penalties, and when the IRS must show it. See Graev v. Commissioner, 147 T.C. No. 16 (November 30, 2016) (“Graev II”), Chai v. Commissioner, 851 F.3d 190, 221 (2d Cir. 2017), and Graev III. There have also been a series of excellent posts by Keith (here, here, and here) and Carl Smith (here) about these cases and their impacts on this site. These posts are worth reading and this post will not re-span the ground they cover other than to identify the landscape post-Graev III, and how Ford builds on it.

Graev III, issued December 20, 2017, held that in a deficiency case, the IRS’s burden of production under § 7491(c) for certain penalties includes showing compliance with the requirements of § 6751(b). Graev III was significant in that it overruled the earlier decision in Graev II and rejected that majority’s holding that the written approval may be obtained at any time before the penalty is assessed, and any challenge under § 6751(b) must be made after assessment of the underlying tax liability. This would effectively postpone challenges under § 6751(b) until after the deficiency dispute has been decided, whether by settlement or at trial. The Graev III court seems to adopt the timing standards set forth by the Second Circuit in Chai v. Commissioner. This rule says that the IRS must “obtain written approval of the initial penalty determination no later than the date the IRS issues the notice of deficiency (or files an answer or amended answer) asserting such penalty.”

Following Graev III, Tax Court judges issued a number of orders asking parties to weigh in on whether and how Graev III affected them. Ford is the first decision issued post-Graev III addressing whether the IRS met its burden of production by showing compliance with the requirements of § 6751(b). As noted above, in Ford Judge Foley held that respondent failed to put on evidence sufficient to meet this burden. This was good for Mrs. Ford and appears to be a good sign for petitioners going forward.

I hesitate to overstate the significance to Ford, but it demonstrates the Court’s willingness to sua sponte require the IRS to show compliance with § 6751(b) in at least some cases involving penalties. We know that Mrs. Joy Ford was represented by counsel, but it’s not clear from the decision to what degree and on what basis her counsel challenged penalties and if the issue of compliance with § 6751(b) ever came up. Therefore, on its own, Ford does not give us clear guidance on what this means for pro se litigants, or even represented petitioners with pending cases involving penalties where § 6751(b) compliance issues were not raised.

If judges increasingly sua sponte require the IRS to show it complied with § 6751(b), then petitioners are likely to prevail on the issue of penalties unless respondent’s counsel immediately anticipates this challenge and puts on evidence that the § 6751(b) requirements were met. Assuming that Ford does not alter the landscape so much as to make it standard for judges to sua sponte require respondent to prove it complied with § 6751(b), another more practical question arises: how should petitioners’ counsel approach penalty challenges in light of the timing rule that respondent must obtain supervisory approval of penalties “until no later than the date the IRS issues the notice of deficiency (or files an answer or amended answer) asserting such penalty”?

Certainly Graev III and Ford empower petitioners and their counsel to raise the issue that the IRS has the burden of production under § 7491(c) to show compliance with the § 6751(b) procedures, and to argue that penalties at issue should not be sustained absent such a showing. But when is the best time to make this argument? More specifically, is this something petitioners should state in their petitions to Tax Court?

As noted above, the language in Chai which Graev III seems to have adopted, would give the IRS up until the notice of deficiency is issued or the Answer or Amended Answer is filed to obtain supervisory approval of penalties sufficient to comply with § 6751(b). Chai seems to suggest that for penalties asserted in a notice of deficiency, the IRS would need to have obtained approval of the penalties by a supervisor before the notice was issued. It also suggests that in instances where respondent’s counsel may seek to assert penalties not originally asserted in the Notice of Deficiency in the Answer (or Amended Answer), then supervisory approval must be obtained prior to the issuance of the Answer (or Amended Answer). At this point, it’s not clear from Chai or Graev III whether the IRS could go back and obtain supervisory approval of a penalty after a notice of deficiency is issued but before an Answer (or Amended Answer) is filed if the IRS determines that the requirements of § 6751(b) were not met prior to issuance of the notice of deficiency.

Because of this uncertainty, I question whether raising a § 6751(b) challenge in a petition would invite the IRS to obtain supervisory approval if it appears to be missing before the Answer is filed. While the students and staff in our clinic strive to be as transparent as possible in our dealings with IRS Counsel, we would not want to show all our cards in the petition if doing so could later preclude us from making an argument in our client’s favor. At this point, unless and until judges require the IRS to show it complied with § 6751(b) as a matter of course, it may be safest for petitioner to simply state she disagrees with the IRS’s proposed assessment of penalties in her petition and save any potential § 6751(b) arguments for later negotiations or trial, if necessary.

