A Drama in Three Acts: Designated Orders Jan. 13 – 17 (Part One of Three)

Sometimes I think the Tax Court Judges like giving me extra work by putting really substantive and interesting issues in designated orders. The week of January 13, 2020 was certainly one of those weeks. So much so, that it warrants (at least) three posts on two orders. Let’s start with our familiar friends (Graev and petitioners failing to prosecute) before moving on to new ones (the Accardi doctrine).

Part One: Tax Court, the Commitment to Getting the Right Tax… And Graev. Meyers v. C.I.R., Dkt. # 8453-19 (order here)

On a cold, winter’s eve I recently watched the critically-acclaimed “Marriage Story” on Netflix. Perhaps because I am unmarried and don’t have kids, what I found most compelling about the film was the portrayal of the family law attorneys -specifically, how incredibly different and adversarial their dynamic is from my own experience in tax. I finished the movie feeling uplifted… about my choice to go into tax law. The Meyers bench opinion was a similarly uplifting story: a reaffirmation that the Tax Court (and generally IRS Counsel) care mostly about getting the right amount of tax, and not simply the most amount of tax.

Of course, since this blog focuses on tax rather than romance (and only rarely the twain shall meet), my post will be on the interesting procedural aspects that arise. Luckily, this case provides a few such lessons that are worth taking a look at.

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“Meyers Story” features a husband and wife in deficiency proceedings for, shall we say, “unlikely” deductions that the IRS disallowed. I will note a few of them for the sake of levity: (1) that 94% of their home was a “home office”, (2) that the husband’s remarkably unprofitable model airplane “business” was not subject to the hobby-loss limits, and (3) that his purchase of model airplanes were ALSO deductible advertising expenses for his (again, remarkably unprofitable) real estate “business.” These are but a few of the many improper deductions at play. Somehow, the case went to trial.

And that is where things get procedurally interesting. For this is not the time-worn tale of taxpayers filing a petition and then just moving on in their life. No, petitioners took many more steps than to simply “file-and-forget.” In fact, they almost saw the case to completion. They filed stipulations with the Court. They even showed up to Court and testified… but only for half of the trial.

Because of the numerous issues that had to be hammered out, the trial was set to span two days. The wife was able to wrap up her part on day one, which was helpful since she appears to work a fairly lucrative (six figure) job. The husband, on the other hand (whose sources of income are less clear) only had time on day-one to finish direct questioning: that is, to give his own testimony. He was set to come back on day two to face cross-examination. After reading the tea-leaves, however, Mr. Meyers decided against facing IRS questioning: in his opinion Judge Gustafson had “already made up his mind -it’s going to be a waste of time.” This was expressed in an email to IRS counsel before the second day of trial. The Court called Mr. Meyers and left a message explaining that he was required to show up to Court, but Mr. Meyers ignored it. Accordingly, the IRS moved that the case be dismissed for failure to prosecute and for the imposition of an IRC 6673 penalty.

So what is Judge Gustafson to do? Grant both motions and leave it at that? To appreciate the dilemma(s) facing Judge Gustafson, let’s look at what is supposed to happen when a case is dismissed for failure to prosecute.

Tax Court Rule 123(b) provides that when a case is dismissed for failure to properly prosecute the court may enter a decision against the petitioner. But can that decision (for our purposes, the deficiency amount) be whatever the Court wants? Does it have to be what the IRS wants, and if so is that simply the amount on the Notice of Deficiency?

The statute on point provides guidance, but some wiggle-room. IRC 7459(d) provides that the Court’s dismissal of a case (other than for lack of jurisdiction) “shall be considered as its decision that the deficiency is the amount determined by the Secretary.”

I think that could reasonably be read as “dismissal = affirming whatever is in the Notice of Deficiency” since that would appear to be the IRS determination that led to the case being brought. The code section doesn’t specifically direct that outcome -arguably, “the amount determined by the Secretary” could be more than the Notice of Deficiency if new issues were raised in the Answer, though that gets into hairy “presumption of correctness” issues not at play in Meyers.

