Clay v. Commissioner: Section 6751(b) Approval Required before 30-Day Letter

Oh boy, another section 6751(b) issue and it’s the storm Judge Holmes foresaw coming. It has arrived, in the Graev of Thrones, winter is here.

The only designated order during the week of May 6 was in Docket No: 427-17, Michael K. Simpson & Cynthia R. Simpson v. CIR (order here). The order itself was not very substantive and only one page long. The case was already tried on April 18, 2019 in Salt Lake City, but on April 24, 2019 the Court issued its opinion in Clay v. Commissioner so it orders the parties to file responses addressing the effect of Clay as it relates to section 6751(b).

So, what happened in Clay?

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Clay’s trial was held before the Court’s opinion in Graev III was issued, so in due course the Court ordered the IRS to address the effect of section 6751(b) and show any evidence of supervisory approval in the record. The IRS couldn’t produce any evidence in the record that satisfied the burden for section 6751(b)(1), but moved to reopen the record and admit two Civil Penalty Approval Forms accompanied by declarations for two of the years at issue.

Petitioners did not oppose the motion but raised issues with the documents the IRS produced in support of 6751(b) compliance. The Court permitted petitioner to conduct additional discovery and granted petitioner’s motion to reopen the record to include documents relating to the review of the penalties to support petitioner’s argument that the supervisory approval was not timely.

Section 6751(b) requires that no penalty be assessed, “unless the initial determination of such assessment is personally approved (in writing) by the immediate supervisor of the individual making such determination.” Graev III held that the initial determination is no later than the date the IRS issues the notice of deficiency (although the IRS can still assert penalties in an answer or amended answer in Tax Court). Clay takes this a step further, and asks, should the initial determination occur earlier than the notice of deficiency?

In other words, is penalty approval required before an agent sends a taxpayer a 30-day letter with a Revenue Agent Report (RAR) attached which proposes adjustments and includes penalties?

The petitioner thinks so and argues that the initial determination of a penalty is “the first time an IRS official introduced the penalty into the conversation.” Graev III, 149 T.C. at 500, 501. In Clay, the RAR was the first correspondence that introduced penalties into the conversation and so it should be considered the initial determination under section 6751(b).

The Court agrees and points out that the determinations made in a notice of deficiency typically are based on the adjustments proposed in an RAR. In situations where an agent sends a taxpayer a formal communication proposing adjustments which advises the taxpayer that penalties will be proposed and advises the taxpayer of the right to appeal them (via a 30-day letter to which the RAR is attached), then the issue of penalties is officially on the table. In other words, Clay requires the IRS to get written supervisory approval before it issues a 30-day letter with an RAR, if the RAR proposes penalties (and most, if not all, of the RARs that I have seen do).

Luckily for the petitioners in Clay, although the Civil Penalty Approval form was initialed before the NOD, it was after the 30-day letter and RAR were issued, and therefore, the Court held supervisory approval was not timely under 6751(b).

Returning to the week of May 6th’s only designated order, the Court orders the parties to identify whether any notice conferring the opportunity for administrative appeal was issued to petitioner, and if so, the parties should direct the Court’s attention to any such notice in evidence. Presumably this is so that the parties can demonstrate whether written supervisory approval was timely obtained under the new standard established by Clay.

Some Facts About the Walquist Case, Along with Some Nuance

Frequent guest blogger Bob Kamman put his formidable investigative skills to work to bring us an in-depth look behind the Walquist opinion. Christine

“Everyone is entitled to his own opinion, but not to his own facts.”
–Daniel Patrick Moynihan

“Facts, sir, are nothing without their nuance.”
–Norman Mailer

The Tax Court is certainly entitled to its opinion in Walquist v. Commissioner, 152 T.C. No. 3, which Keith Fogg blogged here. But a review of the record and other public documents yields facts that may contradict those cited in the opinion, or at least provide some meaningful nuances. Serious questions are therefore raised about its precedential value.

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 Here are what the Tax Court found to be some of the facts:

R through his Automated Correspondence Exam system determined, for Ps’ 2014 tax year, a deficiency in tax and a penalty for an underpayment attributable to a substantial understatement of income tax. R’s computer program generated a 30-day letter inviting Ps to reply and submit relevant information. When Ps declined to respond, the program generated and issued to them a notice of deficiency in the form of a Letter 3219. This letter again invited Ps to contact R, but they did not do so.

Here is what actually happened:

Petitioners filed their 2014 Form 1040 with a paper return that was received by the Fresno Service Center on April 2, 2015. It must have been placed in the “Funny Box” (see Internal Revenue Manual 3.10.73.3.4) because it was stamped “Frivolous Return Program – Internal Revenue Service – Fresno CA” on that day. The next stop in its processing was April 13, 2015, when it was stamped “Received – FRP 306.”

The taxpayers had added to the jurat (declaration under penalty of perjury, just above their signatures), “This return is in accordance with 12 USC 411, 12 USC 95(a)(2), [illegible].” Those sections are used by tax protesters who claim income is not taxable unless paid or measured by Federal Reserve notes, or something like that.

They also wrote “Demand for Lawful Money Reduction” on Line 21, with a bracketed amount of $87,647.96 to indicate a loss. The pretrial memorandum correctly transcribes the first word as “Demand” but a later pleading erroneously changed it to “Remand.”

The next we see of the return is an internal IRS Form 8278, “Assessment and Abatement of Miscellaneous Civil Penalties,” dated July 27, 2015 and signed by “Ms. Bluemel” as originator and Krista Decaria as manager and reviewer. (They work not in Fresno, but at the IRS Ogden Service Center.) It assesses a $5,000 penalty for a frivolous tax return. Assessment of this penalty is not subject to deficiency procedures. In its “Remarks” section, the Form 8278 states “Argument 29.” IRM 25.25.10.2 explains this as “Any other position deemed frivolous.”

