ACA Penalty Notices May Not Meet Section 6751(b) Requirements

We welcome back guest blogger Rochelle Hodes.  Rochelle is a Principal in Washington National Tax at Crowe LLP and was previously Associate Tax Legislative Counsel with Treasury. As we prepare to gear back up for IRS enforcement activity, she provides a timely discussion of the ever popular IRC 6751(b) and another way it may help your client when the IRS seeks to penalize.  Keith

Section 6751(b)(1) generally provides that no penalty can 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.  Written supervisory approval is not required to impose a penalty under Section 6651, 6654, or 6655.  Written supervisory approval also is not required to impose a penalty that is automatically calculated through electronic means. 

Section 6751(b) has been covered many times in the Procedurally Taxing blog. Generally, the Tax Court will not sustain the IRS’s assertion of a penalty if the IRS cannot demonstrate that written supervisory approval is not obtained prior to the initial determination of assessment of the penalty.  The latest in this line of cases is Kroner v. Commissioner, T.C. Memo. 2020-73 (June 1, 2020), which further fine-tunes earlier holdings regarding when the initial determination of the penalty is made. 

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Prior to Kroner, the Tax Court ruled in Clay v. Commissioner, 152 T.C. 223, 249 (2019), blogged here, and Belair Woods, LLC v. Commissioner, 154 T.C. ___ (Jan. 6, 2020), blogged here, that the initial determination is the date on which the IRS formally communicates to the taxpayer Examination’s determination to assert a penalty and notifies the taxpayer of their right to appeal that determination.  In Clay, that court held that the initial determination was the date that the IRS issued the revenue agent’s report (RAR) and the 30-day letter. In Belair, the court held that the initial determination was the date that the IRS issued the 60-day letter, which in the case of a TEFRA partnership is the notice that communicates Examination’s determination that penalties should be imposed and notifies the taxpayer of their right to go to Appeals. 

In Kroner, the IRS issued a Letter 915, which is an examination report transmittal, to notify the taxpayer that Examination is proposing penalties and that the taxpayer has a right to go to Appeals.  Later, the IRS sent the taxpayer an RAR and a 30-day letter.  The written supervisory approval for penalties was issued after the Letter 915 was sent and before the RAR and 30-day letter were sent.  The Tax Court held that regardless of what the IRS calls the notice that provides the taxpayer with its determination of penalties and notification of the right to go to Appeals and regardless of the IRS’s intent, the initial determination for purposes of section 6751(b) is the first time examination determines that it will assert the penalty and notifies the taxpayer that they have a right to appeal that determination.  In Kroner, the court held that this occurred when the IRS issued the Letter 915.  Accordingly, written supervisory approval was issued after the initial determination for purposes of section 6751(b), and the penalty was not sustained.

On May 20, 2020, the IRS issued an immediately effective interim IRM 20.1.1.2.3.1 on the timing of supervisory approval:

For all penalties subject to section 6751(b)(1), written supervisory approval required under section 6751(b)(1) must be obtained prior to issuing any written communication of penalties to a taxpayer that offers the taxpayer an opportunity to sign an agreement or consent to assessment or proposal of the penalty.

Not long before Kroner was decided and the interim IRM guidance above was released, I had a client who received an IRS form letter, Form 5005-A (Rev 7-2018), imposing immediately assessable information reporting penalties under section 6721 and section 6722 for 2017 for failure to timely file Forms 1094-C and 1095-C.  This letter is one of several form letters that are being issued under the IRS’s ACA employer compliance initiative. Under section 6056, employers are required to file and furnish these ACA-related forms to report offers of health coverage. 

The Form 5005-A states that the taxpayer can agree with the penalty and pay it.  If the taxpayer disagrees, the letter states that the taxpayer will “have the opportunity to appeal the penalties after we send you a formal request for payment.” A Form 866-A, Explanation of Items, is attached explaining the basis for assertion of penalties.  The conclusion section states: “Subject to managerial approval, because the Employer failed to file Form(s) 1094-C and 1095-C and furnish Forms 1095-C as required pursuant to section 6056, the employer is subject to the penalties under IRC 6721 and IRC 6722 calculated above.”

The Letter 5005-A and Form 866-A are striking in three regards:  1) The letters clearly communicate Examination’s determination to impose the penalty; 2) the Letter 5005-A is less clear about the opportunity to go to appeals because it delays the opportunity until a formal request for payment is made, but there is clear notification that the right to go to Appeals exists and can be exercised; and 3) the Form 866-A takes the guess work out of whether there was supervisory approval—it states affirmatively that there has not yet been supervisory approval. 

Kroner makes it clear that the name or number of the form the IRS uses to communicate the determination and right to appeal is of no consequence.  As applied to the Letter 5005-A, there is a determination and arguably there is notification of the right to appeal, therefore, the date of this notice is the initial determination of the penalty.  Since according to the Form 866-A there was no supervisory approval before the date the Letter 5005-A was issued, the IRS has failed to satisfy section 6751(b) and the penalties should not apply. 

Even if the “notice of the right to go to Appeals” prong of Kroner is not satisfied, the Letter 5005-A clearly meets the standard for when supervisory approval is required under the interim IRM provisions because the taxpayer is provided the opportunity to agree with and pay the penalty.  While the interim IRM provisions were issued on May 20, 2020, they represent the IRS interpretation of how they should be complying with section 6751(b).  Therefore, failure to comply with the interim IRM provisions in the past should be a failure to comply with section 6751(b). 

IRS is currently sending penalty notices that were being held back due to the pandemic.  For penalties other than sections 6651, 6654, and 6655, practitioners should carefully review notices to evaluate whether section 6751(b) applies and if so, whether the letter is an initial determination required to be preceded by written supervisory approval.

Is IRS Too Soft on People Claiming EITC? Treasury Says Yes and Also Suggests No

The pressure on the IRS to deliver the economic impact payment (EIP) highlights some of the general challenges the IRS faces when Congress tasks the IRS to deliver benefits.  With respect to the EIP, faced with a public that needs the money that Congress has earmarked, IRS has had to move quickly. In times like these, when balancing speed with accuracy, IRS should and admirably has erred on the side of speed.  With lives upended and millions of Americans struggling, this is the right call. 

As an administrator that regularly gets taken to task when it comes to its administration of refundable credits like the EITC, IRS faces a similar trade off in its more routine day to day work.  IRS knows that millions of Americans rely on those Code-based benefits. At the same time, about 25% of the EITC is classified as an improper payment, as Congress has been sure to remind Commissioner Rettig when he has been up on the Hill.

Two recent publications highlight the competing pressures the IRS faces as a result of it having responsibility for administering the EITC.  One is a TIGTA report taking the IRS to task for failing to impose civil penalties and bans on individuals who appear to be improperly claiming the EITC. The other is a Treasury Office of Tax Analysis (OTA) working paper that emphasizes that the vast majority of people claiming the EITC have an eligible familial relationship with a claimed qualifying child.

For folks who are looking for differing perspectives on an issue I suggest that you read both, back to back.  If reading TIGTA reports and OTA working papers is not your ideal way of spending an afternoon, in this post I will discuss the highlights of both.