However, more often the Tax Court and IRS are willing to enter a decision for an amount less than the Notice of Deficiency when a case is dismissed. As Judge Gustafson notes, “it is the frequent practice of this Court -often at the instance of the Commissioner to dismiss a case for failure to prosecute but to enter a decision in a deficiency amount smaller than what appears in the SNOD.”  Usually, this happens when the IRS has conceded some issues, but, Judge Gustafson notes, that isn’t the only circumstance: “we prefer […] to enter a decision based on the facts demonstrated by the evidence rather than as a punishment.” In other words, even when you have a bad actor that doesn’t prosecute their case and the IRS is standing by the SNOD the Court wants the right amount of tax when there is reason to believe the SNOD may be off.

Getting the right amount of tax rather than the most amount of tax… My eyes aren’t teary, I just have winter allergies.

Of course, the Tax Court does not take lightly the petitioner’s failure to prosecute. Judge Gustafson calls the failure to appear for cross “a most serious offense against the process” in our adversarial system, and does not wish to “reward[] the petitioner for his non-appearance.” But again, that isn’t enough to “punish” the taxpayer with an amount of tax that may be incorrect, so Judge Gustafson walks through the merits as if the case had been seen through to fruition.

Because a lot of the issues come down to the credibility of evidence, and because the petitioners have proven themselves to be extraordinarily non-credible (a little more on that in a moment), the vast majority of deductions are denied. Some deductions, however, are more mechanical. Judge Gustafson has no problem completely disallowing the ridiculous home office deductions, but notes that since 94% of the home mortgage interest payments were attributed to this (i.e. deducted on Schedule C), the petitioners should likely get that foregone 94% as an itemized deduction (i.e. deducted on Schedule A instead).

In sum, the SNOD was likely correct to disallow (almost) all the deductions, but it still didn’t quite get the right amount of tax after that. So we arrive at the procedural fix: what I’d style as a “conditionally” granted motion to dismiss. The IRS’s motion to dismiss is granted but only to the “extent of undertaking to enter decision in amounts of tax deficiencies smaller than those determined in the SNOD[.]” In other words, the case is dismissed, and a decision will be entered, but in an amount determined under Rule 155.

Everything appears to be neatly wrapped up. Except that there were two motions at play, and we have only resolved the motion to dismiss. What about the motion to impose sanctions under IRC 6673?

On the merits of the penalty, there is more to this than just the petitioner failing to show up for day two and taking egregious deductions. Petitioner husband pretty obviously created a fake receipt (one may say, committed fraud on the Court) for a charitable deduction from Habitat for Humanity, by altering the date to make it fall within the tax year at issue. Judge Gustafson doesn’t use the word “fraud,” but instead concludes that the husband “deliberately concocted a non-authentic receipt and tried to make the Commissioner and the Court assume it was authentic.” Fraud-lite, you may say.

Let’s just assume that the behavior and absurdity of the deductions are enough on the merits to warrant a penalty under IRC 6673. Are there any other hurdles that the IRS must clear?

Why yes, there (apparently) is: our old friend Graev and IRC 6751. Like any good story, this provided an unexpected twist. Although the penalty is proposed by motion, orally, at trial, Judge Gustafson finds that it would (likely) need written supervisory approval first. The IRS attorney had, in fact, asked their supervisor about the possibility of moving for an IRC 6673 penalty via email. But the supervisory response was simply “Print these for the court, please.” Cryptic, and apparently not enough to demonstrate approval.

The tax world has been abuzz recently with published opinions on IRC 6751. Procedurally Taxing has covered some here and here. Here, again, we have a designated order as bellwether for an emerging issue: none of the cases have ruled on whether written supervisory approval is needed in this context (i.e. a motion for court sanctions at trial). I fully anticipate that this order will result in either the IRS changing their procedures for such motions, or (less likely, in my opinion) litigating the issue.

Is that the end of the Myers saga? Not quite. In one final twist, we are reminded that the Court could impose the penalties sua sponte (perhaps “nudged” by the IRS motion). And the Court has (conveniently) found that it does not need written supervisory approval for imposing such penalties. See Williams v. C.I.R., 151 T.C. No. 1 (2018).