 

Comments

  1. At last week’s S Case Calendar Call in San Diego Judge Leyden required Chief Counsel to provide evidence of supervisor approval in every case, even those in which Petitioners were no shows. When cases were recalled on Tuesday Chief Counsel just gave up trying to meet their burden of production.

    I suspect the IRS has ordered a whole new batch of rubber stamps to be used pre-deficiency notice.

  2. jim grubka says:

    does a proposed civil fraud penalty require the same managerial approval???

    • Carl Smith says:

      Yes. A civil fraud penalty requires managerial approval. See Judge Foley’s reference to section 6751(b) in the civil fraud penalty case of Byrum, T.C. Memo. 2018-9 at *7. There is a box on the internal managerial penalty approval form to check next to the Code section 6663 if the auditor is imposing that penalty.

      To clear up what the IRS position is on 6751(b) (or at least was as on December 2016 — before Chai was issued), for everyone’s benefit, I show here below the two Manual Sections on managerial approval. I am not sure I agree with each thing the IRM provides (such as electronic signatures of managers, which I think are subject to abuse by auditors, who may not show the form to managers, but put on the electronic signature themselves) .

      20.1.5.1.4 (12-13-2016)
      Managerial Approval of Penalties

      1. IRC 6751(b)(1), Approval of Assessment, provides in general, that no penalty under the IRC 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 or such higher level official as the Secretary may designate.

      a. Handwritten signatures or digital signatures through Adobe® PDF are sufficient to meet the requirements of IRC 6751, Procedural Requirements. Issue Management System (IMS) generated forms may apply the ink signatures.

      b. An acting manager with an approved designation to act is considered an immediate supervisor for the purpose of IRC 6751 requirements.

      2. Exceptions to these procedural requirements are found in IRC 6751(b)(2) that include the following:

      a. Any addition to tax under IRC 6651 (with exception to subpart (f)), IRC 6654, or IRC 6655; or

      b. Any other penalty automatically calculated through electronic means. See IRM 20.1.5.1.4 (4) for further guidance for AUR and campus exam correspondence cases.

      3. Any function not listed in IRM 20.1.5.1.4.1 that has examiners asserting penalties must obtain written managerial approval as required by IRC 6751(b). This written approval must be documented in the workpapers.

      4. Any penalties automatically calculated through electronic means are excluded from IRC 6751(b)(1) requirement.

      a. When IRC 6662 accuracy-related penalties for negligence and substantial understatement are assessed under the automated underreporter (AUR) program without an employee independently determining the appropriateness of the penalty, then the penalty is one that is automatically calculated through electronic means and may be assessed without written supervisory approval.

      b. However, if a taxpayer responds either to the initial letter proposing a penalty or to the notice of deficiency that the program automatically issues, an IRS employee will have to consider the taxpayer’s response. Therefore, the IRS employee will have to make an independent determination as to whether the response provides a basis upon which the taxpayer may avoid the penalty. The employee’s independent determination of whether the penalty is appropriate means the penalty is not automatically calculated through electronic means. Accordingly, IRC 6751(b)(1) requires managerial written approval of an employee’s determination to assert the penalty.

      5. The IRS also requires managerial approval of the non-assertion of penalties when there is a substantial understatement of tax under IRC 6662(d), Substantial Understatement of Income Tax.

      20.1.5.1.4.1 (12-13-2016)
      Documenting Managerial Approval of Penalties

      1. The employee initially proposing the penalty should indicate the name of the penalty, the IRC section, and the amount of the penalty on Form 4318-OA, Examination Workpapers Index, Form 4318, Examination Workpapers Index, Form 4700, Examination Workpapers, or Form 5772, EP/EO Workpaper Summary. The penalty computation should also be documented in the case file.

      2. For SB/SE field and office examination cases, written managerial approval and non-assertions should be documented on the 300–Civil Penalty Approval Form lead sheet.

      3. For LB&I cases, managerial approval and non-assertions should be documented on the penalty lead sheets. The LB&I information management system (IMS) provides lead sheets based on the standard audit index number (SAIN) entry for the penalty issue. SAIN 011 is used to approve penalties in LB&I. IMS generated forms may apply the ink signatures.

      4. For W&I and SB/SE campus cases, written managerial approval and non-assertions may be documented on Form 4700. On correspondence examination automation support (CEAS) cases, the manager must input a report generation software (RGS)/CEAS non-action notation to indicate concurrence with the penalty assertion. The notation must include the penalty name and a statement of approval of the assertion or non-assertion of the penalty. See IRM 4.19.13.5.2, Managerial Approval of Penalties/Bans.

      5. For TE/GE, managerial approval and non assertions may be documented on Form 5772 or similar workpaper summary.

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