Procedural Challenges to Penalties: Section 6751(b)(1)’s Signed Supervisory Approval Requirement

The post today is brought to you by Frank Agostino, Brian D. Burton, and Lawrence A. Sannicandro. Frank Agostino, Esq. is a principal of, and Brian D. Burton, Esq. and Lawrence A. Sannicandro, Esq. are associates at, Agostino & Associates, a Professional Corporation in Hackensack, NJ. The guest posters are counsel of record in many of the current cases discussed in the post. Keith

Some tax practitioners may be of the mindset that the IRS’s procedural missteps will not do much to help a taxpayer avoid the imposition of penalties under the Code. This pessimism may be based, for example, on a long line of cases holding that that neither­­ IRM nor due process violations will ordinarily result in suppression of evidence concerning the collection of taxes. The Supreme Court has maintained a precedent that, “except in rare and special instances, the due process of law clause contained in the Fifth Amendment is not a limitation upon the taxing power conferred upon Congress by the Constitution.” Furthermore, the Third Circuit has held a court will not exclude evidence in a tax case “merely because there was official misconduct.” (Emphasis added.)

By 1998, however, Congress was overwhelmed with horror stories of the IRS committing due process violations as part of its daily practices. As most practitioners know, Congress responded to the IRS’s misdeeds by passing the IRS Restructuring and Reform Act of 1998 (“Act”). In passing the Act, Congress was especially concerned with respect to the timing and decision to impose penalties. Not surprisingly, many IRS employees used the threat of penalties as leverage in negotiations, a practice that some IRS employees continue to follow to this day. An important, but often overlooked, provision of the Act is section 6751(b)(1).

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That subsection provides:

(b) Approval of assessment

(1) In general

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 or such higher level official as the Secretary may designate.

(2) Exceptions

Paragraph (1) shall not apply to—

(A) any addition to tax under section 6651, 6654, or 6655; or

(B) any other penalty automatically calculated through electronic means.

Section 6751(b)(1) continues to be relevant today and, as this post will discuss, is being hotly litigated in the United States Tax Court (“Tax Court”) and the district courts. Specifically, practitioners have begun to question whether, in the absence of the requisite signed supervisory approval of an initial penalty determination, section 6751(b)(1) prohibits the assessment of the penalty. Before discussing the specific cases, we draw special attention to the following important caveat: the 6751(b)(1) challenge must concern a penalty, additional tax, or additional amount that is not calculated through electronic means or which is not imposed under sections 6651, 6654, or 6655.

The IRS’s noncompliance with section 6751(b)(1) is a systemic problem, as recently confirmed by the Treasury Inspector General For Tax Administration (“TIGTA”). TIGTA first flagged this noncompliance in late 2013 when it issued its Report entitled, “Improvements Are Needed in Assessing and Enforcing Internal Revenue Code Section 6694 Paid Preparer Penalties”. TIGTA’s study found that eight percent of the completed section 6694 preparer penalty case files randomly sampled did not contain the proper documentation that the manager had appropriately approved the penalty in accordance with section 6751(b)(1). In addition, the report also found that more than half of the preparer penalty case files contained procedural errors. Based on these findings, TIGTA concluded that approximately $454,643 in improper penalties may have been assessed against preparers under section 6694 for Fiscal Years 2009 through 2011. Prophetically, TIGTA recognized that “[t]he lack of proper approval could hinder the IRS’s ability to successfully litigate these penalty assessments in court if necessary.” While TIGTA’s study focused on preparer penalties, as recent cases confirm, the findings concerning noncompliance with section 6751’s signed supervisory approval requirement have far wider reach.

As TIGTA predicted, the first reported section 6751(b)(1) court opinion addressing the issue court challenge came soon thereafter, in a section 6672 trust fund recovery penalty (“TFRP”) case, United States v. Rozbruch (docket No. 11 Civ. 6965 (GWG)). There, the taxpayer moved to set aside a TFRP because there was no signed supervisory approval under section 6751(b)(1). However, the SDNY sidestepped the issue by finding that “IRC 6672 is a collection device and not a penalty” to which section 6751(b)(1)’s signed supervisory approval requirement would apply. The Rozbruch case is expected to be appealed to the U.S. Court of Appeals for the Second Circuit. That Appellate Court previously held that section 6672 “essentially provides penalties for breach of [the] trust imposed by section 7501.” Thus, the taxpayer in that case maintains that the TFRP is, as its name suggests, a “penalty” subject to compliance with section 6751(b)(1). There are also various test cases in which the section 6751(b)(1) issue is being litigated, in both the deficiency and partnership contexts.