But in this instance Judge Gustafson decides to let them off with a warning and an indication that the Court may not be so forgiving in the future. A tantalizing cliff-hanger for the possibility of a sequel…

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.

Belair Woods – The Ghouls Continue

In the recent case of Belair Woods, LLC v. Commissioner , 154 T.C. No. 1 (2020) the Tax Court once again goes into its court conference room to have a discussion about the fallout from the Graev opinion and IRC 6751(b).  Because Congress is really slow and has been sitting on his reappointment for a long time, neither the court nor we as consumers of the court’s opinions have the benefit of Judge Holmes’s views on the most recent iteration of a procedural statute written by someone with no background in tax procedure.  This post is dedicated to him and his coining of the term ‘Chai Ghouls’ to describe the many situations the Tax Court would face in trying to provide meaning to this statute.  So, the court is once again tasked with making sense out of nonsense. 

The court deeply fractures, again, over what to do with this statute, and this time it is deciding when the IRS must obtain supervisory approval of the decision to impose the penalty.  The taxpayer argues that the approval must come at the first whiff of the imposition of the penalty, because even at the earliest stages, mention of the imposition of a penalty can cause the penalty to be used as a bargaining chip and that’s what Congress seemed to be wanting to prevent.  This is a logical argument and persuades almost half of the voting judges.  Judge Lauber, writing for a plurality, picks a later time period – the issuance of a formal notification and finds that the IRS had obtained the appropriate approval by that point (for most of the penalties in contention.)

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The case involves a TEFRA partnership.  Normally, in a TEFRA partnership, the IRS issues a 60-day letter (much like the 30-day letter outside TEFRA) and finally an FPAA (the ticket to the Tax Court that is the basis of this case).  Here, the IRS got managerial approval of the penalty before the 60-day letter, which showed a penalty.  Problem is that about two years earlier, the agents had sent a calculation of the potential 60-day letter income adjustments (including showing the penalty) to the partners and suggested a conference to discuss what was effectively this proposed 60-day letter.  But, the agents did not obtain penalty approval before sending this pre-60-day letter. 

Judge Lauber plus seven judges hold that it is time to create as bright a line as possible, citing United States v. Boyle, 469 U.S. 241, 248 (1985) (bright-line rule for late-filing penalty in the case of filing agents), and that the required approval moment should be when a penalty “is embodied in the document by which the Examination Division formally notifies the taxpayer, in writing, that it has completed its work and made an unequivocal decision to assert penalties.”  In this case, the pre-60-day letter was just a proposal.  It was not the critical moment.  Judge Lauber cites the opinion in Kestin v. Commissioner, 153 T.C. No. 2, at slip op. pp. 26-27 (2019), for the similar proposition that a letter suggesting section 6702 penalties might be applied if the taxpayer does not correct a frivolous return is also not a critical moment for managerial approval under section 6751(b).

In a separate concurring opinion, Judge Morrison writes:

 “On the facts of this case, I agree with the opinion of the Court that the 60-day letter was the initial determination to impose the penalties. However, I do not agree with any suggestion in the opinion of the Court that the initial determination to impose the penalties may only be ‘a formal written communication to the taxpayer, notifying him that the Examination Division has completed its work and has made a definite decision to assert penalties.’”

Judge Gustafson and six dissenters agreed with the taxpayer that the pre-60-day-letter was the critical moment for managerial approval of the penalty on these facts. Thus, only 8 of the 16 judges voted for the proposition that the initial determination to impose the penalties may only be ‘a formal written communication to the taxpayer, notifying him that the Examination Division has completed its work and has made a definite decision to assert penalties’”. It appears that there is still no bright line — at least one than can be cited outside the TEFRA partnership context of Belair Wood.

