Graev’s Long Shadow: Section 6751(b) and Supervisory Approval of Penalties

Today we welcome guest blogger Professor Monica Gianni. Professor Gianni serves as an Associate Professor in the Department of Accounting of the David Nazarian College of Business and Economics at California State University, Northridge. She is the successor author to Volume 6, Tax Practice and Procedure, of the Bittker & Lokken treatise on Federal Taxation of Income, Estate and Gifts and Of Counsel at Davis Wright Tremaine LLP. She wrote to me and asked if I could mention her article forthcoming in The Tax Lawyer – a publication of the ABA Tax Section.  I suggested that she might do a better job of describing her article than me and persuaded her to write a description herself.  She writes on the penalty litigation that has consumed the Court – and this blog – for the past few years.  Keith

As a reader of this blog, you have undoubtedly read numerous posts on Section 6751(b). Section 6751(b) requires supervisory approval in writing prior to assessment of certain penalties. Enacted in 1998 as part of the IRS Restructuring and Reform Act, the statute’s purpose was to prevent IRS agents from using penalties as bargaining chips. The section remained essentially dormant for over 20 years, with both the IRS and taxpayers accepting the position that approval needed to be obtained only prior to assessment. The trilogy of Graev cases and the decision of the Second Circuit Court of Appeals in Chai v. Commissioner changed the Section 6751(b) landscape completely, opening a Pandora’s box of taxpayers using Section 6751(b) to avoid penalties on the technicality of no-written-supervisory approval. Hundreds of court cases have followed, resulting in cases inconsistently interpreting Section 6751(b) and well-counseled taxpayers avoiding tax penalties.

I’ve written an article on this subject, which is due to be published in the next volume of The Tax Lawyer—Supervisory Approval of Penalties: The Opening of a Graev Pandora’s Box. The article tries to bring some order into the case law that has resulted from a badly drafted statute. (You can download the article here). After examining the current state of case law, the article concludes by recommending that the statute be repealed. Internal IRS procedures can address issues with the conduct of IRS employees while not opening the door to taxpayers using a technicality to avoid penalties and IRS employees potentially imposing penalties overbroadly in their attempts to comply with Section 6751(b). While others argue that repeal is not the answer, there seems to be agreement that something needs to be done. As Keith Fogg has pointed out, if the statute isn’t repealed, “maybe we will still be litigating Graev cases into the next decade helping to provide a never-ending source of blog posts.” 

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The bulk of the litigation on this section has addressed when supervisory approval must be given to comply with Section 6751(b). The Tax Court has taken an expansive interpretation of the statute in favor of taxpayers, generally requiring that supervisory approval be obtained prior to the first formal communication to the taxpayer advising that a penalty will be imposed. The Circuit Courts of Appeals have started to disagree with the Tax Court. The Ninth Circuit, in Laidlaw’s Harley Davidson Sales, Inc. v. Commissioner, held that approval is required at the earlier of the assessment of the penalty or before the supervisor “loses discretion whether to approve the penalty assessment.” More recently, the Eleventh Circuit in Kroner v. Commissioner and Carter v. Commissioner reversed the Tax Court, holding that approval is required only before the assessment of penalties.

Rather than examine those decisions one more time, this post looks at procedural requirements of supervisory approval that have resulted from numerous Tax Court decisions in actions brought by taxpayers for penalty relief based on inadequate supervisory approval. First, what is required of a supervisor to fulfill the penalty-approval requirement? The simple answer is nothing but the approval itself. No cross-examination of the supervisor by the taxpayer is required, no reasonable-cause defense by the taxpayer has to be presented first, and there is no requirement that the “thought process” of the supervisor be analyzed or that her review of the penalty have been “meaningful.” The supervisor does not have to consider the merits of the penalty determination, does not have to have real estate expertise for a valuation penalty, and can even approve a valuation penalty before receiving the appraisal report. As summarized in Belair Woods, LLC v. Commissioner, the penalty approval form itself does not have to “demonstrate the depth or comprehensiveness of the supervisor’s review.”

The next question is—how is approval shown? The approval, by the express language of the statute, must be in writing. That being said, an actual signature is not required, and approval can be shown by an electronic signature or even by e-mail. If the approval form, however, shows no date of approval or the date is illegible, the taxpayer will prevail under Section 6751(b). The reason for the penalty on the approval form must be the same as contained in the Notice of Deficiency, and the specific penalty must be listed and not just a general statement that penalties are approved.