An example of a partnership case involving a section 6751(b)(1) challenge is 15 West 17th Street, LLC v. Commissioner (Tax Court docket No. 25152-11). At issue there is a $64 million deficiency and a 40 percent gross valuation misstatement penalty (or, alternatively, a 20 percent accuracy-related penalty). The parties there appear to agree that the original Civil Penalty Approval Form, issued in 2011, did not include approval of the IRS’s alternative penalty determination concerning the section 6662(a) and (b)(1), (2) or (3) penalties. In an attempt to remedy the lack of signed supervisory approval, nearly three years after the Tax Court Case commenced, the IRS had the Revenue Agent Group Manager, who approved the initial Civil Penalty Approval Form, execute a “revised” Civil Penalty Approval Form to “correct the defect in the original form” and approve the section 6662(a) and (b)(1), (2) or (3) penalties at issue. One of the questions that the Court will hopefully address is whether the “initial determination” of a penalty is permitted to occur at any time prior to the “assessment” of the penalty – including as a litigation tactic after a court case has been commenced – or whether the “initial” determination of a penalty must occur earlier, for example, before the Notice of Final Partnership Administrative Adjustment (“FPAA”) or the notice of deficiency is issued, before the 30-day letter is issued, or perhaps even earlier. Highlighting the magnitude of the parties’ disagreement over this issue, the taxpayer and the government have cross-moved for partial summary judgment on the issue. The parties’ respective responses are due August 15th

A similar 6751(b)(1) deficiency test case is Graev v. Commissioner (docket No. 30638-08). There, the IRS asserted deficiencies exceeding $650,000 and gross valuation misstatement penalties exceeding $135,000. The notice of deficiency also asserts in the alternative, as in 15 West 17th Street, LLC, accuracy-related penalties under section 6662(a) and (b)(1), (2) or (3). The IRS has stipulated that the taxpayers are not liable for the gross valuation misstatement penalties. The underlying penalty approval form in Graev strongly resembles the one at issue in 15 West 17th Street, LLC in that they both approved the assertion of a gross valuation misstatement penalties but not the alternative 6662(a) and (b)(1), (2) or (3) penalties ultimately asserted against the taxpayers.

On April 14, 2014, the taxpayers moved for partial summary judgment with regard to the penalty issue on the ground that the IRS failed to comply with section 6751’s signed supervisory approval for the alternative accuracy-related penalty position. The IRS took the position that, for purposes of section 6751(b)(1), “the individual” who made “the initial determination” of the section 6662(a) and (b)(1), (2) or (3) accuracy-related penalties was an attorney in the Office of Chief Counsel – not the revenue agent originally assigned to this case (or any another individual in Exam or the Technical Services Unit) – and it was the attorney’s immediate supervisor that approved his determination, purportedly in compliance with section 6751(b)(1).

On July 16, 2004, the Court in Graev issued a detailed Order, stating that its assigned Judge “understand[s] respondent’s contention to be not that [the attorney] simply advised or recommended the penalty to IRS examination personnel who then made the determination (since advising and recommending are evidently not subject to section 6751(b)), but rather that [the attorney] was ‘the individual’ who made ‘the initial determination.’” The court noted that the Secretary is authorized to issue a Statutory Notice of Deficiency (“SNOD”) pursuant to Delegation Order 4-8 (Internal Revenue Manual Part 1.2.43.9 (Sept. 4, 2012); however, “that delegation does not seem to extend to the Office of Chief Counsel.” The Court posited that “[i]f, in fact, it was [the attorney] who made ‘the initial determination of such [sec. 6662(a) penalty] assessment’, then it would seem that there must be some delegation of authority to Chief Counsel to make such a determination.” However, as assigned judge [Judge Gustafson] “is unaware of any other delegation to Chief Counsel of the authority to determine a penalty liability in an SNOD; and respondent has not yet identified a relevant delegation of authority that would enable a Chief Counsel attorney to be ‘the individual’ who makes such a determination,” the Court ordered the IRS to file a response by August 4, 2014, “identifying any relevant delegation of authority to Chief Counsel and commenting on or correcting the foregoing tentative discussion.”

It remains to be seen whether the court will agree with the taxpayer’s or the government’s argument, but one thing is apparent, the Tax Court is taking the section 6751(b)(1) argument very seriously. In view of the fact that the IRS (and the Tax Court) have so strictly adhered to the Code’s substantiation requirements, one is hopeful that a similar strict compliance standard will be applied when interpreting a statutory provision clearly intended to protect taxpayer’s procedural due process rights. The taxpayer’s reply to the government’s response in Graev is due August 18, 2014.

