Graev Stops Assertion of the Fraud Penalty

The whole month of February passed without us writing a blog post on another Graev issue.  While we did not write a Graev based post in February 2021, the Tax Court issued another precedential opinion on the issue of supervisory approval.  In Beland v. Commissioner, 156 T.C. No. 5 (2021) the Tax Court determined that the fraud penalty the IRS sought to assert failed the requirements of IRC 6751(b) allowing the taxpayers to avoid the 75% penalty proposed by the IRS without getting to the merits.  The Court issued this opinion granting partial summary judgment on the fraud issue only five years after the case was filed.  Presumably, it will now hold a trial at some point in the future to determine what amount of tax the taxpayers owe.

The Tax Court had previously ruled in a non-precedential opinion that the IRS flubbed the approval process in a fraud penalty case in Minemyer v. Commissioner, T.C. Memo 2020-99 – a case that took 10 years to decide.  I wrote about the Minemyer case here and expressed surprise that IRC 6751(b) would stop the application of the fraud penalty in a case that involved a prior prosecution of the taxpayer, since the assertion of the fraud penalty following prosecution occurred automatically, with the hands of the agent and the agent’s supervisor essentially tied.  Of course, the statute does not specifically address prior criminal cases or create any special exception for them.

Beland does not involve the imposition of the fraud penalty in a prior criminal case but does bring out in its discussion the special processing that occurs when the IRS seeks to impose the fraud penalty.  As I will discuss below, that processing generally provides the protections sought by the legislation but does not follow the format adopted by the statute. For another take on the decision read Bryan Camp’s post on this case as part of his lessons from the Tax Court.  As usual Bryan has great insight on the case.

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The opinion does not really discuss what Mr. Beland did to cause the IRS to impose the fraud penalty as the issue here arises on a motion for summary judgement concerning the timely approval of the penalty.  When a revenue agent seeks to impose the fraud penalty, the agent must send the case from exam over to obtain approval from the fraud technical advisor (FTA).  The FTA is a Small Business/Self Employed revenue agent specially trained on tax fraud issues. The IRS set up the system of having agents refer cases to FTAs so that an investigator trained specifically in fraud detection could determine if the revenue agent had gathered enough information to support the fraud penalty and to allow the FTA to determine if this case should chart a path toward criminal prosecution prior to imposition of the civil fraud penalty. See IRM 25.1.2.2 (08-12-2016).

Requiring that the imposition of the fraud penalty first go through an FTA seems to provide even better protection against the use of the fraud penalty as a bargaining chip than having the immediate supervisor sign off of the penalty, but the statute has a specific structure applicable to all penalties.  It does not recognize the special handling the IRS has long pursued when it perceives that fraud exists.  In addition to sending the case through the FTA, before the agent can issue a notice of deficiency, the agent must obtain prior approval from Chief Counsel’s office. See IRM 25.1.6.2(14) (04-29-2016).  This approval occurs because the burden of proof in fraud cases rests on the IRS and before sending out a notice of deficiency, the IRS wants to make sure that it has the necessary proof to sustain the fraud penalty.

The opinion notes that the agent did seek assistance from the FTA.  It even says that the agent and her supervisor referred the case to the FTA.  If the supervisor signed off on the referral to the FTA, an argument exists that the supervisor has engaged in at least some form of approval of the penalty given the reason for the referral to the FTA.

Here, the FTA requested that the agent summons petitioners to appear before them.  I found this an odd request.  I do not remember seeing a summons in this situation when I worked for Chief Counsel but perhaps procedures have changed.  After some delay due to the birth of a child, petitioners came to the IRS for a meeting which not only served as the response to the summons but also as the closing conference.  As is normal, the agent attempted to obtain the agreement of the petitioners to the proposed adjustments.  And as is normal in a fraud case, the petitioners declined to sign up for the tax and fraud penalty.  The number of taxpayers who willingly consent to the assessment of the fraud penalty cannot be a very high number.