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TIGTA: IRS Not Doing Enough to Deter and Punish Improper Claimants

First, the TIGTA Report. TIGTA’s steady drumbeat on EITC and refundable credits is that IRS is not using the enforcement tools that Congress has given to it. 

Congress provided the IRS with tools to address taxpayers identified as submitting fraudulent or reckless refundable credit claims. These tools include the authority to assess the erroneous refund penalty and require taxpayers to recertify that they meet refundable credit eligibility requirements for credits claimed on a return filed subsequent to disallowance of a credit, and the ability to apply two-year or 10-year bans on taxpayers who disregard credit eligibility rules. However, the IRS does not use these tools to the extent possible to address erroneous credit payments. 

What are the consequences of IRS not using its robust power to sanction taxpayers? In TIGTA’s view,

[t]he ineffective use of the various authorities provided in the I.R.C. is a contributing factor in the high rate of improper payments. The IRS estimates that 25 percent ($18.4 billion) of EITC payments made in Fiscal Year 2018 were improper payments. The IRS also estimates that nearly 33 percent ($8.7 billion) of ACTC payments made during Tax Years 2009 through 2011, and more than 31 percent ($5.3 billion) of AOTC payments made during Tax Year 2012, were potentially improper. 

The main gripe TIGTA emphasizes is that the IRS has failed to use its power to impose a 20% erroneous refund penalty under Section 6676, a power that Congress amended a few years ago to specifically apply to individuals erroneously claiming refundable credits like the EITC:

In Years 2015, 2016, and 2017, the IRS assessed the erroneous refund penalty on 3,190 erroneous claims totaling $2.7 million. However, our analysis identified 494,555 withholding and refundable credits disallowed for Tax Years 2015, 2016, and 2017 (as of December 27, 2018). These taxpayers filed 798,504 tax returns that claimed more than $2.6 billion in improper withholding or refundable credits. Applying the 20 percent erroneous penalty rate to the disallowed credits computes to almost $534.7 million in penalties that the IRS potentially could have assessed. 

TIGTA goes on state that IRS has studied the impact of the few cases when IRS has in fact imposed the 6676 penalty, and it appears that IRS is teeing up some recommendations based upon its study (FYI – I have not seen the study nor do I know if IRS is planning on releasing it; it would be interesting as well to see how much tax is collected out of previously assessed penalties—I suspect not much). 

The report also criticizes IRS for failing to systematically impose a two-year ban on taxpayers who in TIGTA’s view are recklessly or intentionally disregarding rules and faulty IRS processes for allowing individuals to recertify eligibility for the EITC (and other disallowed credits). As to the ban, TIGTA notes that in successive years people appear to be incorrectly claiming the EITC. ( Note: as advocates know appearances may be misleading as claimants may be unaware of the rules or simply not able to document meeting eligibility criteria. For more on the ban, see Bob Probasco’s excellent three part series, The EITC Ban-Further Thoughts Part 1Part 2 and Part 3.) In a heavily redacted section, TIGTA suggests that the IRS should impose the ban earlier and more frequently. This would free scarce audit resources to investigate other individuals and prevent erroneous claims.

The TIGTA report also discusses recertification. For individuals who have had credits denied through deficiency procedures, Section 32(k) provides that “no credit shall be allowed under this section for any subsequent taxable year unless the taxpayer provides such information as the Secretary may require to demonstrate eligibility for such credit.” TIGTA highlights IRS problems with its processes to ensure that taxpayers who recertify are in fact eligible for the claimed credits.

OTA: The “Improper” EITC Claimants Look Like the Proper Claimants

The OTA paper looks at the EITC very a different perspective. While noting the stubborn 25% or so improper payment rate, OTA attempts to study the characteristics of the people who are not eligible or who appear to be overclaiming the credit. The reason for the inquiry is to help frame the debate around improper payment rates. As OTA notes, 

from the social welfare perspective, policymakers might view a case where a child lived with her low-income grandmother for 6 months of the year differently from a case where an unrelated person claimed a child she did not live with at all; but, both cases would be counted equally in computing the EITC error rate.

What the improper payment rates alone fail to tell us is context. 

When a taxpayer fails to meet the qualifying child tests for an EITC claim, it is generally unknown how closely this taxpayer is related to the child and whether another taxpayer could have correctly claimed the child. 

It is possible for more than one taxpayer to have provided some care for the child during the year, but no single taxpayer to be eligible to claim the EITC for that child under the law (e.g., the child does not live with any taxpayer for more than half the year). In other cases, the erroneous claim may have precluded the actual caregiver from claiming the child. 

What OTA does in the paper is to provide more detail to allow for a “more nuanced consideration of EITC qualifying child errors and the associated social welfare implications.”

What kind of nuance did OTA look to identify? Essentially OTA looked to see if there was a family relationship between the adult and the child claimed as a qualifying child:

Specifically, we analyzed the intensity of the familial relationship between the child and the actual claimant as well as the length of the shared residency, providing information about whether the claim, despite being erroneous, might nonetheless have supported a low-income worker caring for a child. In addition, we studied possible reasons why the “wrong” taxpayer may have claimed the child—whether this occurred due to complicated family circumstances, intentional credit-maximizing behavior, or other reasons—to better understand the causes of EITC noncompliance. Finally, we estimated the credit that could have been received by the parent who did not already claim the child and was potentially the actual caregiver. This result offers an insight into the extent to which the EITC improper payment estimates may overstate not only the social welfare loss but also the monetary loss to the government. 

OTA’s study showed that in the overwhelming number of cases, when there was an error, there still was a close familial relationship between the adult and the child or children, though typically the adult was not the child’s biological parent:

Our analysis suggests an intense relationship between the child and the claiming taxpayer in most cases. About 87 percent of the children, despite being claimed with qualifying child errors, had a valid familial relationship (84 percent) or lived with the taxpayer for more than half of the year (7 percent) or both. However, compared to children who met all of the qualifying child tests, the children in our sample were much less likely to be the son or daughter of the taxpayer, and more likely to have other valid familial relationships (e.g., grandchild or nephew/niece) with the taxpayer. 

The whole paper deserves a careful read, but the bottom line conclusion is that the majority of children claimed with qualifying child errors had an eligible familial relationship with their claimants and in a majority of the cases there was no parent who under current eligibility criteria could in fact be eligible to claim a child.