The Walquists filed a joint return. Both spouses had W-2 income. Craig Walquist earned $20,113 from two employers, with $624 federal income tax withheld. Maria Walquist earned $59,840 from one employer, with $5,105 withheld. The total withholding from W-2 forms was $5,729 but their return claimed $5,730.69. In August 2015, IRS grabbed the $5,000 penalty from this amount. That left $730.69, which was applied to taxes they owed for 2008. Then IRS allowed $54.12 interest from April 15 on the “overpayment.” That amount went to 2008, also.

All of these facts come from IRS pleadings in the Tax Court case. To find out what happened between August 2015 and August 2017, when the Notice of Deficiency was issued, we must look elsewhere. Did IRS just throw the fishy 1040 back in the sea of returns, only to have the audit commence again because of some unreported income? Fortunately, the taxpayer attached some IRS correspondence to the lawsuit he filed in the District Court for Minnesota. But first, let’s look at some more facts from the Tax Court opinion.

Alerted to petitioners’ underreporting by computer document matching, the IRS processed the examination of their return through its Automated Correspondence Exam (ACE) system, employing its Correspondence Examination Automated Support (CEAS) software program. This software is designed to process cases ‘with minimal to no tax examiner involvement until a taxpayer reply is received.’ Internal Revenue Manual (IRM) pt. 4.19.20.1.1 (Dec. 18, 2017).

On July 26, 2017, the CEAS program generated and issued to petitioners a Letter 525, General 30-Day Letter. In cases such as this–where the understatement of income tax calculated by the program exceeds the greater of $5,000 or 10% of the tax required to be shown on the return–the program systematically includes in the letter a substantial understatement penalty. See sec. 6662(b)(2), (d)(1)(A). The program accordingly calculated a penalty of $2,766.40, or 20% of the proposed deficiency of $13,832. See sec. 6662(a).

What Walquist attached to his District Court complaint, though, is a Letter 525 dated June 30, 2017. It says, “We’re auditing your 2014 Form 1040, and need a response from you.” Attached to the letter is a computation showing a balance due of $18,003. This included $13,832 tax; $2,766 Section 6662 penalty; and $1,405 interest. In a box on the Letter 525 for “Examiner’s Signature,” there is printed “Tax Examiner”; and in the box for “Employee ID,” the number 1000099771.

The Letter 525 adds, “let us know by July 30, 2017 if you agree or disagree with our proposed changes.” The Walquists both signed a two-page, single-spaced letter dated July 26, 2017, asserting tax-protester arguments based on Federal Reserve notes. (There is no proof it was mailed, but no reason to believe it was not. It would not have accomplished anything, anyway). IRS responded with the August 30, 2017 Notice of Deficiency.

In addition to his $20,113 of W-2 income, Walquist received $14,159 in “non-employee compensation” reported on Forms 1099-MISC, which IRS determined was subject to $2,001 self-employment tax. He also received $1,215 in unemployment compensation.

As IRS stated in a November 26, 2018 filing, “respondent’s determinations are chiefly based on a misclassification of income rather than underreporting of income by petitioners.” In other words, the $14,159 of self-employment income should not have been reported as wages, but instead shown on Schedules C and SE.

The Notice of Deficiency shows the same employee identification number as the Letter 525. It is attributed to Christine L. Davis, from Ogden’s “Return Integrity and Compliance Services, Integrity and Verification Operation.” That IRS office “detects, evaluates and prevents improper refunds.”

As it turned out, the software that IRS relied on to figure the tax did not produce an accurate result. It was only after the Tax Court petition was filed that IRS Counsel reduced the $13,832 amount to $12,220, and the $2,766 Section 6662 penalty to $2,444. A $60 filing fee saved the taxpayers $1,934 plus interest. They should have quit while they were ahead. The Tax Court also corrected its error in ordering them to pay the filing fee, before it found that it had already been received. Perhaps it was paid in Federal Reserve notes which caused some accounting problems.

Some more facts from the Tax Court:

Whether an accuracy-related penalty determined by an IRS computer program is a ‘penalty automatically calculated through electronic means’ does not appear to have been decided in any published Opinion of this Court. . . .The penalty at issue was calculated and instantiated in letter form by a computer software program. Because the computer did this without human intervention, no ‘individual making such determination’ appears to exist.

Yes, “instantiated” is a word. But that part about human intervention?

In its pretrial motion dated October 5, 2018, the IRS attorney informed the Court:

Respondent determined that petitioners were liable for an I.R.C. §6662 accuracy-related penalty for their 2014 tax year. I.R.C. § 6662 (a). Respondent is able to satisfy its burden of production with respect to this penalty. I.R.C. § 6751 requires respondent to furnish evidence of managerial approval of the accuracy-related penalty prior to the issuance of the notice. As an exhibit to respondent’s September 5, 2018 motion to dismiss, respondent submitted a signed Declaration and Case History demonstrating managerial approval of the accuracy-related penalty in this case prior to issuance of the notice. As such, respondent is able to meet its burden of production.

In other words, in a case where the Tax Court saw no human intervention in a tax-protester audit, the IRS itself saw the need for managerial approval of a Section 6662 penalty, and confirmed it was done.

But maybe that is not the precedent the Court intended to establish with this case. Maybe the message is the $12,500 penalty it assessed under Section 6673, for taking a position in Tax Court that was frivolous or groundless.