After the meeting the agent obtained the signature of his immediate supervisor on the Civil Penalty Approval Form.  Keep in mind that this all occurred in 2015 before the Graev opinion and the attention on IRC 6751.  The Tax Court had not yet, and would not for several more years, opine on when an initial determination occurred.  It’s possible to fault the IRS for not getting in front of the IRC 6751 issue shortly after it because law in 1998, but the agent obtained the supervisory signature in a reasonable time frame and had already, presumably, obtained approval to assert fraud from the FTA.  Nothing in the agent’s actions appears to point toward use of the penalty as a bargaining chip.

Between the time of the supervisory signature and the hearing on the motion for summary judgment, the Tax Court held in Clay v. Commissioner, 152 T.C. at 249 that an initial determination occurred when the IRS issued an agent’s report proposed the penalties and included the 30 day letter.  In Oropeza II, 155 T.C. at (slip opinion pp. 4-6) the Tax Court held that the agent’s report (together with the letter saying the taxpayer would not be offered a trip to Appeals due to the running of the statute of limitations) served as the initial determination.

Here, the Court finds that presenting petitioners with the agent’s report at the closing conference “sufficiently denoted a consequential moment in which RA Raymond had made the initial determination to impose the fraud penalty.”  The Court went on to explain:

While the revenue agents in Clay, Belair Woods, and Oropeza II sent the taxpayers the RARs through the mail, we have never held that an initial penalty determination must be communicated by letter. Rather, the Court’s focus is on the document and the events surrounding its delivery that formally communicate to the taxpayer the IRS’ decision to definitively assert penalties.

The Court also noted that using the summons to essentially force the petitioner to attend the closing conference added to the formality of the meeting.  So, the Court pushes the time period of the initial determination back before the formal issuance of the 30-day letter.  This may open up additional opportunities for taxpayers seeking to attack the imposition of a penalty.

Although the Court knew of the referral to the FTA, it does not talk about that process in reaching its conclusion.  In discussing the arguments made by the IRS, it does not appear that the IRS sought to argue the referral process used in fraud cases played in role in determining when approval occurred.

This decision is important for taxpayers in cases where the immediate supervisor has signed prior to delivery of the agent’s report, but the agent has had some formal meeting before the delivery of the report.  That aspect of the decision makes sense to me, given the purpose of the statute in preventing the IRS from using penalties as a bargaining chip.  Where I have trouble in the cases involving the fraud penalty is the countervailing policy argument that the IRS has taken other steps to protect the taxpayer from having the fraud penalty used as a bargaining chip.

Graev and the Early Withdrawal Exaction under IRC 72(t)Graev and the Early Withdrawal Exaction under IRC 72(t)

In Grajales v. Commissioner, 156 T.C. No. 3 (2021) the Tax Court determined that the 10% exaction imposed under IRC 72(t) that most people colloquially call a penalty is not a penalty for purposes of whether the IRS must obtain supervisory approval prior to its imposition.  The taxpayer in this precedential opinion involving $90.86 was represented by Frank Agostino who pioneered the use of IRC 6751(b)

The case pits the characterization of IRC 72(t) in Tax Court cases against its characterization in bankruptcy cases.  In many ways it presents the mirror image of IRC 6672 which goes under the name of trust fund recovery penalty and which the Tax Court treats as a penalty, but bankruptcy law treats as a tax.  These are not the only two code sections where the label as tax or penalty depends on the context and where that context has applications that can result in significant differences based on the label.

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The Tax Court has consistently treated IRC 72(t) as imposing a tax.  The issue has come up in several contexts prior to the challenge under IRC 6751(b).  The decision in Grajales continues the Tax Court’s consistent treatment of the provision.  The court notes:

In contexts apart from the application of section 6751(b)(1), this Court has held repeatedly that the section 72(t) exaction is a “tax” and not a “penalty”, “addition to tax”, or “additional amount”. See, e.g., Williams v. Commissioner, 151 T.C. 1, 4 (2018) (holding that the section 72(t) exaction is not a “penalty, addition to tax, or additional amount” within the meaning of section 7491(c) for purposes of placing the burden of production); El v. Commissioner, 144 T.C. 140, 148 (2015) (same); Dasent v. Commissioner, T.C. Memo. 2018-202, at *7 (same); Summers v. Commissioner, T.C. Memo. 2017-125, at *5 (same); Thompson v. Commissioner, T.C. Memo. 1996-266, 1996 WL 310359, at *7 (holding that the section 72(t) exaction is a “tax” rather than a “penalty” for purposes of the joint and several liability provision of section 6013(d)(3)); Ross v. Commissioner, T.C. Memo. 1995-599, 1995 WL 750120, at *6 (same).