Furthermore, about 60 percent of the children did not appear to have a parent who could be the “right” taxpayer, as stipulated by law, who could file a claim. We conclude that a substantial portion of erroneous EITC claims likely helped support children in low-income families despite those children being claimed in error. Parents of another 4 percent of children were found to have filed a duplicate claim with the taxpayer under audit. For the remaining 36 percent of children, who had a tax-filing parent not already claiming the child, the family members’ filing patterns were consistent with the credit-maximizing motive in 85 percent of cases. We offer a few explanations, including taxpayer confusion about EITC rules or law changes, to account for the claiming pattern of the remaining 15 percent of cases. Finally, we estimate that the forgone credit that could have been received by non-claiming parents amounted to about 10 percent of the total overclaims attributable to qualifying child errors, or 4 percent of all EITC overclaims. Taken together, these results suggest that the official improper payment rate overstates the social welfare loss and monetary loss to the government.  (emphasis added)

Conclusion

At the end of the day, the OTA study and TIGTA report are likely to appeal to differing parts of the trade off I discussed in the introduction. It could very well be that administrators (and readers and Congress for that matter) do not necessarily value social welfare concerns in the same way that I or others do.  People could place a higher value on rule following. After all, Congress is responsible for determining the eligibility criteria, and it could change the criteria to reach some of the adults who are improperly claiming the credit (I and others have suggested this in past papers, most recently from me in the special report to Congress on the EITC that was part of the TAS FY 2020 Objectives Report). 

How does the current pandemic and economic crisis influence this issue? If I were in the IRS now, I would be strongly advocating for the IRS to slow down on the TIGTA recommendation to impose more civil penalties and sanctions on EITC claimants. Context matters. People are struggling. While it should not mean a green light for allowing erroneous claims to go out of the door, OTA helps us understand that the overwhelming majority of Americans who appear to be improperly claiming the credit have a close family relationship with the children identified on their tax return. 

When the current crisis clears, Congress should take a hard look at the EITC and other credits. It could help the IRS by boosting the childless EITC, which in addition to helping millions of working Americans will also likely decrease incentives for people to share children to ensure eligibility. Congress should also reconsider the eligibility requirements that are difficult and expensive for the IRS to verify and which make less sense in today’s world, like pegging eligibility on arbitrary residency rules that 1) may understate the importance of family members who are connected financially and emotionally but who do not live with a child for more than 6 months and 2) do not work well when there are multigenerational families living together.

In Wells Fargo 8th Circuit Holds Reasonable Basis Defense to Negligence Penalty Requires Taxpayers Prove Actual Reliance on Authorities

In an important opinion the 8th Circuit in Wells Fargo v US held that the reasonable basis defense to the negligence penalty requires a taxpayer to prove that they actually relied on relevant legal authority rather than just show that objectively the authority supported the taxpayer’s position. Wells Fargo is the first appellate opinion to hold that reasonable basis for penalty defense purposes is based on a subjective rather than objective standard. The earlier district court opinion had attracted significant interest, and as I discuss below, the court’s holding may force taxpayers to waive attorney client privilege if they want to use the defense to the negligence penalty.

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Some Background

Before getting to the 8th Circuit opinion I will give some context.

The transaction at issue involved interest deductions and a complex foreign tax credit generating transaction. At the district court, the government lost in its effort to use the economic substance doctrine to disallow interest expense deductions for a transaction that lacked a non tax business purpose but won on its use of the doctrine to disallow the foreign tax credits arising from a trust structure. The district court also sustained the negligence penalty attributable to the tax due from the disallowed foreign tax credits. 

There are a couple of tangential issues that that I need to address before I get to the main parts of this post. I am not analyzing Wells Fargo’s economic substance issue; for readers looking for more background see Stu Bassin’s post Wells Fargo Decision Answers Economic Substance Question that followed the district court opinion. In addition, the negligence penalty in this case was not asserted on audit but arose as part of the government’s offset defense in the district court litigation. That is important for purposes of a separate Section 6751(b) managerial approval/Graev issue that I do not analyze in this post. Essentially the 8th Circuit in this opinion held that supervisory approval is not required when the government asserts a penalty as an affirmative defense in refund litigation, as done in this case. For readers wanting more on 6751(b), I direct you to many posts on the issue or newly revised ¶ 7B.24 in Saltzman and Book.

To the negligence penalty and reasonable basis. 

Section 6662 imposes a 20 percent penalty on any underpayment of tax that is attributable to the taxpayer’s “negligence or disregard of rules or regulations.” Treasury regulations under Section 6662 provide a defense to the negligence penalty if the taxpayer’s “return position” was “reasonably based on one or more of the authorities set forth in § 1.6662-4(d)(3)(iii) (taking into account the relevance and persuasiveness of the authorities, and subsequent developments).” The Wells Fargo opinion cross references regs under Section 6114 (addressing treaty based return positions) which provide that a “taxpayer is considered to adopt a ‘return position’ when the taxpayer determines its tax liability with respect to a particular item of income, deduction or credit.” 

As I discussed following the district court opinion in Wells Fargo and The Negligence Penalty for A Transaction Lacking Reasonable Basis, the penalty issue was “teed up for the district court in a somewhat odd manner, with Wells Fargo stipulating that if the foreign credit generating transaction was a sham, it should not be subject to the penalty because ‘there was an objectively reasonable basis for Wells Fargo’s return position under the authorities referenced in § 1.6662–3(b)(3).’  In finding that the transaction was a sham, the district court also held that Wells Fargo was subject to the penalty because it had to prove that it in fact consulted with the authorities before adopting its position on the return. 

In my 2017 post I noted that the penalty aspect of the opinion was controversial:

At or around the time of the opinion, Jim Malone of Post & Schell wrote a terrific blog post critiquing the district court opinion, suggesting that perhaps Wells Fargo deserved to be penalized but that the court’s approach to the issue was “troubling”. There was also a piece in Bloomberg that quoted Jim and former PT guest poster Andy Grewal, with Andy saying that “it would be more sensible to apply Section 1.6662-3(b)(1) in accordance with its plain meaning and examining all relevant authorities supporting the treatment of a position, whether or not the taxpayer was aware of them.”

Practitioners have been closely following the case. For example, a February 2020 article in Tax Notes co-written by my old Davis Polk colleague Mario Verdolini and Christopher Baratta The Objectivity of the Reasonable Basis Defense to Tax Penalties (subscription needed) criticized the district court opinion and urged the 8th Circuit to adopt an objective approach in applying reasonable basis.

The 8th Circuit Majority Opinion on Reasonable Basis

The 8th Circuit, in affirming the district court, disagreed, finding that reasonable basis requires evidence that a taxpayer actually relied on relevant legal authority in support of its positions taken on tax returns. In so doing the 8th Circuit sidestepped the possible thorny administrative law issue concerning whether IRS is entitled to deference regarding an interpretation of its own regulations because it concluded that the regs were not ambiguous. (Aside: Deference to an agency’s interpretation of its own ambiguous regulations is the so-called Auer issue I discussed in my earlier post on the case. Last year the Supreme Court addressed Auer in Kisor v. Wilkie, where it tightened the standard under which courts are to defer to agency interpretations of their own regulations. For those wanting more on this, see Saltzman and Book IRS Practice & Procedure ¶ 3.6, where Greg Armstrong and I recently added a revised discussion of the importance of Auer deference in light of Kisor; I discuss this a bit more below in reviewing the dissent.  See also an earlier post discussing Kisor.)

Citing Black’s Law Dictionary, the opinion stressed that the “plain or common usage of the word “base” suggests that one is relying on particular information in order to form an opinion or a position about something.”