The maximum penalty that could have been assessed is $25,000. It might not be coincidence that $12,500 nearly matches the amount of tax, $12,220, that should have been shown on the Walquists’ frivolous return. That does not include the $5,000 penalty they had already paid to IRS.

The Tax Court penalty can now be collected from either spouse. In 2014, Mrs. Walquist was the primary breadwinner, responsible for 63% of the income. Filing separately, she still would have owed more than $3,000 tax. But there is little evidence that she is the primary tax protester. She was not a plaintiff in the District Court case. An IRS notice attached to that complaint indicates that for 2016 her husband filed separately, and was again penalized $5,000. It is the husband who has self-published a book that asks such questions as, “Have American Christians erred in assuming our country is Biblically on the side of good?”

I searched Tax Court opinions from 2017 to date for cases involving joint returns where the Section 6673 penalty was considered. Most such cases during this period involved taxpayers who are unmarried or filing separately.

I found two cases involving joint returns. In one of them, Henry and Kathy Jagos, TCM 2017-202, the taxpayers had income of $544,167 in 2012. They denied owing tax because they “are private-sector citizens (non-federal employee) employed by a private-sector company (non-federal entity) as defined in 3401(c)(d).”

From the Court’s opinion:

At trial the Court encouraged the Jagoses to abandon their frivolous arguments and cited specific authorities for them to consider. The arguments raised in their 70-page brief were a rehash of the very same arguments that were dispatched in those cases. And the Jagoses have raised frivolous arguments at every stage of this process from their 2012 income tax return to their closing brief. For disregarding the cases cited to them and wasting the Court’s resources with their frivolous arguments, we impose a sanction under section 6673 . . .

The Court found that they owed $155,149 in tax – but assessed only a $1,000 penalty under Section 6673.

In the other case, Michael Wells and Lynn Kirchner-Wells, TCM 2018-188, the Court noted:

Petitioners also attached Forms 4852, Substitute for Form W-2, Wage and Tax Statement, to each of the returns indicating zero wages and the same amounts of tax withheld as was shown on each Form W-2. The Forms 4852 included the following tax protester statements: I am a private-sector worker, not an ‘employee’ as defined in IRC 3401(c) and IRC 3121. I worked with a private-sector company, not a federal employer as defined in IRC 3401(d). I did not engage in a ‘trade or business’ as defined in USC Section 7701(a)(26).

The tax deficiency was $52,051, but no Section 6673 penalty was assessed. “The Court may on its own determine whether to impose a penalty not to exceed $25,000 when it appears to the Court that a taxpayer’s position is frivolous or groundless. Sec. 6673,” Judge Gerber wrote. “We did not find in the record that petitioners have made these or similar frivolous claims in the Court before or that they have been previously forewarned. Thus we will not impose one here, nor does respondent seek a section 6673 penalty in this case.”

Has the Tax Court now announced an end to leniency for tax protesters? At least the Walquist case suggests that those with frivolous arguments (and their spouses) should stick to the facts, and keep their opinions to themselves.

Prior Supervisory Approval Not Necessary for Late Filing Penalty Imposed Under IRC 6699

In ATL & Sons Holding LLC v. Commissioner, 152 T.C. No. 8 (March 13, 2019) the Tax Court determined that the IRS could impose the penalty for filing a late return by a flow through entity, here an LLC, without obtaining supervisory approval. No big surprise here but now the Tax Court has a precedential opinion on the subject. Petitioner was represented by an officer and not a law firm. The lack of professional representation probably did not impact the outcome in this case. The issue arises in the context of a Collection Due Process (CDP) case.

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Petitioner filed its LLC return late for the 2012 tax year without requesting permission to file late even though the individual owners did request an extension of time to file. Although petitioners initially seemed to dispute the filing of a request for extension by the LLC, in the end the parties did not dispute the fact that the return was filed late without an extension request. The IRS imposed the IRC 6699 penalty for late filing applicable to the situation of a late filed LLC return (also known as the delinquency penalty) and did not obtain written supervisory approval before doing so. The computer code on the transcript of account indicated that the IRC computer automatically imposed the penalty. As you probably know, the taxes reported on the return flowed through to the owners and the LLC had no taxes to pay on the return it late filed.

Petitioner argued that the request for extension filed by the individual members of the LLC should suffice because it was really the tax returns of the members of the LLC where the taxes would show up after flowing through the LLC. Petitioner also argued that for 2013 the individuals filed an extension and the LLC did not. Even though the LLC also filed late in 2013 under precisely the same circumstances that existed in 2012, the IRS abated the penalty for 2013 while refusing to do so for 2012. Petitioner argues that the IRS should similarly abate the penalty for 2012 based on its actions in 2013. The court explains why both of these arguments are losers. Since these arguments do not impact the IRC 6751 issue, I will not go into the reasons the court did not accept these arguments except to say the failure to accept these arguments came as no surprise to me.

As we have discussed before in many posts, IRC 6751(b) generally requires that the IRS obtain the approval of the immediate supervisor of the employee proposing the imposition of a penalty; however, IRC 6751(b)(2) contains two exceptions to this general rule. First, the IRS need not obtain prior approval if the liability imposed is an addition to tax under IRC 6651, 6654 or 6655. Second, prior approval is not needed for “any other penalty automatically calculated through electronic means.” The exceptions mesh with the statutory purpose of stopping the IRS from using penalties as a bargaining chip. In situations in which the IRC computer imposes penalties without anyone thinking about it, it becomes difficult to think that the penalty served as a bargaining chip.

The issue of the application of the exception to these facts is squarely teed up here because the IRS argued the exception applied and petitioner argued that it did not. So, the court set out to resolve this clear dispute.