Stay tuned…

 

From Sword to Shield – Reliance on RRA98 Section 1203 to Bolster a Taxpayer’s Credibility at Trial

By Frank Agostino, Jairo G. Cano, and Crystal Loyer

[Today’s post was written by Frank Agostino, Jairo G. Cano, and Crystal Loyer, all of Frank Agostino and Associates of Hackensack, New Jersey.  Frank was the recipient of the 2012 Janet Spragens Pro Bono Award from the ABA Tax Section for his work with the New York City Calendar Call program and his general work for unrepresented taxpayers.  He and his associates write today about a Tax Court case decided last month in which the taxpayer works as a Revenue Officer for the Internal Revenue Service.  We previously posted on the issues raised for IRS employees by Section 1203 of the Revenue Reform Act of 1998.  The Brewer case points out that the harsh punishment that awaits an IRS employee found to have met the criteria of 1203 can cause litigation in a case that might otherwise have settled.  This procedural aspect of the case draws our attention.]

In Brewer v. Commissioner, T.C. Memo. 2013-295, the Tax Court determined that James Brewer, an IRS Revenue Officer, was entitled to claim the First Time Homebuyer Credit in connection with his purchase of a principal residence in 2008.  The Tax Court based its decision on Mr. Brewer’s credible trial testimony.  What makes Mr. Brewer interesting is not that his credible testimony carried the day, but that no one at the IRS was willing to take responsibility for concluding that he was credible.

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To qualify for the First Time Homebuyer Credit, a taxpayer must prove that he purchased a home with the intent to use it as his principal residence.  The taxpayer must also prove that he did not have an ownership interest in another principal residence during the preceding three years.  When a taxpayer – such as Mr. Brewer – has an ownership interest in another property, the trier of fact must analyze the circumstances surrounding that ownership to determine if the other property was a principal residence.  Factors to consider include the taxpayer’s place of employment, where his family members reside, the address listed on his tax returns, driver’s license, automobile registration and voter registration card, the mailing address for bills and other correspondence, and the location of religious organizations and other social clubs attended by the taxpayer.

IRS computer systems include software to identify taxpayers who potentially do not qualify for the Credit.  If the taxpayer has claimed a mortgage interest or real estate tax deduction for another property, the IRS system will flag the tax return for further review.  This is what happened in Mr. Brewer’s case.  In such cases, the Internal Revenue Manual asks that the Revenue Agent secure a written “reasonable explanation that any prior year mortgage interest/real estate tax was for something other than a principal resident.1”  Throughout the examination and trial process, Mr. Brewer credibly explained that he purchased a condominium in Staten Island in 2005.  At the time he was engaged to his fiancée, a New Jersey resident.  He ultimately moved into his fiancée’s home and allowed his sister to live in the Staten Island condominium while she attended college.

Mr. Brewer eventually married his fiancée and purchased a home in New Jersey with his wife in 2008.  Because Mr. Brewer did not use the Staten Island property as a principal residence, his ownership interest should not prevent him from claiming the Credit.  Furthermore, the Staten Island property qualified as a second home whereby he could claim a deduction for both mortgage interest and real estate taxes.  Under these circumstances, Mr. Brewer qualified for the Credit and this case should not have extended beyond the cursory examination required by the computer system’s flagging of his return.  In other words, a written explanation of the circumstances surrounding Mr. Brewer’s ownership of the Staten Island property at the time he purchased the new home should have been sufficient for the IRS to close this case.  However, because Mr. Brewer is an IRS employee, those assigned to his case were, in a sense, obligated to hold him to a higher standard of review I.R.M. 21.6.3.4.2.11.6.1(6)(Oct. 1, 2011).

For starters, Section 1203 of RRA98 provides that the IRS must terminate the employment of any employee who engages in certain misconduct.  Specifically, the Internal Revenue Manual provides that as an Internal Revenue Officer, Mr. Brewer is expected to fully comply with all tax laws by accurately reporting and timely filing [his] federal, state, and local tax returns and fully paying their tax when due.  RRA 98 sections 1203(b)(8) and (b)(9) provide for the removal of IRS employees who willfully fail to file any return or who willfully understate federal tax liability respectively.

Given this requirement, an outside observer might view the IRS’s reliance solely on Mr. Brewer’s statements as self-serving and improper.  Therefore, absent anything more to substantiate his testimony, Mr. Brewer was forced to proceed to trial.  At trial, Mr. Brewer acknowledged his understanding the Section 1203 requirements.  He observed that he was subject to termination if he provided untruthful testimony during the trial.  Indeed, Judge Wells acknowledged: “[w]e find petitioner to be reasonable and honest and his testimony to be credible and persuasive.  We note that petitioner testified that he could be dismissed from his position as a revenue officer with the IRS if he gave untruthful testimony.”  Brewer v. Commissioner, T.C. Memo 2013-295 at 10; fn. 6.

At the conclusion of the case, impartiality and common sense prevailed and Mr. Brewer received the tax benefits he deserved.