As the district court noted, “[i]t is difficult to know how a taxpayer could ‘base’ a return position on a set of authorities without actually consulting those authorities, just as it is difficult to know how someone could ‘base’ an opinion about the best restaurant in town on Zagat ratings without actually consulting any Zagat ratings.” Indeed, the regulation does not require the taxpayer’s position to be simply “consistent with” or “supported by” the relevant legal authority. If it did, then it might be sufficient that the relevant authorities supported the taxpayer’s position, regardless of whether the taxpayer relied upon them. But in order for a taxpayer to “base” its position on relevant authority, it must have actually known about those authorities and actually relied upon them when forming its return position. (emphasis added though citations omitted, including cites to some district court opinions taking a contrary view of the issue)

In addition to its use of a plain language analysis, the opinion also notes that the subjective approach to the reasonable basis defense is “sensible in light of the broader context of the statute and accompanying regulatory definition.” In reaching that conclusion, the opinion looks to the underlying issue relating to a penalty, and how that suggests some foundation in actual taxpayer behavior:

Again, the government is seeking to impose a “negligence penalty,” which suggests that the focus of the inquiry must be, at least in part, on the taxpayer’s actual conduct—whether it met the requisite standard of care in preparing its tax return and considering its return position—rather than simply determining whether its legal position finds support in the relevant legal authority. See 26 U.S.C. § 6662(c) (defining “negligence” as “any failure to make a reasonable attempt to comply with the provisions of this title”). 

In support of its view that considering actual conduct is at least part of the inquiry, the opinion notes that in a 1996 case, Chakales v Comm’r, the 8th Circuit stressed that “the burden is on the taxpayer to prove that he did not fail to exercise due care or do what a reasonable and prudent person would do under similar circumstances.” 

The opinion does spend time directly addressing the arguments that Wells Fargo offered, including that other regulations directly require taxpayers or third parties to analyze authorities or facts and circumstances (recall that the reasonable basis regs employ the passive voice “is based” approach rather than directly requiring that the taxpayer base its position on authorities):

That other statutory provisions or regulations use different language in creating an actual reliance requirement does not mean that the provision at issue in this case requires only that the taxpayer’s position be objectively reasonable with respect to the relevant legal authorities. 

While it brushed that away the passive voice argument, the opinion noted that Wells Fargo’s concern that a subjective standard “would likely require a taxpayer to waive attorney-client privilege in order to prove that it actually relied on the relevant legal authority” had more “appeal.” Despite that appeal, the opinion noted that other defenses (like actual reliance) trigger similar concerns and that this argument “standing alone” was insufficient to carry the day.

As a final matter, Wells Fargo argued that policy issues supported its view of the regulations and that it should not matter if a taxpayer gets to a reasonable position by luck or design. The opinion disagreed:

[T]here is a sound policy reason underlying a subjective or actual reliance requirement—it incentivizes taxpayers to actually conform to the requisite standard of care rather than simply taking the chance that there may be a reasonable basis for their underpayment of tax. It also reflects the understanding that a taxpayer who carefully studies the relevant legal authorities but arrives at an incorrect conclusion of law, albeit with a reasonable basis for its position, is perhaps less blameworthy or culpable than a taxpayer which simply ignored the existing authorities in forming its tax position and attempts to generate a reasonable basis as a post-hoc justification for its underpayment.

The Dissent

There is a brief but powerful dissenting opinion by Judge Grasz. The dissent disagrees with the majority opinion’s finding that the regulation was unambiguous. In so doing, the dissent is persuaded by Wells Fargo’s argument that the reasonable basis regulations on their face do not impose a reliance argument, and is cast in “objective terms”, unlike the reasonable belief defense, which directly requires that taxpayers “analyze the pertinent authorities.”

The Supreme Court has explained that when “Congress includes particular language in one section of a statute but omits it in another section of the same Act, it is generally presumed that Congress acts intentionally and purposely in the disparate inclusion or exclusion.” Russello v. United States, 464 U.S. 16, 23 (1983) (quotation omitted). I see no reason why the same canon of statutory construction would not apply when interpreting the regulation here. See Black & Decker Corp. v. C.I.R., 986 F.2d 60, 65 (4th Cir. 1993) (“Regulations, like statutes, are interpreted according to canons of construction.”). If the IRS wanted to require actual reliance on the specified authorities to satisfy the reasonable-basis defense, it could have expressly said so, as it did in setting forth eligibility for the reasonable-belief defense. Its failure to do so indicates actual reliance is not required. 

Judge Grasz also returns to the Zagat’s restaurant review analogy (i.e., it is difficult to know how someone could ‘base’ an opinion about the restaurant in town on Zagat ratings without actually consulting any Zagat ratings) in the original district court opinion that the majority also used. While Judge Grasz notes that the analogy is “incisive and colorful” it in his view is based on the faulty premise that the consulting has to be done before the taxpayer takes a position on the return: 

It assumes the taxpayer must base its position on the specified authorities before the return is filed. The regulation makes no such demand. Instead, 26 C.F.R. § 1.6662-3(b)(3) simply provides that a return position will generally be considered — presumably by the agency or the courts — to have a reasonable basis if it is based on one of the authorities designated in 26 C.F.R. § 1.6662-4(d)(3)(iii). And § 1.6662- 4(d)(3)(iii) further indicates that the agency or courts should consider only such designated authority to make its determination. Reading these regulations together, I believe the agency and/or the courts — not the taxpayer — are to make the determination whether there was a reasonable basis for a return position based on the specified authorities. 

The dissent extends the analogy to show why he believes that the majority’s view strays from the regulations:

To illustrate this distinction [that is that the agency or the courts and not the taxpayer are to make the determination under the regs], let us alter the district court’s restaurant analogy. Suppose three friends try to decide where to go for dinner. Two of the friends, Friend A and Friend B, offer differing suggestions, each claiming his suggestion is the best restaurant in town. Tasked with resolving the dispute, Friend C consults Zagat to see which of the two recommended restaurants is indeed “the best,” and, after doing so, sides with Friend A. Friend C’s decision was indeed based on the Zagat ratings. But Friend A did not rely on the Zagat ratings when taking his position. In other words, Friend C’s determination was based on Zagat, regardless of whether Friend A ever relied on the service. 

Once establishing that there is at least ambiguity in the regs, that tees up the Auer/Kisor issue.  Kisor essentially looks to see if five additional factors are present before a court is to give an agency’s view greater deference. Here, according to Judge Grasz, three of those factors were absent, that the interpretation must be the agency’s authoritative or official position; the interpretation must in some way implicate the agency’s substantive expertise; and the interpretation must reflect fair and considered judgment. 

In light of his view that the regulations did not require a subjective standard and in light of Kisor, Judge Grasz felt that the court effectively improperly gave deference to the IRS’s own view of the regulation. That did not mean necessarily mean that Wells Fargo established that it had reasonable basis. He would have remanded it to the district court to see if in the court’s view Wells Fargo’s foreign tax credit had a reasonable basis in the authorities. (Those few readers still with me might wonder what exactly is reasonable basis? Well that is for another day but most observers peg a position as having a reasonable basis if it has a 20% or more probability of winning).