A further question is—who is the supervisor that must approve the penalty? Section 6751(b) requires that the taxpayer’s “immediate supervisor” approve the penalty, and this connection must be shown on the approval form. “Immediate supervisor” is not defined in the statute, and there are no regulations under this section. When faced with the issue, the Tax Court in Sand Investment Co. v. Commissioner determined that such supervisor “is most logically viewed as the person who supervises the agent’s substantive work on an examination, even if the examiner’s direct supervisor is someone else.” The IRS considers an acting supervisor to be the agent’s immediate supervisor if he has an approved Designation to Act or a Notification of Personnel Action on file.

If a taxpayer wants to challenge a penalty in court based on lack of IRS supervisory approval, are there any limitations? A taxpayer cannot raise the Section 6751(b) issue for the first time on appeal when the issue could have been raised in the Tax Court. Nor can the issue be raised for the first time at the district court level if it was not raised in administrative proceedings. For a TEFRA partnership action, Section 6751(b) must be raised at the partnership level and is not a partner-level defense. And, if a taxpayer enters into a closing agreement agreeing to the assessment of penalties rather than going to court, he waives any subsequent Section 6751(b) challenge.

The above describes just some of the procedural rules that have developed from numerous court cases post-Graev. Although there is more certainty now than there was prior to these cases, different results for taxpayers can occur depending on which circuit has venue over any ensuing appeal. Whether the statute has succeeded in preventing penalties from being used as bargaining chips seems to have become an irrelevant consideration, as taxpayers have used the statute to escape often well-deserved penalties.

The “What” and “When” of IRC 6751(b)

In Kroner v. Commissioner, No. 20-13902 (11th Cir. 2022) the court reverses the decision of the Tax Court concerning the timing of the supervisor’s approval of a penalty agreeing with the Ninth Circuit’s decision in Laidlaw’s Harley Davidson Sales, Inc. v. Comm’r, 29 F.4th 1066, 1071 (9th Cir. 2022), blogged here, and setting up a direct conflict with the Second Circuit in Chai v. Commissioner, 851 F.3d 190 (2d Cir. 2017) initially blogged here.  Maybe 6751(b) has a ticket to the Supreme Court.  This is the second big victory for the IRS in a row at the circuit level after it has mostly struck out at the Tax Court on timing issues. 

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Mr. Kroner failed to report millions of dollars in income received during the years 2005, 2006 and 2007 and like the majority of taxpayers seeking penalty relief under 6751(b) does not present a very sympathetic figure.  The revenue agent sent him a letter proposing to adjust his taxes to add in the millions of dollars he neglected to report.  In that letter the RA proposed penalizing Mr. Kroner for the oversight.  At the time of sending this letter, the supervisor had not approved the imposition of the penalty against Mr. Kroner though I doubt the RA was too worried about obtaining approval under these circumstances.  The supervisor did approve the penalty prior to the issuance of the notice of deficiency and long before the assessment.

At the time of this audit Frank Agostino had not yet educated the IRS concerning IRC 6751(b) and the IRS was not paying careful attention to supervisory approval whatever the “what” and “when” of the statute meant.  Mr. Kroner filed his petition in Tax Court in 2014 and not quite six years later in 2020 the Tax Court rendered its opinion in T.C. Memo 2020-73 upholding the tax deficiency and striking down the proposed IRC 6662 penalties for the years at issue due to the timing of the supervisory approval.

I do need to make brief mention that you know an opinion is well researched when it contains the citation “see also MICHAEL I. SALTZMAN & LESLIE BOOK, IRS PRACTICE & PROCEDURE § 10.01 (June 2022 ed.)”  Citing to the treatise that caused the creation of this blog does not make the opinion automatically correct but does indicate the court was researching in the right places.  The only thing better would have been a citation to the blog itself.  The opinion cites to the treatise in determining the meaning of assessment and uses that meaning in the first prong of its reason for holding for the IRS.

In rejecting the decision of the Tax Court, the 11th Circuit directly takes on the decision of “when” the supervisory approval must occur:

Essentially, the Tax Court reads the statute as follows: “No penalty shall be communicated to a taxpayer until such communication has been approved by the communicator’s immediate supervisor.”

We disagree with Kroner and the Tax Court. We conclude that the IRS satisfies Section 6751(b) so long as a supervisor approves an initial determination of a penalty assessment before it assesses those penalties. See Laidlaw’s Harley Davidson Sales, Inc. v. Comm’r, 29 F.4th 1066, 1071 (9th Cir. 2022). Here, a supervisor approved Kroner’s penalties, and they have not yet been assessed. Accordingly, the IRS has not violated Section 6751(b).