With that history of the treatment of IRC 72(t) in Tax Court cases, the opinion provides no surprises, as it methodically works through the reasoning for finding that the provision should receive treatment as a tax.  Looking at the treatment of the provision in other contexts within the tax code, the Court finds consistency in the description of this provision:

First, section 72(t) calls the exaction that it imposes a “tax” and not a “penalty”, “addition to tax”, or “additional amount”. Second, several provisions in the Code expressly refer to the additional tax under section 72(t) using the unmodified term “tax”. See secs. 26(b)(2), 401(k)(8)(D), (m)(7)(A), 414(w)(1)(B), 877A(g)(6). Third, section 72(t) is in subtitle A, chapter 1 of the Code. Subtitle A bears the descriptive title “Income Taxes”, and chapter 1 bears the descriptive title “Normal Taxes and Surtaxes”. Chapter 1 provides for several income taxes, and additional income taxes are provided for elsewhere in subtitle A. By contrast, most penalties and additions to tax are in subtitle F, chapter 68 of the Code.

After establishing why the Court should treat 72(t) as a tax and therefore not impose on the IRS a requirement that it obtain supervisory approval prior to its imposition, the Court addresses the arguments presented by petitioner.

It first rejects petitioner’s argument that it should change its practice of following the label given to the liability in the tax code.  It then rejects petitioner’s argument that the Supreme Court’s decision in Nat’l Fed’n of Indep. Bus. v. Sebelius (NFIB), 567 U.S. 519 (2012) in which the Supreme Court recharacterized the label given to a liability imposed by the Affordable Care Act in order to determine that the Anti-Injunction Act did not bar it from making a decision.  Finally, it addressed the numerous bankruptcy court decision holding that 72(t) imposes a penalty for bankruptcy purposes.

The Tax Court does not reject the characterization of 72(t) as a penalty for bankruptcy purposes any more than it embraces the treatment of the TFRP as a tax.  Back in 1979 the Supreme Court first characterized the TFRP as a tax for purposes of bankruptcy.  The decision in United States v. Sotelo, 436 U.S. 268 (1978) held that for bankruptcy purposes TFRP was a tax which has significant implications in the payment of that liability through bankruptcy.  In Chadwick v. Commissioner, 154 T.C. No. 5 (2020), blogged here, the Tax Court determined that the IRS must follow the requirements of IRC 6751(b) in TFRP cases.

Not only is the decision in Grajales consistent with prior Tax Court decisions regarding 72(t), it is consistent with the way the Tax Court and the courts interpreting the bankruptcy laws have treated tax provisions labeled as tax or labeled as penalties.  The Tax Court consistently treats these cases as following their designations in the Tax Code.  Courts interpreting the same provisions for bankruptcy purposes have consistently looked behind the label on the provision to the effect or function of the provision and treated provisions labeled as tax as though they were penalties and vice versa where the circumstances supported a different label.

I am not troubled by the Tax Court following the form while courts interpreting the bankruptcy code follow function.  The systems serve different purposes.  As long as each applies the rules consistently in their realm, taxpayers and practitioners can adjust to the realities of the situation in which they find themselves.  The prior approval process required by 6751(b) lives in the tax code and applies to tax provisions labeled as penalties.  The tests developed in the bankruptcy code to treat certain provisions in a manner differently than the label they carry serves a different purpose. 

In Grajales the Tax Court addressed a provision most people call a penalty but Congress did not.  The opinion logically follows the path the Tax Court has followed in the path and it is a path that does not need to be changed.  At the same time the petitioner’s arguments here also logically pointed out the difference in treatment of tax provisions in other settings.  If we want consistency, it raises larger questions.