Bryan Camp has written an excellent post on this case which can be found here.  I agree with Bryan’s analysis and will not rehash why it’s a good analysis, but anyone interested in this issue should read his post.  Bryan concludes that Judge Lauber’s reasoning makes the most sense.  Because Bryan does such a good job of explaining the case and the various reasons behind the decisions made by judges on this issue, I want to focus on another issue.  Why doesn’t Congress understand what assessment means, and why doesn’t it fix an obvious mistake, instead leaving Tax Court judges to scratch their heads and spend inordinate amounts of time bonding in a conference room?

When I teach assessment, I almost always poll my students by asking how many of them have ever had taxes assessed against them.  Almost no students raise their hands admitting to such a terrible tax gaffe.  They think, like most people and certainly like most members of Congress, that an assessment is a bad thing.  In reality, assessment is a neutral act of recording a liability on the books and in most instances is a good and important act, because it is a necessary predicate to obtaining a refund of federal taxes.

The Congressional misunderstanding of assessment comes through loud and clear in IRC 6751(b).  I will circle back to IRC 6751(b), but before doing so, I want to spend a little time with an even greater screw-up by Congress in misusing the term ‘assessment’.  The greater example I want to offer is found in Bankruptcy Code 362(a)(6) passed in 1978 as part of the new bankruptcy code adopted that year.  This code replaced the bankruptcy code of 1898 which had been substantially updated in 1938.  The adoption of the new bankruptcy code in 1978 followed almost a decade of debate and discussion.

One of the primary features of the bankruptcy code is the automatic stay.  The stay protects the debtor and creditors from aggressive creditors who might seek self-help and reduce the property available to all creditors or property available to the debtor through the exemption provisions.  The stay is a good thing.  Congress placed the stay in BC 362 and in paragraph (a) enumerated 8 different things impacted by the stay.  Because the stay does not stop everything, Congress inserted in paragraph (b) a list of (now) 28 actions not stopped by the stay.  So, what went wrong?

Bankruptcy code 362(a)(6) provides:

Except as provided in subsection (b) of this section, a petition filed under section 301, 302, or 303 of this title, …, operates as a stay, applicable to all entities, of—

(6) any act to collect, assess, or recover a claim against the debtor that arose before the commencement of the case under this title;

If BC 362(a)(6) stays any act to assess that arose before the commencement of the case, then it stops the IRS from assessing the liability reflected on a return for a year that ended before the filing of the bankruptcy case.  We have had years since 1978 when over 1.5 million new bankruptcy cases were filed.  The vast majority of those cases were filed by individuals.  A decent percentage of those cases were filed during the first 3 and ½ months of the year and most of those returns sought refunds.  So, how could the IRS send to these individuals in distress their tax refund when it could not assess the liability?  Keep in mind also that in 1978 we were still in an era of paper filing.  So, the IRS would need to set these returns to the side to be processed once the stay lifted, and they would sit in rooms in the Service Centers around the country waiting for the stay to lift, so the IRS could perform the simple act of assessment and then send out the tax refund.

You can imagine that debtors in this situation did not really want to hear about the problem Congress created with the language of 362(a)(6) prohibiting assessment as though making the assessment was a bad thing.  The IRS faced a choice of what to do to avoid potentially tens of thousands of stay lift motions that would really be unnecessary if the statute were worded properly to reach its intended result.  Sixteen years later, in 1994, the IRS finally convinced Congress to amend BC 362(b)(9) to permit assessment in this circumstance.  The statutory language creating the stay on assessment still exists in 362(a)(6) as a lasting testament to Congressional misunderstanding of assessment, but finally the IRS did not have to stack returns in rooms in the Service Centers in order to move cases along.

Because it took over 15 years for problems in IRC 6751(b) to come to everyone’s attention, perhaps under the timeline of BC 362(a)(6) we still have another decade or more before Congress will get around to fixing its mistaken understanding of assessment in 6751.  The Congressional sentiment of stopping the IRS from using penalties as a bargaining chip makes sense and is probably bipartisan.  With help from the tax community, Congress could make amendments that would allow courts and the IRS to properly administer the statute. We could wish, however, that it will recognize the problem more quickly this time.  In the meantime, the court conference room at the Tax Court will continue to get plenty of use as the court tries to make sense of nonsense.