The Court gives three reasons for its decision and then follows up the brief statement of reasons with a more detailed discussion of year.  The brief statement is:

First, we think it is more consistent with the meaning of the phrase “initial determination of such assessment,” which is what must be approved. Second, we think it reflects the absence of any express timing requirement in the statute. And third, we think it is a workable reading in the light of the statute’s purpose.

Addressing the first of its reasons the Court states:

we are confident that the term “initial determination of such assessment” has nothing to do with communication and everything to do with the formal process of calculating and recording an obligation on the IRS’s books.

So, the Court takes a much different tack on the initial determination, the “what”, then taken by the Tax Court.  The Tax Court has focused on that phrase to determine that the first written communication to the taxpayer serves as the initial determination.  The 11th Circuit rejects that view giving the IRS much more time to get the supervisor on the scene but also giving the IRS much more time to use the penalty as a bargaining chip.  The concurrence comes in with a detailed explanation of why the Tax Court misses the right answer by focusing on what it thinks is the intent of the statute rather than on the language of the statute.

In describing its conclusion on the second point, the 11th Circuit states that the word “initial” describes “what must be approved and not when.”   The court applauds the IRS for now causing the approval to occur early in the process but says that the administrative position the IRS has adopted is not driven by the language of the statute because the word “initial” modifies ”determination of such assessment” and does not modify the phrase “no penalty under this title shall be assessed.”

The 11th Circuit then took on what it described as the “Tax Court’s communication-based pre-assessment deadline for supervisory approval.”  The 11th Circuit attributed the Tax Court’s approach to the approach taken by the 2nd Circuit in Chai – the first circuit court to review an IRC 6751(b) approval issue.  Because of the ambiguity in the phrase, “initial determination of assessment”, a phrase I think falls more into the meaningless or inexplicable category than the ambiguous category.  In trying to determine what Congress meant, according to the 11th Circuit, the Tax Court fell into the trap of looking at some of the legislative history which suggested the purpose of the statute was to keep the IRS from using penalties as a bargaining chip in reaching a resolution more favorable to the IRS than it might have reached without the threat of penalties.  The 11th Circuit explains why it doesn’t think this approach is correct.

The concurring opinion goes into even greater detail on why this approach by the Tax Court was a flawed approach.

As I have written before in describing this statute, I think any court will struggle to find the meaning of the statute in the words used by Congress since the words do not work.  Judge Holmes, whose concurring opinion in Graev is mentioned by the 11th Circuit, warned of the myriad of problems the statute could cause. I sympathize with the IRS to a certain extent because it has lost a number of penalty cases against taxpayers who deserve the penalties from which they were relieved.  My sympathy for the IRS is tempered by the fact it appears to have ignored the statute for the first 15 years of its life (causing cases like the Kroner case) and since being made aware of its responsibility by the litigation Frank Agostino initiated, the IRS has not written any regulations putting down a clear marker that could guide courts to a decision more favorable to the IRS.

With what appears to be a clear split in the circuits and a fair amount of money at issue, maybe Mr. Kroner will offer the Supreme Court the opportunity to parse the language of this statute.  Maybe the IRS will try again to obtain a repeal of this provision or maybe we will still be litigating Graev cases into the next decade helping to provide a never-ending source of blog posts.

Can the IRS Approve a Penalty Too Soon?

The Freeman Law International Tax Symposium will take place October 20 & 21 with a number of speakers familiar to readers of this blog.  Registration is available here.

We have written many posts on the various issues raised by IRC 6751(b) regarding the requirement that the immediate supervisor of the agent proposing a penalty approve the penalty in writing.  For years the IRS did not pay attention to this provision which was added as part of the Restructuring and Reform Act of 1998.  Taxpayers have received relief from numerous penalties as the Tax Court has worked out the meaning of this statute including when and who must approve the penalty.

In Sparta Pink Property, LLC v Commissioner, T.C. Memo 2022-88, the Tax Court examines an unusual argument that the IRS approved the penalty too soon thereby rendering the approval ineffective.  The issue arises in the context of a conservation easement case.  The Court decides the issue in the context of the IRS motion for partial summary judgment.  In the summary judgment motion the IRS sought a ruling that the easement deduction should be disallowed because the easement’s purpose was not “protected in perpetuity.”  The Court declines to grant summary judgment on this issue and I will not discuss it further.  On the IRC 6751(a) issue the Court finds that the IRS properly obtained supervisory approval for imposing the penalty.  Let’s examine why petitioner raised the issue.