First, the court notes that the penalty imposed in this case, the IRC 6699 penalty, is not one of the three additions to tax excepted from prior supervisory approval in IRC 6751(b)(2)(A). So, it moves on to the issue of whether the penalty imposed here fits into the exception in IRC 6751(b)(2)(B) as a penalty calculated through electronic means. The court notes that neither the statute nor the regulations define the terms “automatically calculated” or “electronic means.” It goes on to fill in that gap – one of many in this statute.

The court explains that the calculation of the IRC 6699 penalty occurs based on a simple formula designed around the number of shareholders and the number of months late, times $195. The calculation of the penalty requires no thought concerning the appropriate amount for the circumstances. The court stated: “if one knows the number of shareholders, the date the return was due, and the date it was filed, then the amount of the penalty is a simple and automatic computation.”

The court then notes that the IRS calculates the penalty automatically using its computer program. It states in a footnote that it could imagine possible circumstances in which IRC 6699 penalties might occur outside of the computer program; however, in this case that did not occur. As a result of its reasoning, the court concludes that the IRC 6699 meets the requirement of the exception to IRC 6751(b)(2)(B). The result here seems so straightforward that the court engages in little analysis at the end of this discussion having methodically walked through the applicable provisions.

The case had two small procedural issues in addition to the IRC 6751(b)(2)(B) issue. First, petitioner argued that the IRS should not have offset a 2013 overpayment to partially satisfy the 2012 liability prior to the conclusion of this case. The court pointed out that IRC 6330 prevents the IRS from collection by means of levy but does not stop the IRS from using its offset powers. Second, petitioner received its day in court despite the fact that the IRS treated the CDP hearing as an equivalent hearing. It did so because it demonstrated the timely mailing of its CDP request although the court does not spend time on this issue during the opinion.

The opinion covers the application of IRC 6751 to one of the many penalties imposed by the Code. This particular penalty had not been the subject of a prior precedential opinion. The result should surprise no one. As we forecast when IRC 6751 burst into full blossom and as Judge Holmes has eloquently pointed out on a number of occasions, the many permutations of IRC 6751 will continue to keep the court busy for some time to come.

An IRC 6751 Decision Regarding the Initial Penalty Determination

In Palmolive Building Investors, LLC v. Commissioner, 152 T.C. No. 4 (2019) the Tax Court addressed one of the issues presented by the language of IRC 6751 regarding the initial determination of a penalty. Unlike the Walquist case involving IRC 6751 discussed here, the petitioner in the Palmolive case had excellent counsel and pursued the case without the distractions present in Walquist. Still, the taxpayer lost in is effort to knock out the penalty for IRS’s failing to follow the statute.

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The petitioner in Palmolive filed a partnership return claiming a huge charitable contribution for a façade easement. In an earlier decision the Tax Court sustained the IRS determination disallowing the deduction. At issue in this opinion is the correctness of the related penalty determination. The IRS not only disallowed the claimed contribution deduction, but the revenue agent (RA) examining the case asserted two penalties in the alternative – a 40% penalty for gross valuation misstatement and a 20% negligence penalty. The RA obtained the approval of the immediate supervisor on a Form 5701 attached to the Notice of Proposed Adjustments.

Petitioner requested an Appeals conference. The Appeals Officer (AO) proposed issuing an FPAA asserting four alternative penalties: the two proposed by the RA plus penalties for substantial understatement and substantial valuation misstatement. The AO’s immediate supervisor signed Form 5402-c on the approval line and an FPAA was eventually issued determining the imposition of all four penalties in the alternative.

An issue that the court does not decide concerns whether the 40% gross valuation misstatement also includes the 20% penalty. The IRS position was that approval of the 40% penalty necessarily included the lesser penalty if the valuation ultimately supported the lower penalty amount. Taxpayer contested this assertion. The court found that since the notice issued by Appeals included both and since the court found the additional penalties added by Appeals met the requirements of IRC 6751, deciding the issue of whether the 40% penalty necessarily included the lower penalty was unnecessary here.

The Tax Court begins its analysis by noting the statutory language.

Section 6751(b)(1) provides: No penalty under this title shall be assessed unless the initial determination of such assessment is personally approved (in writing) by the immediate supervisor of the individual making such determination * * * .

At issue here is whether there can be more than one initial determination. The court noted that Congress sought to keep the IRS from using penalties as a bargaining chip in passing IRC 6751. The court finds:

on the undisputed facts, we hold that the “initial determinations” are those by Agent Wozek on or before July 2008 and by Appeals Officer Holliday in June 2014.

Petitioner argued that the RA did not propose and his supervisor did not approve all of the penalties. Therefore, because the RA’s determination was the initial determination, the subsequent determination by the AO does not meet the requirement of the statute. The court dismisses this argument stating:

Section 6751(b)(1) includes no requirement that all potential penalties be initially determined by the same individual nor at the same time.

Petitioner also argued that the IRS failed to follow its Internal Revenue Manual provisions which require that the case history reflect the decision to impose the penalty. The court replied that the IRM

does not have the force of law, is not binding on the IRS, and confers no rights on taxpayers.’” Thompson v. Commissioner, 140 T.C. 173, 190 n.16 (2013) (quoting McGaughy v. Commissioner, T.C. Memo. 2010-183, slip op. at 20).

The court found that the supervisory approval need not occur on a specific form and that the form used need not reference the employee recommending the imposition of a penalty.