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.

The Difference between Proposed and Determined, Designated Orders August 26 – August 30

Four orders were designated during the week of August 26, including a bench opinion in favor of petitioners in Cross Refined Coal, LLC, et. al v. C.I.R. which is summarized at the end of this post. The only order not discussed found no abuse of discretion in the IRS’s determination not to withdraw a lien (order here).

Docket No. 1312-16, Sheila Ann Smith v. C.I.R. (order here)

First is another attempted development in the ever-expanding universe that is section 6751(b)(1). Petitioner moves to compel discovery related to section 6751 supervisory approval for the section 6702 penalties asserted against her while the Court’s decision is pending.

The Court first explains that some district courts have incorrectly held that the 6702 penalty is automatically calculated through electronic means, and thus, does not require supervisory approval. This is incorrect, because although the penalty is easily calculated since it is a flat $5,000 per frivolous return, it still requires supervisory approval pursuant to IRM section 4.19.13.6.2(3).

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Since the penalty requires supervisory approval and the record already contains some proof of approval, the Court goes on to evaluate the timing at issue (and whether additional discovery is warranted) in this case by looking to Kestin v. Commissioner, 153 T.C. No. 2, which it decided at the end of August. Like petitioner’s case, in Kestin, a section 6702 penalty for filing a frivolous tax return was at issue and a Letter 3176C was sent to the taxpayer warning of the imposition of the penalty. The Court held a Letter 3176C is not an “initial determination” of penalty for purposes of section 6751(b)(1), so approval is not required prior to the letter being sent.

This is an unsurprising result. The letter warns the taxpayer that the penalty may be imposed, but also provides the taxpayer with an opportunity to withdraw and correct their frivolous return to avoid the penalty. By providing a taxpayer with an opportunity to act to avoid the penalty, the letter does not need the protection afforded by the section 6751(b) approval requirement. Supervisory approval is required when there is a determination of a penalty, rather than “an indication of a possibility that such a liability will be proposed,” like the Letter 3176C.

The Court denies petitioner’s motion as moot, since the evidence she seeks to compel is already in the record showing that section 6751 approval was timely obtained after the issuance of the Letter 3176C.

Docket No. 26734-14, Daniel R. Doyle and Lynn A. Doyle (order here)

In this designated order, petitioners move the Court to reconsider its decision about whether they can deduct the legal expenses they paid in settlement of a discrimination suit. Unfortunately, petitioners didn’t make this argument during their trial. They had originally argued the expenses were related to petitioner husband’s consulting business, but the fees were not related to his business because they were for a suit against his former employer.

The Court denies petitioners’ motion to reconsider because they are raising a new legal theory that is not supported by the record and they did not allege new evidence, fraud, nor newly voided judgments which would allow the Court to vacate and revise its decision under Fed. R. Civ. P. 60(b).

Docket No. 19502-17, Cross Refined Coal, LLC, et. al. v. C.I.R. (order and opinion here)

Petitioners are victorious in Cross Refined Coal – a case involving a partnership in the coal refining industry and the section 45 credits. The section 45 credits are for refined coal that is produced and sold to an unrelated party in 10 years, subject to certain requirements. The bench opinion consists of 24 pages of findings of fact and 22 pages of legal analysis, so I only highlight some aspects here.

The IRS’s main issue is whether the partnership was a bona fide partnership under the Culbertson test and Tax Court’s Luna test. The IRS had an issue with two (of the eight) factors in Luna which help establish whether there was a business purpose intent to form a partnership.

First, the IRS posits that the contributions the parties made to the venture were not substantial, even though the partners made multi-million dollar contributions of their initial purchase price and to fund ongoing operating expenses. The Court disagrees and points out that the contributions are not required to meet any objective standard, the partners’ initial investments were at risk, and they continued to make contributions to fund operating expenses even when the tax credits were not being generated.

Second, the IRS argues that the partners did not meaningfully in share profits and losses, because the arrangement should justify itself in pre-tax terms in order to be respected for tax purposes. Disagreeing with the IRS, the Court finds petitioners shared in profits and losses, even though the arrangement resulted in net losses because the credit amounts increased as the profits increased.