Conclusion

This case is sure to attract attention and is a powerful tool in the government’s arsenal to penalize aggressive tax positions, or at least put taxpayers in a bind of waiving privilege claims to successfully assert a reasonable basis defense.

I do believe that the majority opinion perhaps overstates its position that the broader context of the statute and regulations support the conclusion that the regs require a taxpayer to show that it actually relied on the authorities. For example, as the Verdolini & Baratta article in Tax Notes earlier this year notes, the reasonable basis regulations take into account subsequent developments. If, as Verdolini and Baratta note,  “a taxpayer had to rely on the authorities when filing a return, it would be impossible for the taxpayer to rely on any developments after the filing of the return.”  

I anticipate that this will not be the last appellate word on this issue.

Boyle and the AWOL Return Preparer: No Excuse for Late Filing

A recent case out of the Northern District of California, Willett v United States, illustrates the difficulty taxpayers face when trying to base a reasonable cause defense to the late filing of tax returns on the conduct of their return preparer.

I will summarize the facts and the court’s analysis.

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The Willetts had filed an extension for the 2014 year. In August of 2015, they delivered their K-1s, W-2s and 1099’s to their longtime preparer, who was a CPA. After dropping off the documents, for about three months their preparer did not respond to their phone calls. In October, the preparer contacted the Willets and told them that she had been seriously ill, would prepare the returns upon her release from an extended care facility, and would pay any penalties and interest associated with the late filing.

After another month or so of not hearing from the accountant, in November Mrs. Willett visited her preparer’s house to get an update. The preparer assured Mrs. Willett that she would complete the return. Unfortunately, despite the Willetts’ repeated efforts to contact her, that was the last that time that they heard from her (she in fact passed away in early 2017).  

The Willetts alleged that by December of 2015 they actively sought a replacement but were unable to get someone until June of 2016 due to other preparers claiming that (1) they were too busy or (2) the return was too complex. By June of 2016, they found someone and hired another CPA, and they filed the return in September of 2016. 

When the Willetts filed the delinquent return, IRS assessed over $34,000 and $6,000 of late filing and late payment penalties. The Willetts paid the penalties and filed a timely refund claim, alleging that their late filing should be excused based on their reasonably relying on their longtime accountant to prepare and file the returns on their behalf.  The IRS rejected the claim, and the Willetts filed suit in federal court. 

In response to the complaint, the government filed a motion to dismiss based on Boyle.  In response to the motion to dismiss, the Willetts amended their complaint and included even greater detail about the efforts they made to contact their longtime preparer after they dropped their tax documents off in August of 2016.   

The additional facts did not help: 

The Willetts’ allegations do not sufficiently plead reasonable cause entitling them to a refund for the late-filing penalties. Their allegations illustrate that they relied on their CPA, Ms. Goode, who possessed the original copies of their tax documents, became seriously ill, and was unable to complete their 2014 tax return on time.  In their Amended Complaint, the Willetts attempt to salvage their claims by providing a detailed timeline of the failed attempts to contact Ms. Goode. However, this timeline fails to demonstrate ordinary care, because it merely illustrates the numerous attempts to contact Ms. Goode.  But those allegations plead no excuse for the late-filing other than reliance on the Willetts’ agent, which is not “reasonable cause” under Boyle.

The Willett opinion does not break new ground. It refers to a couple of cases where the Tax Court held that a nonresponsive or ill accountant does not constitute reasonable cause for late filing. 

It also distinguishes Conklin Brothers of Santa Rosa, a post Boyle 1993 Ninth Circuit case which “held, in the case of a corporate-taxpayer, that reliance on an agent can establish reasonable cause if the taxpayer shows that “it was disabled from complying timely”—e.g., where its agent’s conduct was beyond the taxpayer’s control or supervision.” In distinguishing Conklin the opinion notes  (unpersuasively) that no court has extended it to individuals. More persuasively, the opinion explains that even if Conklin’s limited exception did apply to individuals, the facts as alleged did not support a finding that the Willetts were disabled from complying with their filing responsibilities:

The Willetts seem to imply that Ms. Goode’s possession of the original tax documents “disabled” them from filing their taxes themselves, and prevented them from hiring another CPA. They allege that they made attempts to contact other CPAs, and that those other CPAs would not take them as clients. The insufficiency of these allegations is apparent when compared to other cases holding that the disability exception did not apply. In Conklin, the agent in charge of Conklin’s tax obligations, the corporation’s controller, failed to timely file Conklin’s returns.  For over two years the controller also “intercepted and screened the mail,” “altered check descriptions and the quarterly reports,” and “concealed the deficiencies by undertaking the performance herself of all payroll functions.”  Although the controller’s concealment meant that Conklin’s officers were not aware of the IRS’s penalty assessments, the Ninth Circuit held that the controller’s “intentional misconduct” was not enough to establish that Conklin was disabled from timely complying.  The Willetts’ allegations do not suggest that their agent’s misbehavior was remotely comparable to the controller’s misconduct in Conklin.

(emphasis added; citations omitted)

Conclusion

Willett is a reminder that Boyle generally will prevent a reliance defense in the context of missing a return filing deadline. While there are grounds to challenge Boyle in the context of e-filing (as we have discussed before), Boyle casts a long shadow over taxpayers seeking to escape the hefty civil penalties for late filing. While the Willetts were mightily inconvenienced by their preparer’s failure to prepare the returns and the absence of their K-1s, W-2s and 1099s, the circumstances did not excuse the tardy filing.

As Willett demonstrates, the responsibility to file rests on the taxpayer. One of the barriers that the Willetts faced was that their old preparer had their tax information returns. To be sure the government could make it easier for taxpayers to comply by, for example, seamlessly providing taxpayers access to all information returns they receive from third parties. Last summer, I signed up for an online tax account from the IRS-one of its virtues is that by the time I got around to filing last October I was able to see in one spot the information returns that the IRS had on record for my 2018 year. Of course, most financial institutions and many employers provide access to the information returns if a taxpayer no longer has the original. At some point I suspect that the IRS will make a central portal more readily available for all taxpayers, thereby reducing the burdens of compiling (or retrieving) the returns that are necessary to file.

Graev and the Trust Fund Recovery Penalty

The Tax Court is marching through the penalty provisions to address how Graev impacts each one.  It had the opportunity to address the trust fund recovery penalty (TFRP) previously but passed on the chance.  In Chadwick v. Commissioner, 154 T.C. No. 5 (2020) the Tax Court decides that IRC 6751(b) does apply to TFRP and that the supervisor must approve the penalty prior to sending Letter 1153.  Having spoiled the ending to the story, I will describe how the court reached this result. See this post by Bryan Camp for the facts of the case and further analysis.