This decision gives the IRS much more flexibility in meeting the requirement of IRC 6751 than the taxpayer’s arguments would have permitted. The IRS still must show supervisory approval at each level at which a new penalty is imposed, but the decision provides it with much latitude in how to accomplish the approval. The term “initial” in the statute does not limit the IRS to getting it right at the first step or else forgoing a penalty. The decision lines up with the purpose of the statute. Since the statute provides a difficult procedural roadmap for the court to follow, perhaps having the decision line up with the purpose is the primary goal to seek when writing an opinion on this topic.

Automatically Generated Penalties Do not Require Managerial Approval

This is the first of several posts on precedential cases decided by the Tax Court earlier this year regarding the IRC 6751 provision requiring preapproval by a manager before the assertion of certain penalties. The case of Walquist v. Commissioner, 152 T.C. No. 3 (February 25, 2019) represents the type of case that one might wish had been litigated by a petitioner other than a pro se petitioner that did not engage in the process; however, the outcome would almost certainly have been the same with a more robust litigation participant. In the Walquist case the Tax Court addresses the imposition of a penalty in a setting in which the IRS argues that automation removes the need for prior managerial approval. The court agreed.

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The IRS sent the Walquists a statutory notice of deficiency for 2014 determining a liability over $13,000 and a related accuracy penalty. Although petitioners earned almost $100,000 in 2014, on their return they claimed a deduction for almost the same amount based upon a “Remand for Lawful Money Reduction,” a tax protestor type claim. The IRS disallowed this claimed deduction resulting in the deficiency determined. The IRS handled the case through its Automated Exam Correspondence Unit designed to minimize the amount of human involvement in the audit.

The Automated Exam process generated a 30-day letter to petitioners. Because the amount of the liability determined through the process exceeded $5,000, the program automatically placed on the notice an accuracy related penalty of 20% of the liability. Petitioners did not respond to the 30-day letter, resulting in the issuance of the SNOD. Petitioners timely filed a petition with the Tax Court in which they continued to assert tax protestor type arguments. The tax protestor activity did not stop and the court gives a detailed accounting of the time wasting efforts of petitioners before it ultimately imposes the IRC 6673 penalty because of their post-petition actions. I will not describe this aspect of the case as it is relatively boring.

The ultimate finding of the court with respect to the requirement for managerial approval is that:

Because the penalty was determined mathematically by a computer software program without the involvement of a human IRS examiner, we conclude that the penalty was ‘automatically calculated through electronic means,’ sec. 6751(b)(2)(B), as the plain text of the statutory exception requires.

The court goes on to say that this conclusion is consistent with the description of the imposition of a penalty in this situation as described in the Internal Revenue Manual and the context in which the statutory exception appears in IRC 6751. Computer generated penalties do not raise the concerns that caused Congress to enact IRC 6751 because no one is imposing them in order to influence to taxpayer to accept the liability or otherwise to coerce an outcome. The court stated that if the penalty imposed under these circumstances fails to meet the statutory exception it is difficult to imagine a penalty that would meet the exception.

The court noted that its conclusion in this precedential opinion was consistent with unpublished orders that it had issued in recent years. Another reason for paying attention to those orders.

The result here makes perfect sense. The IRS did not impose this penalty as a bargaining chip. The court provides a detailed analysis for its decision. Perhaps the only thing surprising about the opinion is that a precedential opinion on this issue did not previously exist. Although petitioners did nothing to advance their argument that the exception should not apply, their failure did not create the result in this case.

The decision here was the first of several precedential IRC 6751 opinions issues in the first few months of the year as the court continues to answer the questions raised by this unusual statute. We will cover all of the opinions in the coming days.

Tenth Circuit Agrees with Graev II – IRS Attorney Can Impose Penalties

The case of Roth v. Commissioner raises again the issue of whether the IRS can raise a penalty once the case arrives in Tax Court. In certain cases the IRS attorney assigned to a case once the taxpayer files a Tax Court petition sees a penalty issue that the examination division did not. In the Roth case, the IRS attorney raised an additional penalty in answering the petition. Because the answer will always receive a review from the docket attorney’s supervisor, the raising of the penalty in the answer does receive supervisory approval in the Office of Chief Counsel. At issue is whether IRC 6751 permits the raising of the penalty at that stage of the case.

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The Roths donated land to a conservation easement and valued the contribution at almost $1 million. The Tenth Circuit characterized their case as follows:

The Roths’ case is one of the so-called “gravel-pit cases” in which Colorado taxpayers claimed large deductions based on the appraisal and donation of conservation easements prohibiting the mining of gravel on what had historically been farmland. The IRS later determined these easements to be effectively worthless (or worth drastically less than the taxpayers claimed) because the subject farmland was more valuable as farmland than it would be if mined for gravel. Esgar Corp. v.Comm’r, 744 F.3d 648, 658 (10th Cir. 2014).

The revenue agent who audited the case disallowed the easement deduction almost in its entirety and imposed the 40% gross overvaluation penalty after obtaining the appropriate managerial approval. The Roths went to Appeals where the appeals officer made what the IRS characterized as a clerical error by reducing the penalty from 40% to 20%. The manager in the Appeals Office approved the report of the appeals officer and the notice of deficiency contained the 20% penalty. The Roths then filed a Tax Court petition. In answering the petition, the IRS attorney, and her supervisor, responded by asserting the 40% penalty. While appeals officers almost never raise new issues in a case, Chief Counsel attorneys regularly raise new issues that they spot when working a case. The ability and the willingness of Chief Counsel attorneys to raise new issues should cause taxpayers to think about potential issues in their cases before filing a Tax Court petition in knee jerk fashion. As happened here, filing the petition can result in more taxes than the IRS asserted in the notice of deficiency.