The IRS also argues that partners shared no risk of loss because the partners joined the partnership after the coal refining facility had been established. The Court points out that the IRS’s own Notice 2010-54 allows for lessees of coal refining operations to receive tax credits. The Court also distinguishes this case from a Third Circuit decision, Historic Boardwalk v. CIR, 694 F.3d 425 (3rd Cir. 2012), rev’g 136 T.C. 1 (2011), where the Court held there was no risk of loss when taxpayer became a partner after a rehabilitation project had already begun. Historic Boardwalk, however, dealt with investment credits. The credits at issue in this case are production credits, so what the IRS argues is the “11th hour” (because the coal refining facility had already been established) is actually the first hour because it is the production of coal that generates the credit, rather than the establishment of the facility.  

An overarching theme in the IRS’s position is that the existence of the credits make it less likely that the partners had a true business purpose, and the Court should find abuse when a deal is undertaken only for tax benefits. The Court responds to this argument at multiple points in the opinion explaining that the congressional purpose behind section 45 credits is to incentivize participation in the coal industry, an industry that no one would participate in otherwise. As a result, the credits should not be subject to a substance over form analysis in the way that the IRS seeks.

I encourage those interested in more detailed aspects of the analysis to read the opinion itself, but overall, this seems like the correct result for petitioners.

An IRC 6751 Case Regarding the Burden on the IRS to Produce the Supervisory Approval

The partnership case of RERI Holdings I, LLC v. Commissioner, No. 17-1266 (D.C. Cir May 24, 2019) recently decided by the DC Circuit addresses in part of the opinion an argument by petitioner that the penalty imposed by the IRS and sustained by the Tax Court should be abated because the IRS did not affirmatively prove that the initial supervisor timely and properly approved the imposition of the penalty.  Carl discussed the Tax Court opinion and set up the argument presented in the appeal of this case in a post here.  The DC Circuit determines that petitioner could not raise this issue on appeal where it did not raise the issue below sustaining the imposition of the penalty.  Thanks to Carl for noticing the decision and providing some of the write up.

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This is a charitable contribution case where the substantive issue was substantial compliance with the requirement to complete a Form 8323, where the taxpayer left the line for basis blank.  Petitioner claimed a huge charitable contribution for a gift of land to the University of Michigan.  The IRS disallowed the deduction and imposed a penalty for gross overvaluation. 

The Tax Court held that the basis was necessary — even applying the rule that substantial compliance would be enough.  On appeal, the Department of Justice (DOJ) argued that there should be a much higher level of test than substantial compliance, but the D.C. Cir. found it unnecessary to decide the legal issue, since it agreed with the Tax Court that, even if the substantial compliance rule applied, the omission of the basis did not satisfy substantial compliance.  If you are interested in this issue, the opinion goes into some detail.  This post will focus on the IRC 6751(b) issue also raised by petitioner.

The Circuit Court took relatively little time in agreeing with the Tax Court that the contribution should not be allowed and spent most of its time in the opinion with various issues regarding the penalties imposed.  One issue the taxpayer raised in the appeal was that the IRS hadn’t introduced into the Tax Court record evidence of compliance with 6751(b).  Citing Chai, the taxpayer argued that the IRS hadn’t met its burden of production on the penalty.  (BTW, RERI is a TEFRA partnership and so the Tax Court would probably today hold that 7491(c), which applies to individuals, doesn’t shift the burden of production to the IRS on the 6751(b) issue, but the D.C. Cir. makes no mention of the TEFRA issue and doesn’t decide who has the burden of production,)  The D.C. Circuit, unlike Chai, holds that the taxpayer waived the issue by not raising it in the Tax Court.  Here’s what the D.C. Circuit wrote on this point:

RERI asks us to excuse its failure to raise this argument before the Tax Court on the ground that prior to Chai it did not clearly have a claim the IRS violated § 6751(b)(1). Fiddlesticks. The fact is that when RERI was before the Tax Court, it “was free to raise the same, straightforward statutory interpretation argument the taxpayer in Chai made” there. Mellow Partners v. Comm’r, 890 F.3d 1070, 1082 (D.C. Cir. 2018); accord Kaufman v. Comm’r, 784 F.3d 56, 71 (1st Cir. 2015). We therefore see no reason to excuse RERI’s failure to preserve its claim. 