Tax Shelter Investor Relieved of Penalties by Graev

In the latest precedential opinion from the Tax Court on Graev, Oropeza v. Commissioner, 155 T.C. No. 9 (2020), the Court refuses to impose any penalty on the petitioner despite his investment in a tax shelter.  The case receives precedential treatment because it finds yet another way in which the Graev case impacts the IRS as it goes to impose penalties.  Mr. Oropeza, as have several beneficiaries of the Graev precedent, benefits from the age of this case.  The tax year is 2011 and he docketed his Tax Court petition in 2015.  At the time the revenue agent worked this case, Graev had not burned into the IRS consciousness the need to obtain penalty approval prior to sending out the revenue agent’s report.  The statute came into existence in 1998.  So, it’s hard to build up significant sympathy for the IRS regarding the way it handled penalties after Congress had spoken, but timing here does matter.

If you are interested in this case, you should also read the excellent post by Bryan Camp in his Lessons from the Tax Court series.  The IRS has also issued some guidance related to Graev that should be noted.  I was alerted by Jack Townsend of a new IRM provision that provides important guidance to revenue agents in this area:

20.1.1.2.3.1 (10-19-2020)

Timing of Supervisory Approval

For all penalties subject to IRC 6751(b)(1), written supervisory approval required under IRC 6751(b)(1) must be obtained prior to issuing any written communication of penalties to a taxpayer that offers the taxpayer an opportunity to:

  • Sign an agreement, or
  • Consent to assessment or proposal of the penalty

Jack has blogged on this provision and you can find his post here.

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Mr. Oropeza invested in microcaptive insurance.  The upcoming Supreme Court argument in CIC Services presents the same type investment though, as with Mr. Oropeza, the case does not directly involve the taxation of the investment itself.  The revenue agent audited Mr. Oropeza’s return and proposed, in Letter 5153 and a revenue agent report dated January 14, 2015 accuracy related penalties under 6662(a) of 20%.  Prior to the sending of this letter, the immediate supervisor of the revenue agent had not signed the approval of the penalties and did not sign it until two weeks later.

On May 1, 2015, the revenue agent changed his recommendation proposing a penalty under 6662(i) for 40% for a transaction lacking economic substance.  The revenue agent’s immediate supervisor signed the form approving this increase.  A notice of deficiency issued on May 6 focused on the 40% penalty with the 20% penalty as a fallback position. 

Based on Belair Woods, LLC v. Commissioner, 154 T.C. 1, 14-15 (2020) interpreting IRC 6751(b), we know that the 20% penalty will fail because the supervisory approval came after the agent transmitted the IRS position to the taxpayer.  At the time it filed its original brief in the Oropeza case, the government attorneys did not have the benefit of the Belair Woods decision and argued that the notice of deficiency was the appropriate date for determining whether approval of the immediate supervisory had occurred.  The IRS argued that it met the requirement of the statute.  In subsequent briefing on the case, it had the opportunity to address the Belair Woods decision.

At issue here is the impact of 6751(b) on the 40% penalty for which the revenue agent obtained approval prior to notifying the taxpayer.  (Some uncertainty on this issue exists because the immediate supervisor failed to date the approval form as he signed it; however, his testimony supported the fact that he signed on the same day as the revenue agent.  Of course, the date of his signature does not matter given the outcome of the case.)  The IRS argued that imposition of the penalty under IRC 6662(i) represented a separate penalty properly approved before notifying the taxpayer.  The Tax Court decided the case on cross motions for summary judgment.

The IRS argued that Oropeza differed from Belair because the letters offering a conference with Appeals differed slightly.  The Tax Court rejected the attempt to make a distinction based on the type of letter offering an Appeals conference.  It stated:

The Letter 5153 clearly communicated the same message to petitioner: It told him that he could now go to Appeals, but only if he first executed a Form 872 that would give Appeals enough time to consider his case.