The Tax Court sustained the penalty, noting that the IRS had obtained the appropriate approvals at every step and that the IRS can change the penalty at the Tax Court stage if it acts appropriately in obtaining the penalty approval.

On appeal, the Roths acknowledged that the IRS obtained supervisory approval at every step but argued that the notice of deficiency contains the initial determination of the penalty locking the IRS into the amount of penalty in the notice. While the Tax Court and the Second Circuit had approved the initial raising of a penalty by a Chief Counsel attorney at the Tax Court stage, the issue was one of first impression in the Tenth Circuit and only the second time this issue has reached a circuit court. The Roths also framed the issue in a slightly different way than prior cases. The Tenth Circuit described the issue before it as follows:

In short, the Roths raise a narrow question of statutory construction: whether the statutory notice of deficiency constitutes the IRS’s § 6751(b) initial determination. To answer this question, after stating the standard for our review, we consider the meaning of § 6751(b) generally before applying that meaning to the facts before us.

The Tenth Circuit noted that the Roths raised a legal question which required it to give a de novo review. So, like other courts before it the Tenth Circuit began to try to interpret the puzzling language of IRC 6751 in order to determine if the word “initial” in the statute had the meaning offered in the taxpayer’s arguments. Because of prior cases seeking to make this same determination, the Tenth Circuit did not operate without the guidance of the prior judges who had struggled to fit the language of the statute into the norms of tax procedure. It stated:

Given these accepted definitions, § 6751(b)’s phrase “the initial determination of such assessment” poses an obstacle to plain-language interpretation. The Code does not require, or even contemplate, that “assessments” will be “determined.” See Chai, 851 F.3d at 218–19 (“[O]ne can determine a deficiency, and whether to make an assessment, but one cannot ‘determine’ an ‘assessment.’” (quoting Graev v. Commissioner (Graev II), 147 T.C. 16, No. 30638-08, 2016 WL 6996650 (2016) at *31 (Gustafson, J., dissenting) (internal citations omitted))). Indeed, the IRS has seemingly little discretion to make any determination with respect to the assessment of a liability.

The Tenth Circuit agreed with the Second Circuit that the language of IRC 6751 is ambiguous. So, it began to look at legislative history in order to find an answer to the meaning of the language. It found that the purpose of IRC 6751 was to prevent “rogue” IRS agents from proposing penalties in order to get taxpayers to agree to their adjustments. Having determined why Congress enacted the provision, the Tenth Circuit then set off to determine how it should apply the language of the statute given the facts in the Roths’ case.

According to the Tenth Circuit, nothing in the statute requires that the IRS include its initial determination in the notice of deficiency. It finds that the determination of the revenue agent could be viewed as the initial determination but also that the determination of the IRS attorney could be viewed as the initial determination as well. The court noted that the statutory scheme for the Tax Court clearly contemplates that the IRS can add additional liabilities and that adopting the position of the Roths would undermine that statutory context in which this question arose.

As its final reason for rejecting the argument of the Roths, the Tenth Circuit mentions that to accept their argument would upset Tax Court jurisprudence and it does not want to lightly do that. It cites to the Supreme Court case of Dobson v. Commissioner, 320 U.S. 489, 502 (1943). In the Dobson case the Supreme Court briefly flirted with the notion that Tax Court decisions should be given special deference because of the expertise of the Tax Court. Justice Jackson, a former Chief Counsel, IRS, argued for such a result but I had thought the case had very little viability at this point.

The decision here follows the decisions in the Second Circuit and the Tax Court. It adds little to the jurisprudence other than adding another circuit to those interpreting IRC 6751 to allow Chief Counsel attorneys to add penalties. Since the statute makes little internal sense, the court’s decision to pursue legislative history in trying to find an answer makes sense and fits with the approach of earlier courts that have wrestled with the provision. Still, it’s possible that other taxpayers will continue to attack this position in hopes that a court will back another interpretation of a confusing statute.

Application of Chenery to Supervisory Affidavits in Graev Cases

Ray Cohen, a faithful reader and a CPA in Paramus, New Jersey, asks the following question of other readers and invites them to send comments to the post to help him work through the answer. Keith

When the original signature of the immediate supervisor is missing, the IRS attempts to get around this by using an affidavit of the immediate supervisor. Attempts have been made to defeat the affidavit by calling it hearsay. Unfortunately, the court have not accepted this argument. SEC v Chenery Corp (Chenery II) 332 U.S.194 (1947) might be the answer. Does anybody think so?

Section 6751(b)(1) states that “[n]o penalty under this title shall be assessed unless the initial determination of such assessment is personally approved (in writing) by the immediate supervisor of the individual making such determination….”
According to Notice CC-2018-006 from the Office of Chief Counsel, supervisory approval is required when the IRS “files an answer or amended answer asserting penalties. In Graev v Commissioner III, it states that “IRC Sec. ‘6751(b)(1) requires written approval of the initial penalty determination no later than the date the IRS issues the notice of deficiency ((or files an answer or amended answer)asserting such penalty’, id. At 221.

While the Federal Rules of evidence permit the use of affidavits, the IRS rules and chief counsel require original signatures in asserting a penalty.