This is another decided case with a pro se petitioner, in which the petitioner essentially dropped out and offered the court very little, if any, assistance.  The number of precedential cases decided with no assistance from the petitioner continues to bother me.  I do not suggest that the Tax Court does a bad job in deciding the case or seeks to disadvantage the taxpayer, but, without thoughtful advocacy in so many cases that the court decides on important issues, all taxpayers are disadvantaged — and not just the taxpayer before the court.  Clinics and pro bono lawyers have greatly increased the number of represented petitioners in the Tax Court over the past two decades, but many petitioners remain unrepresented. These unrepresented petitioners, by and large, do not know how to evaluate their cases and how to represent themselves, which causes the court to write opinions in a fair number of pro se cases relying on the brief of the IRS and the research of the judge’s clerk in creating a precedential opinion.  Should there be a way to find an amicus brief when the court has an issue of first impression, so that subsequent litigants do not suffer because the first party to the issue went forward unrepresented?

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The real question here is whether the TFRP is a tax or a penalty.  The IRS argues that IRC 6751(b) does not apply to the TFRP because it is a tax.  We know it’s a tax because the Supreme Court has told us so in Sotelo v. United States, 436 U.S. 268, 279 n.12 (1978).  In Sotelo the Supreme Court sought to characterize the TFRP for purposes of bankruptcy.  In bankruptcy getting characterized as a penalty has very negative consequences with respect to priority classification, discharge and even chapter 7 priority of secured claims.  We have written about several code sections that bankruptcy courts have characterized from tax to penalty or vice versa based on the Supreme Court’s analysis in Sotelo.  You can find a couple of those posts here, and here

So, if TFRP acts as a tax for purposes of bankruptcy, should it, could it act as a penalty for purposes of 6751(b)?  While the Tax Court had skirted the issue previously, the Southern District of New York had decided it head on in United States v. Rozbruch, 28 F. Supp. 3d 256 (2014), aff’d on other grounds, 621 F. App’x 77 (2nd Cir. 2015).  In Rozbruch the court held the TFRP a tax that did not require penalty approval under IRC 6751(b).

The TFRP does not seem like the kind of penalty Congress intended when it worried about using penalties as a bargain chip.  The TFRP is the chip.  It imposes on the responsible person or persons the unpaid tax liability of the taxpayer charged with collecting taxes on behalf of the United States, who failed to fulfill that responsibility.  Good reasons exist not to apply IRC 6751(b) in the TFRP context.  The reasons could have made for another contentious Tax Court conference in the Graev Conference Room, but no one at the court seemed up for the fight.

Instead, the Tax Court settles for a straightforward determination that Congress put the TFRP in the penalty sections of the code, Congress called the TFRP a penalty, and it has some features of a penalty to support its label as a penalty.  While acknowledging that the Supreme Court has held that for bankruptcy purposes TFRP will act as a tax, the Tax Court says that does not mean it isn’t a penalty, citing the wilfullness element necessary to impose the TFRP.  It also finds that the assessable feature of the TFRP supports the penalty label.  So, without a decent fight between Tax Court judges, we get the result that the Tax Court finds the TFRP to be a penalty.  This fight may not be over if the IRS wants to bring it up again.  Unlike lots of liabilities that primarily if not exclusively get decided in Tax Court, matters involving the TFRP primarily get decided in district courts.  Only in the CDP context will the Tax Court see a TFRP case.  So, this may not be the end of road for this issue.

Having decided that the TFRP is a penalty, the Tax Court then decided when the “initial determination” occurred.  Relying on its recent opinion in Belair Woods LLC v. Commissioner, 154 T.C. 1 (2020), the Tax Court decided that the initial determination of the penalty assessment was the letter sent by the IRS to formally notify the taxpayer that it had completed its work.  In the TFRP context this is Letter 1153.  Here the IRS had obtained the right approval prior to the sending of this letter and the court upheld the TFRP.

The Court reaches a taxpayer-friendly conclusion that the IRS must obtain supervisory approval prior to the application of this unusual provision and perhaps did not find any judges putting up a fight against that result because it was taxpayer-friendly.  As with most 6751 decisions, it’s hard to say what Congress really wanted in this situations.  The result here does not bother me.  Certainly, the result has logical support, but the opposite result would have logical support as well.  It will be interesting to see if the IRS wants to fight about this further in the district courts or if it will just acquiesce.  At the least the IRS will want to cover its bases by timely giving the approval, even if it thinks the approval is unnecessary.  The first time a large TFRP penalty gets challenged and the approval was not timely given, the IRS will have to swallow hard before giving up the argument entirely.

Graev and the Reportable Transaction Penalty

In Laidlaw’s Harley Davidson Sales, Inc. v. Commissioner, 154 T.C. No. 4 (2020) the Tax Court addresses the need for supervisory approval and the necessary timing of supervisory approval when the IRS imposes the reportable transaction penalty under IRC 6707A.  We will discuss the mechanics of the penalty below, but this is a really harsh penalty and setting the scene deserves some attention.  When I say harsh, I do not mean to imply that the penalty should not exist or that the IRS improperly imposed it here or elsewhere.  The harshness of this penalty derives from the amount of the possible penalty.  We discussed this penalty in the context of the Flora rule in the case of Larson v. United States where the IRS assessed a penalty of about $163 million against Mr. Larson and others for failing to disclose a reportable transaction.  See the discussion of Larson here and here.  So, the ability of 6751(b) to provide a basis for removing this penalty if the IRS failed to follow the proper procedures for supervisory approval could make a huge dollar difference to certain taxpayers.

The Laidlaw case also deserves attention for the procedural posture of the case at the time the Court makes its decision here.  Note that petitioner filed this case in the Tax Court in 2014 and that the tax year at issue is fiscal year 2008.  Remember that in 2008 no one paid attention to IRC 6751(b).  The issue comes up here in the context of Collection Due Process (CDP) many years after the IRS made the assessment.  The IRS must verify the correctness of its assessment in the CDP process.  Here, the CDP process offers the taxpayer the opportunity to raise an issue and obtain court review it otherwise would not have.  How many other penalties assessed long ago before anyone paid attention to IRC 6751(b) might CDP prove as the place where penalties go to die?  Since Graev brought 6751 to everyone’s attention, the number of times the IRS will fail to get the appropriate supervisory approval will be quite low; however, many penalties exist on the books of the IRS from 10 years ago that were imposed at a time when the IRS did not pay careful attention to the supervisory approval rule or have court guidance on when the approval must occur.  Taxpayers with old penalties who might pay those penalties should make certain to raise the supervisory approval issue through CDP, audit reconsideration or whatever procedural avenues remain open.

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Laidlaw participated in a listed transaction and did not disclose that participation on its tax return.  Subsequent to filing its return for fiscal year 2008, Laidlaw did send to the IRS Form 8886 amending its return and reporting the participation.  A revenue agent examined Laidlaw’s 2008 return and concluded that because it did not include the reportable transaction on the original return, the 6707A penalty applied.  The revenue agent made the initial determination as that phrase is used in 6751 by sending a 30-day letter.  This letter did not contain the approval of the revenue agent’s supervisor.  A month after sending the 30-day letter the revenue agent’s supervisor did approve the assertion of the 6707A penalty.