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 The Revenue Agent (RA) determined that the easement petitioner sought to deduct had a value of about $45,000 while petitioner claimed a charitable contribution deduction of over $15 million.  Based on the significant valuation disparity, the RA proposed a penalty for gross valuation misstatement as well as some alternative penalties.  The RA prepared a civil penalty approval form which his manager signed on February 10, 2020.

On February 24, 2020, the RA sent petitioner a draft report setting forth his findings including the recommendation for the penalty.  On July 9, 2020, the IRS issued petitioner a notice of final partnership administrative adjustment (FPAA) reducing the deduction as described above and asserting the gross valuation penalty.  The Court finds that because the RA secured the approval of his immediate supervisor before sending the report and before sending the FPAA the approval was timely.  The Court noted in a footnote that the RA’s actions here secured the necessary approval before either possible deadline given that there is a split between the Tax Court’s view and that of the 9th Circuit:

Because RA Rikard secured supervisory approval on February 10, 2020, we need not decide whether the “initial determination” to assert penalties was embodied in the RAR (dated February 24, 2020) or in the FPAA (dated July 9, 2020). In Laidlaw’s Harley Davidson Sales, Inc. v. Commissioner, 29 F.4th 1066 (9th Cir. 2022), rev’g and remanding 154 T.C. 68 (2020), the U.S. Court of Appeals for the Ninth Circuit considered the timeline for obtaining supervisory approval of “assessable penalties,” which are not subject to deficiency or TEFRA procedures. The court held that, for an assessable penalty, supervisory approval is timely if secured before the penalty is assessed or “before the relevant supervisor loses discretion whether to approve the penalty assessment.” Id. at 1074. The court suggested that, in a deficiency or TEFRA case such as this, the deadline for securing supervisory approval would be the issuance of the notice of deficiency or the FPAA. See id. at 1071 n.4. If that analysis were adopted here, supervisory approval of the penalties was clearly timely: Approval was secured in February 2020, and the FPAA was not issued until July 2020.

We discussed the Laidlaw case here.

Petitioner does not argue that the supervisory approval came too late but rather argues that:

“[r]espondent did not make any effort to authenticate the documents attached to the declarations,” including the civil penalty approval form and the sworn declarations from Ms. McCarter [the supervisor] and RA Rikard. Petitioner asserts that the relevant facts must be established at trial.

The Court disagrees finding that the IRS supplied the signed approval form and an affidavit from the supervisor stating that she reviewed the RA’s work.  This is enough.  The RA and the supervisor need not be subjected to cross-examination.

Petitioner counters this by pointing out that the engineer’s report valuing the property did not reach the RA until February 24, 2020, two weeks after the signature of the supervisor.  Because the engineer’s report was not in the file reviewed by the supervisor, petitioner argues that the supervisor could not have undertaken an actual review of the RA’s substantive work.

The Court states that:

We have repeatedly rejected any suggestion that a penalty approval form or similar document must “demonstrate the depth or comprehensiveness of the supervisor’s review.” Belair Woods, 154 T.C. at 17. Faced with assertions that IRS officers gave insufficient consideration to the matters before them, we have ruled such lines of inquiry “immaterial and wholly irrelevant to ascertaining whether respondent complied with the written supervisory approval requirement.” [case cites omitted]

To the extent petitioner asks us to look behind the civil penalty approval form, “it would be imprudent for this Court to now begin examining the propriety of the Commissioner’s administrative policy or procedure underlying his penalty determinations.”

While this case is merely a memo opinion relying on earlier precedential opinions, it makes clear that petitioners cannot go behind the approval form with language similar to the language it uses to prevent petitioners from going behind the notice of deficiency.  Adopting this approach saves the Court from a host of litigation regarding the quality of the information available to the supervisor but does not prevent the petitioner from attacking the penalty on the merits. 

Petitioner in this case can still show that the penalty should not apply but petitioner cannot eliminate the penalty based on the quality of the decision of the supervisor to approve it as required by IRC 6751(b).  The outcome makes sense but does not preclude an inquiry regarding the supervisor’s approval if it were totally disconnected to the appropriate process, e.g., a supervisor signing a penalty approval at the outset of an examination might find that the Court would look behind that just as it looks behind the notice of deficiency in sufficient egregious circumstances.