SEC v Chenery Corp (Chenery II)332 U.S.194 (1947) states “ That rule is to the effect that a reviewing court, in dealing with a determination or judgment which an administrative agency alone is authorized to make, must judge the propriety of such action solely by the grounds invoked by the agency. If those grounds are inadequate or improper, the court is powerless to affirm the administrative action by substituting what it considers to be a more adequate or proper basis. To do so would propel the court into the domain which Congress has set aside exclusively for the administrative agency.“

Putting IRS Records at Issue: Proving Supervisory Approval and Receipt of Notice of Deficiency. Designated Orders 9/10/28 – 9/14/18

We welcome designated order blogger Caleb Smith from the University of Minnesota with this week’s discussion of the orders the Tax Court has deemed important. Keith

Taxpayers routinely get into problems when they don’t keep good records. At least in part because of the information imbalance between the IRS and taxpayer, when the IRS reviews a return and says “prove it” the burden is (generally) on the taxpayer to do so. Attempts by the taxpayer to turn the tables on the IRS (“prove you, the IRS, have good reason to challenge my credit, etc.”) are unlikely to succeed.

However, there are areas where demanding the IRS “prove it” can be a winning argument. Not unsurprisingly, these are areas where the information imbalance tips to the IRS -in other words, procedural areas where the IRS would have better knowledge of whether they met their obligations than the taxpayer would. We will dive into two designated orders that deal with these common areas: (1) proving supervisory approval under IRC § 6751, and (2) proving mailing in Collection Due Process (CDP) cases. Because it gives a better glimpse into the horrors of IRS recordkeeping, we’ll start with the CDP case.

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Summary Judgment Haunts the IRS Once More: Johnson & Roberson v. C.I.R., Dkt. # 22224-17L (order here)

Judge Gustafson has tried on numerous occasions to explain what is required for a motion for summary judgment to succeed. Those lessons generally involved motions that failed to fully address relevant legal questions or put forth necessary facts through affidavits, exhibits, and the like.

The IRS motion for summary judgment in this case goes, perhaps, one step further: claiming that facts aren’t “subject to genuine dispute” and, as evidence, attaching documents that seem to prove only that the facts ARE subject to genuine dispute. More on the nature of those documents (and what they say about IRS recordkeeping) in a second. But first, for those keeping score at home, this order also provides a new addition to the list of “signs the judge is not going to rule in your favor”: when the judge finds it necessary to remind a party that they are “responsible for what is asserted in a motion that he signs and files.”

Law students are taught about the potential horrors and responsibilities of FRCP Rule 11. The idea is to imprint upon their mind the responsibilities in making representations to the court, such that Rule 11 will not become something they will need to be reminded of later in practice. A Tax Court judge referencing Rule 33(b) in response to your motion is fairly close to a reminder of that 1L Civil Procedures lecture, and may on its own trigger some unwanted flashbacks.

So what went so horribly wrong in this motion for summary judgment that the IRS needed to be reminded of the “effect of their signature” on that motion? To understand that, we need to first understand what is at issue.

The pro se petitioners in this case wanted to argue their underlying tax liability in the CDP hearing, but were denied the opportunity to do so by Appeals. For present purposes, if the petitioners could show they “did not receive any statutory notice of deficiency (SNOD)” then they can raise the underlying tax as an issue in the CDP hearing. See IRC § 6330(c)(2)(B). Also for present purposes, receiving a SNOD means actual receipt, not just that it was mailed to the last known address.

When a petitioner puts actual receipt of an SNOD at issue in a CDP hearing, the typical song-and-dance is for the IRS to offer evidence that the SNOD was properly mailed to the actual residence of the taxpayer at the time. Since there is a presumption that the USPS does its job (that is, properly delivers the mail), it is usually an uphill battle for the taxpayer to argue “yes, I lived there, but no, I never got that piece of mail” -especially since SNODs are sent certified and refusing to accept the mail is just as good as receiving it. See Sego v. C.I.R., 114 T.C. 604 (2000).

So for this summary judgment motion the IRS basically needs to put out evidence showing that the SNOD was mailed and received by the petitioners, and that the fact of receipt is not subject to genuine dispute. The evidence the IRS puts forth on that point is, shall we say, lacking.

Judge Gustafson immediately finds some issues with the IRS records that, while not proving a lack of mailing, “does not inspire confidence.” First is a dating issue: the SNOD is dated 3/28/2016, but the mailing record only shows a letter (not necessarily the SNOD) going out 3/24/2016 (that is, four days earlier than the SNOD is dated). I don’t put much faith in the dates printed on IRS letters, so this is not particularly surprising to me, but the inconsistency does throw a little doubt on the credibility of the IRS records. Further, Judge Gustafson notes that there is no “certified mail green card bearing a signature of either petitioner” that the IRS can point to.

It seems pretty obvious from the outset that the actual receipt of the SNOD is a fact “subject to genuine dispute.” First, the taxpayers request for a CDP hearing (Form 12153) appears to reflect ignorance of any SNOD being sent. But far, far, more damning are the IRS Appeals CDP records on that point. The “Case Activity Record” speaks for itself:

Dated March 30, 2017: “Tracked certified mail number and found that as of April 16, 2016, the status of the SNOD is still in transit for both taxpayers, therefore, it is determine[d] that the taxpayers did not receive the SNOD.”

There you have it. IRS Appeals has found that there was no receipt of SNOD. The taxpayer is also arguing there was no receipt of SNOD. IRS Counsel is arguing that “petitioners had a prior opportunity to dispute their underlying liability pursuant to the notice of deficiency” and therefore are precluded from raising it in the CDP hearing. With utmost charity, the IRS argument could potentially be saved if it was arguing that there was another opportunity to argue the tax (which, of course, would require other facts). But that is not what is happening.

The IRS motion explicitly asserts (as a fact) receipt of the SNOD by petitioners on March 28. 2016. As evidence of that fact, the IRS attaches “Exhibit 1” and “Rubilotta Declaration, Exhibit D.”