Laidlaw appealed the assertion of the penalty.  After only two years, Appeals sustained the decision to impose the penalty leading to an assessment of the penalty in 2013.  The penalty was assessed in mid-September, and the notice of intent to levy was sent in mid-November.  The short period of time between the assessment and the notice of intent to levy shows the difference in the way the IRS treats assessments against entities compared to individuals, where the time period between assessment and the notice of intent to levy would have been two or three months longer, because the notice stream for individuals is four letters instead of two. 

Upon receiving the notice of intent to levy, the IRC 6330 notice, Laidlaw timely requested a CDP hearing.  In the CDP hearing the Appeals employee notified Laidlaw that it could not challenge the merits of the 6707A penalty because it had an opportunity to do so administratively by going to Appeals before the assessment of the penalty.  (Read the Larson case above or the discussion of CDP cases tried by Lavar Taylor if you want to know more about the inability to litigate the large penalties imposed under 6707A.)  The Appeals employee did not verify that the supervisor had properly approved the penalty.  Of course, at the time of the verification process in this case, the timing of the supervisory approval did not enter the minds of many people inside or outside of Appeals.  What’s important here is that, even though the right to a merits review of the 6707A did not exist, that right exists separately from the obligation under IRC 6330(c)(1) of the Appeals employee to verify the correctness of the assessment.  The verification requirement serves here as a powerful remedy for the taxpayer.

The IRS argued in this case that the supervisory approval did not need to come before the issuance of the 30-day notice but only before the making of the assessment.  No need to go into the tortured language of 6751 and why the IRS or anyone might question the timing of the assessment for those who regularly read this blog.  For anyone wondering why the IRS would not immediately concede the issue, put Graev into the search box of the blog and read the myriad opinions on 6751 trying to parse its meaning.

While the IRS argument might have merit, the Laidlaw case follows the decisions in Clay and in Belair (see discussion of that case here) in which the Tax Court seeks to finally create a bright line for when approval must occur.  Laidlaw seeks to apply that same bright line test to 6707A.  In applying that bright line, Laidlaw looks to the first formal pronunciation by the IRS of the desire to impose the penalty.  That bright line occurs with the sending of the 30-day letter.  At the time the IRS sent that letter it lacked the approval of the revenue agent’s immediate supervisor.  Therefore, the penalty here fails.

Ringing in the New Year with Another Graev Case

On January 7, 2020, the Tax Court issued a TC opinion in Frost v. Commissioner, 154 T.C. No. 2 (2020).  This case presents another permutation of the issues raised in Graev and is another case decided on this issue in which petitioner handled the case pro se, although Mr. Frost has been an enrolled agent for 25 years.  The opinion says that before he became an enrolled agent he performed collections work as an IRS revenue agent.  He would have been a most unusual revenue agent if he performed collection work, so I assume that he was a revenue officer.  Whether he was a revenue officer or revenue agent, working five years or more for the IRS in either position can chart a path to receiving the enrolled agent designation without taking the difficult test to become an enrolled agent. This background indicates that he was not the usual pro se taxpayer though he may have lacked experience in the Tax Court.  His knowledge of the tax system comes back to haunt him in the end.

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The underlying issues in the case concern business expenses and a loss reported on an LLC in which he had a controlling interest.  Though we do not care about his underlying tax issues, the court obviously must and it goes through the case and statutory law governing the proper deduction of business expenses, before arriving at the conclusion that, despite his extensive and long-standing experience preparing tax returns, petitioner failed to present any evidence in support of his expenses and failed to comply with the strict substantiation requirements of IRC 274(d).  He sounds very much like many clients of the tax clinic. 

Similarly, with respect to the loss claimed from his LLC, his failure to establish his adjusted basis torpedoed his chances of winning this issue.  It’s hard to know with proof issues whether his failure was one of lack of understanding the necessary information he needed to place before the court (or the IRS during the administrative phase) or simply the claiming of tax benefits he was never entitled to in the first place.

He made arguments about the notice of deficiency and why he was selected for audit.  I imagine he pointed out there were many taxpayers more deserving of being audited than him, etc., etc.  The court disposed of this argument citing Greenberg’s Express, Inc. v. Commissioner, 62 T.C. 324 (1974) and a few of the other from thousands of cases it could have chosen to knock down this cry for help based on perceived fairness issues.

Now, the court gets to the meat of the case for our purposes and looks at the penalties imposed upon him.  It points out that the IRS bears the burden of production with respect to the penalties, which requires the IRS to come forward with sufficient evidence showing the appropriateness of imposing the penalties.  This includes showing that IRC 6751(b) compliance occurred.  The court walks through the various burdens on the IRS when taxpayer challenges penalties the IRS proposes to impose and discusses the requirements of IRC 7491(c).  It then turns to 6751(b) and notes that here the IRS “produced no evidence of written supervisory approval of the initial determination of section 6662(a) accuracy-related penalties for 2010 and 2011.”  I am a bit confused why the IRS did not concede this issue if it had nothing to show approval of the penalties for these two years.

It’s a different story for 2012.  The IRS does have a signed penalty approval form signed by the revenue agent’s immediate supervisor over a year before the issuance of the notice of deficiency.  The court finds that the introduction by the IRS of the approval form signed before the notice of deficiency satisfies the burden of production on the IRS.  The burden then shifts to petitioner to show evidence suggesting that the approval was untimely.  The court notes in footnote 6 that in Graev it reserved “the issue of whether the Commissioner bears the burden of proof in addition to the burden of production.  We reserve that issue here as well because placement of the burden of proof here… would not change the outcome.  Here, Mr. Frost came forward with no evidence to contradict the supervisory approval for 2012.

Mr. Frost did not claim or put on any evidence that the formal notice of the imposition of the penalty preceded the approval of the penalty.  So, the court turned to the balance of the burden on the IRS as established in Higbee v. Commissioner, 116 T.C. 438 (2001).  This burden requires showing that the penalty should apply in this situation.  Here the IRS showed that the understatement of tax by Mr. Frost exceeded $5,000 and that the IRS correctly calculated the penalty based on the understatement.  It was then up to Mr. Frost to show that he had reasonable cause for the underpayment.  Mr. Frost put on evidence of his brother-in-law’s health issues during the year at issue, but he has the problem that he has lots of tax experience.  The court expects more from him than it would expect from someone who had not been working in the tax system for 40 years and finds his excuses inadequate to meet his burden of showing reasonable cause and good faith.

Frost does not break as much new ground as some of the other recent TC opinions on 6751 but it does do a nice job of laying out what the court expects of each party when they engage in penalty litigation.  I don’t know why the IRS was holding on to 2010 and 2011 as penalty years if it lacked the managerial approval.  Surely, by this time it knew that it must have the approval or fail.  The docket number is from 2015 so perhaps at the time this case was submitted a few years ago, the Graev case had not become clear.  That’s my guess.  When it takes close to five years between the time a case starts until it reaches opinion, intervening legal opinions can change what the IRS might have argued when the case started.

