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

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.

 

Settling a Tax Court Case with an Offer in Compromise

Today we welcome first time guest blogger, Erin Stearns. Professor Stearns directs the low income taxpayer clinic at the University of Denver Sturm College of Law, Graduate Tax Program. She writes today about a little used procedure. Chief Counsel attorneys do not like to use this procedure though the manual provides for its use. I wrote some time ago about the more common use of this procedure when litigating with the Department of Justice. In the right case, settling the merits with a compromise of the payments makes a lot of sense. Keith

This post focuses on how a taxpayer with a pending U.S. Tax Court case can use a little known tool called a “Service Offer in Compromise” to be relieved of federal tax liability while avoiding the need to go to trial.

For many years, taxpayers have been using offers in compromise (“OICs”) for doubt as to collectability or effective tax administration to compromise federal tax liability, penalties, and interest for less than the amount owed. A body of law authorizes and provides guidance on such OICs. See, e.g., IRC § 7122, Treas. Reg. § 301.7122-1, and IRM § 5.8. In 2014, the most recent year for which we have statistics, the IRS received 67,935 offers and accepted approximately 27,000 offers (approximately 40%). The total value of all accepted offers in 2014 was over $179,000,000. See Trends in Compliance Activities through Fiscal Year 2014, Treasury Inspector General for Tax Administration, November 10, 2015. While another type of OIC – for Doubt as to Liability – may be used to dispute liability, discussion of such OICs is beyond the scope of this post.

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Generally the IRS must assess tax on the applicable tax year(s) before it will consider an OIC covering that period. In most instances, a taxpayer who petitions Tax Court based on a statutory notice of deficiency to challenge the alleged liability must either reach a settlement with the IRS or go to trial to determine the amount of liability owed. The Tax Court would then issue a decision approving the settlement or, if the case has gone to trial, a decision as to the correct amount of tax and penalties owed. The IRS would subsequently assess tax, penalties (if applicable), and interest based on the decision of the Tax Court. Once the liability has been assessed, the taxpayer could submit an OIC for doubt as to collectability or effective tax administration to try to settle the debt for less than he or she owes.

A Service OIC operates similarly to the OICs described above with one distinct difference: the taxpayer with a pending Tax Court case (hereafter, the “petitioner”) could submit an OIC to cover the alleged liability even though the IRS has not yet assessed the tax against him or her. A provision in the Internal Revenue Manual, effective July 25, 2012, provides authority for Service OICs. See IRM § 35.8.6.2.1.

The starting point for the petitioner who wishes to submit a Service OIC would be to contact IRS Counsel’s office to obtain its consent to filing a Service OIC.  IRM § 35.8.6.2.1(2). Counsel’s office must agree to follow certain procedures set forth in the IRM provision in order for the OIC to be a “Service OIC.” Therefore, as a practical matter, Counsel’s office could prevent the petitioner from filing a Service OIC if it refuses to follow these procedures. Id. However, assuming Counsel’s office agrees to follow the IRM procedures and allow the petitioner to file a Service OIC, the Counsel attorney assigned to the case would have to follow the procedures set forth in IRM § 35.8.6.2.1. If the case is with IRS Appeals when the petitioner requests permission to submit a Service OIC, then the Appeals Office would need to close the case and transfer it to Counsel’s office, as only Counsel’s office is authorized to follow the procedures related to Service OICs. See IRM § 35.8.6.2.1(2).

If Counsel’s office agrees to allow the petitioner to file a Service OIC, the petitioner would prepare the OIC and send it directly to Counsel’s office.  The OIC would be either an OIC for doubt as to collectability or effective tax administration, and would use the Forms 656 and 433-A(OIC) for an individual offer or 433-B(OIC) for a business offer. Counsel’s office would then send the Service OIC to the appropriate Centralized OIC unit of the IRS, where it would be processed and reviewed like any other OIC for doubt as to collectability or effective tax administration. An offer examiner or specialist would be assigned to determine the petitioner’s Reasonable Collection Potential (“RCP”) based on his or her assets and future income. The examiner may also determine that special circumstances warrant a departure from the petitioner’s RCP in the case of an effective tax administration offer. Because it typically takes the IRS at least six months to review an OIC and the petitioner’s case may be docketed for calendar call during this time, it may be necessary to file one or more motions to continue the Tax Court case generally. Counsel will likely assent to such a motion. Counsel’s office may also request that the IRS conduct an expedited review of the OIC.