Unfortunately, “Exhibit 1” is just the mailing list (which simply shows a letter being sent four days before the SNOD date, and says nothing about receipt), while “Exhibit D” is apparently just the SNOD itself. Basically, the IRS is trying to get summary judgment against pro se taxpayers based on evidence that, at best, shows that the only thing certain in the matter is that there is a big, genuine issue of material fact. Judge Gustafson is not impressed, finds against the IRS on every point, casually mentions Counsel’s responsibilities vis a vis Rule 33(b), and appears on the verge of remanding to Appeals.

One may read this order as a FRCP Rule 11/Tax Court Rule 33(b) lesson, and the importance of due diligence before the court. It definitely provides a lot to think about on those points. But I would note that IRS Counsel’s follies in this case did not go unassisted. Specifically, IRS Appeals did not do their job. Although the settlement officer (SO) specifically found that the SNOD was not received by the taxpayers, the SO also determined “the taxpayer is precluded from raising the tax liability due to prior opportunity” to argue the tax. That is arguably what led to the taxpayer bringing this petition in the first place. Without SNOD receipt this outcome could conceivably be correct, but it would take more explanation from the SO as to what the prior opportunity was. Instead, the poor record-keeping and poor file review was preserved from Appeals to Counsel, culminating in the rather embarrassing order being issued.

Chai/Graev Ghouls and Recordkeeping: Tribune Media Company v. C.I.R., Dkt. # 20940-16 (order here)

Analysis of the IRS burden of proof in penalty cases, and specifically in proving compliance with IRC § 6751 need not be rehashed here (but can be reviewed here among many other places, for those that need a refresher).  Tribune Media Company doesn’t break any new ground on the issue, but it does provide some practical lessons for both the IRS and private practitioners in litigating IRC § 6751 issues.

The first lesson is one that I suspect the IRS already is in the process of correcting, post-Graev. That lesson is on the value of standardizing penalty approval procedures. The IRS loves standardized forms. This isn’t an arbitrary love: the constraints of the IRS budget and the sheer volume of work that goes into administering the IRC pretty much requires a heavy reliance on standardized forms.

The IRS already has standardized forms that it can and does use for penalty approval, but the Service was likely far more lax in tracking (or actually using) those forms pre-Graev. And although Graev/IRC § 6751 does not require a specific “form” as proof of supervisory approval (it simply must be written approval), things can get needlessly complicated if you draw outside the lines. Tribune Media Company demonstrates this well.

As a (presumably) complicated partnership case, there were numerous IRS employees assigned to Tribune Media Company at the audit stage. At the outset there was both a revenue agent and an attorney from local IRS counsel assigned to assist the revenue agent. Both of these parties, apparently, came to the determination that a penalty should be applied, and both received oral approval from their separate immediate supervisors before issuing the notice of proposed adjustment.

Of course, oral approval of the penalty is not enough. So the IRS has to provide something more… What would usually, or hopefully, be a readily available and standardized penalty approval form. Only that form does not appear to exist in this case. The IRS tries to comply with Tribune Media Company requests for documents showing supervisory approval largely through memoranda of the supervisor, email chains and handwritten notes (pertaining to the penalties, one assumes). But these “irregular approvals” aren’t good enough for Tribune Media Company… so formal discovery requests ensue.

Which leads to the second lesson: don’t expect success when you ask the Court to “look behind” IRS documents.

Judge Buch’s order does a good job of detailing the standards of discovery in tax court litigation. Generally, the scope of discoverable information in Tax Court Rule 70(b) is not significantly different from the Rules of Federal Civil Procedure. However, because the Tax Court will not examine “the propriety of the Commissioner’s administrative policy or procedure underlying his penalty determinations” (see Raifman v. C.I.R., T.C. Memo. 2018-101), any discovery requests that could only be used to “look behind” the IRS determination will be shot down.

So when Tribune Media Company requests documents (1) “related to the Commissioner’s consideration, determination, or approval of penalties” and (2) “all forms, checklists, or other documents” the IRS generally uses for memorializing penalty approval they are going a step too far. The IRS has to provide proof of written supervisory approval for the penalties. Full stop. They do not have to provide any detail on the reasoning that went into the penalties, or (arguably) what the typical approval documents would be in this sort of case. (I wonder about this latter issue, as it seems to me it could properly be used by Tribune Media Company for impeachment purposes).

In the end, there appears to me some irony to the Tribune Media Company case. It seems highly likely that there was supervisory penalty approval, or at least a reasoned process leading to the penalty determination. The IRS is better off from a litigating perspective, however, streamlining penalty determination with rubber stamp (or worse, “automated”) approval on standardized forms.

I understand the Congressional desire to keep the IRS from using penalties as “bargaining chips,” but am not convinced that “written supervisory approval” really does much to advance that goal. What I am more worried about, especially in working with low-income taxpayers, is when accuracy penalties are more-or-less arbitrarily tacked on to liabilities in ways that do nothing to help compliance. In those cases, at least with the proper training, I think that supervisory approval could actually result in reducing the number of ill-advised penalties -they aren’t really being proposed as “bargaining chips” in the first place. Instead you have what increasingly looks like a bad-actor loophole -one which may, depending on how things develop with IRC § 6751(b)(2)(B) as applied to AUR, not even be available for the most vulnerable and least culpable taxpayers.

Odds and Ends: Other Designated Orders.

Two other designated orders were issued which will not be discussed. One fits the usual narrative of taxpayers losing in CDP when they do not participate in the CDP hearing, or do much of anything other than file a timely tax court petition (found here). The other provides a quick-and-dirty primer on IRC 351 transfers, and easily disposes the matter in favor of the IRS (found here).