Imposing the Frivolous Return Penalty

At the end of last summer, the Tax Court issued a TC opinion on the issue of imposing the frivolous return penalty of IRC 6702.  In that opinion it also discussed, inevitably, the impact of Graev on this particular penalty.  We should have covered this case closer to the time it came out.  Several subsequent opinions have cited to it.  This post seeks to correct the omission and make you all aware of Kestin v. Commissioner, 153 T.C. No. 2 (2019).

This case provides yet another example of how friendly the Tax Court is to petitioners.  Of course, statistically, the Tax Court rules most of the time for the IRS; however, it generally gives the taxpayers ample opportunities to make their case.  Mrs. Kestin did not appear for the trial of her case but that did not stop the court allowing her to participate in post-trial briefing and for holding, in part, in her favor despite the position she took on her amended return.

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Mrs. Kestin got off to a good start, from a tax perspective, in 2014.  She timely filed a joint return with her husband reporting her wages of over $155,000 from which she was withheld.  Something happened there after that caused her to lose faith with the tax system.  In September 2015 she submitted an amended return which the Tax Court describes as frivolous and which the IRS identified as frivolous for purpose of imposing the IRC 6702 penalty.  The amended return reported a zero liability accompanied by a narrative that I would describe as tax protestor language, together with a request for a refund of all of the money withheld from her in 2014.

The IRS sent her correspondence pointing out that her amended return could result in the imposition of the IRC 6702 penalty and giving her a chance to avoid the penalty by correcting the frivolous filing.  Unfortunately, she doubled down on her newfound position by sending a letter pointing out the IRS was wrong and attaching a copy of the original amended return.  She did not stop there but sent five more letters to the IRS explaining her position, each one attaching a copy of the amended return.  The IRS imposed a new penalty assessment each time it received one of her missives.

To assist in collecting the sizable liability resulting from the imposition of all of these $5,000 penalties, the IRS filed a notice of federal tax lien and that provided her with the opportunity to request a Collection Due Process (CDP) hearing which she did.  In the CDP hearing she sought, inter alia, to contest the imposition of the penalty on the merits.  Faithful readers know it is hard to raise merits issues regarding assessable penalties because taxpayers have typically had a prior opportunity to go to Appeals before the imposition of the assessable penalty at issue; however, Appeals will not hear frivolous arguments, so she got to raise the merits in her CDP case.

The court imposed the 6702 penalty on the original filing of the amended return and says that Mrs. Kestin agrees with that penalty except for some procedural differences.  The focus then turns to the six times she mailed a copy of the frivolous return to the IRS and it imposed additional penalties.  In a 6702 case, the issue is not what is a return – as the court has discussed many times going back to the Beard case – but what purports to be a return.  When she mailed in the additional six documents she marked them as copies.  The court found that because these documents were marked as copies they did not purport to be returns.  The court points out that the statute does not address whether copies might trigger the penalty and neither do the regulations or prior case law.  On the facts here, it holds that the six copies she sent in her follow up correspondence did not purport to be returns and cannot form the basis for imposition of the penalty.  While the decision is important, and certainly important for Mrs. Kestin, the fact pattern here may be a narrow one although a couple of subsequent opinions discussed below may suggest otherwise.

Having removed all but one of the penalties based on the lack of the filing of documents purporting to be a return, the court then moved to the now inevitable inquiry concerning supervisory approval.  The IRS conceded that the penalty here was not calculated by electronic means and required supervisory approval.  Next, the court turned to Letter 3176C sent by the IRS to Mrs. Kestin warning her that if she did not correct the amended return asserting the frivolous position, the IRS intended to impose the 6702 penalty.  Was this letter the “initial determination” of the penalty that required supervisory approval prior to mailing?  The court finds that the sending of this letter did not mark an initial determination because at the time of sending this letter it remained to be seen whether the penalty would apply.

After acknowledging the strange language of the statute that does not fit the situation, the court found this letter served to warn the taxpayer rather than to determine the penalty liability.  Because it gave the taxpayer the opportunity to avoid the penalty by correcting the submission, the initial determination could not occur until after the proffered period of retraction.  The actions of the IRS did not seek to use the letter as a bargaining chip but rather as an opportunity to avoid imposition.  Kestin is one of several cases decided in the past few months on the issue of initial determination including the severely split decision in Belair Woods, LLC v. Commissioner, 154 T.C. No. 1 (2020) (though Judge Gustafson dissents in Belair Woods after penning Kestin because he perceives a distinction between the situations.)  The decision here appears generally consistent with the other decisions and in some respects foreshadows their outcome.

In the short time since the Kestin opinion the Tax Court has had several additional opportunities to address the issue of frivolous penalties and taxpayer submissions.  In Smith, the taxpayer sent an objectionable original return.  She sent at least one copy of that return with later correspondence (can’t tell yet how many).  Her case was tried (without her showing up) and post-trial briefs were filed. Then, both Graev III and Kestin came down.  In an order from August 30, 2019, Judge Halpern invited additional briefing from the parties by mid-September concerning the application of both opinions.  Only the pro se taxpayer filed a supplemental brief.  The case is awaiting decision, which may be further held up pending the Kestin appeal (see discussion below.)  In Luniw, a bench opinion from Judge Carluzzo served Nov. 20, 2019, the taxpayer was hit with three 6702 penalties.  One was for his original return.  Then the IRS wrote back proposed changes to the return causing the taxpayer to generate essentially the same return and sent it again to the IRS.  Later the taxpayer sent a second copy of the return to the IRS.  Judge Carluzzo applies Kestin and holds that only the last document is not subject to a penalty. Finally, in Jaxtheimer, the taxpayer filed his 2013 return three separate times, reporting zero wages and zero tax owed. Upon each instance, the IRS assessed 6702 penalties. Judge Pugh upheld only the first instance of the penalty assessment, citing Kestin and finding that there was insufficient evidence to determine that the two later-filed returns were not copies.

Mrs. Kestin raised a few other issues which the court brushed away with relatively little fanfare.  The most important of these lesser issues concerns the adequacy of the notice of determination.  She argues that the notice fails because it describes two occasions of frivolous action when the IRS sought to impose seven penalties.  Citing to its earlier opinion in First Rock Baptist Church Child Dev. Ctr. v. Commissioner, 148 T.C. 380, 387 (2017), blogged here, the court holds that if the notice contains enough information to allow the taxpayer to understand the matter at issue and does not mislead it satisfies the statutory requirement.

We blogged about the Kestin case prior to its decision here, here, and here.  This may not be the last time we blog about it.  The IRS filed a notice of appeal in the 4th Circuit on Wednesday, January 8.  I am mildly surprised that it is appealing this case because the circumstances seem pretty narrow; however, the three subsequent opinions citing to Kestin suggest my view of the universe of frivolous cases may just be too limited.  From the perspective of the IRS, the amount of effort to handle a copy of a frivolous document probably closely equals the amount of time it takes to handle a document that purports to be a return.  So, it may want to argue that the decision does not follow the intent of the statute.  It seems like it could get where it wants to go with a regulation, but I do not know what drives this decision.  To my knowledge Mrs. Kestin continues to pursue this matter pro se.  If anyone has a significant interest in the issue and feels the Tax Court got it right, perhaps an amicus brief would be of assistance to her.