The IRM provisions on Service OICs state that Counsel’s office “should” obtain from the petitioner a stipulation agreeing to the “full amount of deficiencies and penalties.” IRM § 35.8.6.2.1(3). The “full amount of deficiencies and penalties” would be either the amount alleged on the statutory notice of deficiency or a lesser amount agreed to by the parties. The Service OIC provision in the IRM gives the petitioner the choice to authorize Counsel to (1) file the stipulation with the Tax Court, or (2) hold the signed stipulation in escrow at Counsel’s office.  See IRM § 35.8.6.2.1(3). Under the first option – filing the stipulation with the Tax Court – the petitioner would be bound by the amount agreed to in the stipulation if the OIC were not accepted. Under the second option – holding the stipulation in escrow at Counsel’s office – the petitioner could request that Counsel’s office destroy or return the stipulation to the petitioner in the event that the IRS rejects the petitioner’s OIC.

Although the IRM states that Service OICs may be submitted “[i]f a settlement is reached in a docketed Tax Court case,” as a practical matter, nothing would prevent the petitioner whose stipulation was destroyed or returned from going forward and presenting new evidence to reach an agreement as to a lesser amount or try the case on its merits. While there may be some exceptions, holding the stipulation in escrow appears the more favorable option because it gives the petitioner more flexibility if the IRS rejects the OIC.

The Service OIC should be used to compromise all the petitioner’s outstanding balances and may include tax years not covered by the pending Tax Court litigation. For example, a petitioner may have assessed balances for 2011 and 2012 and may be in Tax Court for years 2013 and 2014 where balances have not yet been assessed. If the petitioner filed an OIC for doubt as to collectability, it could cover 2011 and 2012, as well as the unassessed balances for 2013 and 2014. The petitioner would want to work with Counsel’s office to ensure that the offer is treated as a Service OIC insofar as it applies to 2013 and 2014.

If the IRS accepts the Service OIC and assuming the stipulation is held in escrow, IRS Counsel would file the stipulation with the Tax Court upon learning that the Service OIC has been accepted. The amount agreed to in the stipulation would be assessed against the petitioner, but the Service OIC will relieve the petitioner of some if not most of the liability and penalties. If the IRS rejects the Service OIC, then the petitioner has the right to appeal the rejection to the IRS Appeals Office. If the Appeals Office upholds the OIC rejection, then the petitioner does not have the right to challenge the rejection as part of her Tax Court case, but may still pursue the merits of her case in Tax Court and may continue to work with Counsel to reach a settlement or take the case to trial.

The question arises of when and why it makes sense to file a Service OIC. In my experience a Service OIC can be useful in certain situations, but should be used sparingly. A Service OIC is appropriate where the petitioner could likely prove she does not owe the entire amount alleged by the IRS, but because of either complicated legal issues or substantiation problems, proving this would be cumbersome for the petitioner and the amount the petitioner would rightfully owe still exceeds what she can pay. A Service OIC should not be used in a case where the petitioner is reasonably confident that she can present evidence to reduce her liability to zero or some nominal amount by working with Appeals, Counsel’s office, or by taking a case to trial.

To illustrate when a Service OIC may be useful, assume that the IRS’s statutory notice of deficiency asserts that the petitioner was prohibited from taking a loss deduction because it exceeded her basis in an LLC. The petitioner agrees that the loss deduction did in fact exceed her basis, but is not sure to what extent because the LLC did not keep good records. At a minimum, the resulting liability would be more than she could pay. To determine the correct value for basis, and thus liability, the petitioner would need to go back and reconcile multiple years of LLC records. She does not have the time or skill to do this, and cannot afford to hire someone. The petitioner may wish to bypass this exercise and submit a Service OIC based on her RCP. Counsel’s office may agree to this to avoid protracted negotiations with the petitioner and/or a trial. Counsel’s office would likely require that petitioner sign a stipulation as to the amount alleged on the statutory notice of deficiency, and petitioner should insist that Counsel hold this stipulation in escrow. If the IRS accepts the Service OIC, then the petitioner could be relieved of a significant amount of liability and penalties.

In speaking with attorneys at Counsel’s office about Service OICs, I have learned that they can create administrative challenges because additional work is required to prepare the stipulation, and Counsel’s office must also monitor the case to ensure the IRS correctly assesses the tax, penalties and interest if and when the Service OIC is accepted. Therefore, I would hesitate to ask Counsel’s office to entertain Service OICs on a routine basis. The vast majority of time, it makes sense for petitioners to settle their cases and then proceed with an OIC once assessment has taken place. However, in certain situations, a Service OIC can be a win-win for both Counsel’s office and petitioners. Counsel’s office “wins” because the petitioner will stipulate to an amount of deficiencies and penalties owed while avoiding a trial and the Tax Court’s order will reflect the stipulated amount. The petitioner “wins” because although she is technically liable for the amount to which she stipulates, she can be relieved of some or most of this liability if the offer is accepted and she meets the terms and conditions thereof.