The decision creates a split in the way the two circuits approach the case.  Maybe these types of issues will slowly fade away as everyone argues from the outset that the IRS must prove supervisory approval; however, for at least the next few years there will continue to be cases in which taxpayers did not raise the 6751(b) issue at the first level because they were unaware of the strength of the issue.  The RERI case shows the importance of raising IRC 6751(b) from the outset and in raising all of the possible issues presented by that provision.  Rarely will the taxpayer be a sympathetic party.  Just keeping up with all of the IRC 6751 litigation may turn into a stand-alone blog soon.  For those representing parties like RERI with huge tax dollars and huge corresponding penalties, too much is at stake to fail to lay the foundation for all possible permutations of IRC 6751.  Even for low income taxpayers paying a penalty of $1,000 presents a huge challenge.  All practitioners must pay attention and make appropriate arguments.

It’s hard to fault the practitioners in this case for not having a crystal ball that could see into the future.  It will not be hard to fault practitioners who fail to make the arguments now.

Bonus material

We occasionally write back and forth with Jack Townsend who writes a tax procedure blog at http://federaltaxprocedure.blogspot.com/.  On this case Jack sent me the following note on the burden of proof issue raised by the case.  If you are into tax procedure, you should check out his blog and his book.

If a defense to a new matter “is completely dependent upon the same evidence,” id., as a defense to the penalty originally asserted, then there is no practical significance to shifting the burden of proof. Furthermore, “the taxpayer would not suffer from lack of notice concerning what facts must be established.” Id. Here, the facts required to establish the two elements of the reasonable cause and good faith exception are the same regardless whether the alleged misstatement was “substantial” or “gross.” In other words, although the IRS may theoretically have had the burden of proof as to the increase in penalty, there was no additional fact to which that burden applied.

From that opinion, in my [Federal Tax Procedure] book, I added the following:

I think it would be helpful to illustrate the new matter issue.  Recall that § 6662 provides a 20% substantial understatement penalty that is then increased to 40% if the understatement attributable to a gross valuation misstatement.  If the notice of deficiency asserted the 20% penalty but, in its answer, the IRS asserts the 40% penalty, the IRS will have the burden of proof on the increase in the penalty.  That seems to be the straight-forward reading of the rule shifting the burden of proof to the IRS.  But, let’s focus on one issue raised in this setting.  The taxpayer can avoid the accuracy related penalties if there was reasonable cause for the position on the return.  This is like an affirmative defense to the penalty.  Thus, as to the 20% penalty asserted in the notice and contested in the petition, the taxpayer bears the burden of proving reasonable cause even after the IRS meets its production burden under §7491(c); as to the increased 40% penalty, the IRS bears the burden of proof, including establishing absence of reasonable cause.  fn

fn  See Blau, TMP of RERI Holdings I, LLC v. Commissioner, ___ F.3d ___, ___ (D.C. Cir. 2019) (discussing the Tax Court authority and expressing “no opinion as to whether Rule 142 requires the IRS to negate affirmative defenses when it pleads a new penalty in an answer;” the Court of Appeals accepted the Tax Court’s holdings that the burden on the reasonable cause defense did shift to the IRS as new matter; but “If a defense to a new matter “is completely dependent upon the same evidence,” id., as a defense to the penalty originally asserted, then there is no practical significance to shifting the burden of proof;” the Court then held that the burden had been met on the record but the facts were fully developed so “there was no additional fact to which that burden applied;” I am not sure exactly what that holding means, because, assuming that the trier (the Tax Court) were in equipoise as to reasonable cause (equipoise being a possible, although rare phenomenon), the IRS could have prevailed on the 20% penalty but the taxpayer on the 40% penalty.).