So, the IRS communicated the initial determination to the taxpayer in the Letter 5153 and sent it prior to supervisory approval.  Does that lock the IRS into failure on the penalty issue or does the change in penalty position and the obtaining of a signature prior to communication with the taxpayer of the new penalty provide the IRS with a reprieve?

In approaching this issue, the Tax Court stated:

Litigants sometimes refer to section 6662(i) — like section 6662(h), applicable in the case of a “gross valuation misstatement” — as imposing a “40% penalty.” As the statute’s text makes clear, however, section 6662(i) does not impose a distinct penalty. It simply increases the rate of the penalty imposed by section 6662(a) and (b)(6) for engaging in a transaction lacking economic substance.

Given the statutory structure, we think the proper analysis requires that we answer two questions. The first is whether the RAR should be read as asserting a penalty under section 6662(a) and (b)(6) for engaging in a transaction lacking economic substance. If so, that penalty did not receive timely approval. The second question is whether, if the base-level penalty was not timely approved, the IRS can satisfy section 6751(b)(1) by later determining that section 6662(i) applies because the transaction was not disclosed on the return.

The Tax Court examined the IRS communication regarding the 20% penalty, noting that a taxpayer receiving the correspondence from the IRS would struggle to know which of the grounds of IRC 6662 the IRS sought to apply including “a transaction lacking economic substance.”  The IRS argued that while the revenue agent’s report might have been ambiguous, additional evidence shows what it meant.  The Court declines to look behind the information provided to the taxpayer and that information included the possibility that the penalty related to a transaction lacking economic substance.

The Tax Court then looked at IRC 6662(i).  It concludes that this subsection does not impose a distinct penalty but simply increases the rate of the penalties imposed under 6662(a) and (b)(6).  Based on this analysis, the Court finds that 6662(i) serves as something similar to an aggravating factor in criminal law leading to a higher punishment.  It moves from that conclusion to the conclusion that the initial penalty proposed in Letter 5153 operates as the touch point that it must review to determine if the IRS timely approved the penalty.  Looking at the transaction at that point, the IRS fails.

Linking the penalties imposed under 6662 in this way may benefit the IRS if it timely approves the first notice of a 6662 penalty but does not obtain a timely approval of an increase with the categories of 6662 penalties.  Maybe the next case will fall in the IRS’s favor because of this linkage.  There may be other implications of the linkage determined in Oropeza as we look at penalty cases in the future.  Professor Camp’s post does a good job of looking at possibilities and inconsistencies.  This case may have implications that reach beyond mere penalty approval.

Splitting More Graev Hairs – Tax Shelter Generic Settlement Offers

In yet another precedential opinion involving the interpretation of IRC 6751(b) Tax Court Judge Greaves decides a Graev issue in favor of the IRS.  In Thompson v. Commissioner, 155 T.C. No. 5 (2020) the issue turns on the impact of a settlement offer made to the taxpayer prior to supervisory approval of the penalty proposed by the IRS.  The Tax Court determines that proposing to settle a penalty does not equal an initial determination under the statute.  Because the settlement proposal did not equal an initial determination, the IRS does not lose the penalty for making the settlement offer before obtaining permission of the revenue agent’s immediate supervisor.

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 The taxpayer invested in a distressed asset trust transaction (DAT transaction) which the IRS had targeted for special treatment as an abusive transaction.  For these types of targeted transactions, the IRS sometimes develops special settlement initiatives to try to run multiple cases through the same procedure, avoiding as much time and trouble as possible.  A revenue agent sent the taxpayer a letter at the beginning of the examination laying out the terms of the settlement, including the amount of the penalty the taxpayer would need to pay for the IRS to accept a deal.  The court described the letter as the revenue agent stating he was:  “aware that * * * [petitioners] participated in an abusive transaction” and offered them “the opportunity to resolve * * * [their] tax liabilities associated with that transaction in accordance with the terms set forth in * * * [Announcement 2005-80 (Oct. 28, 2005)].”

The court further stated that this initial “letter did not identify a tax period or tax form to which it related, provide an underpayment amount, or request petitioners’ consent to assessment and collection. Petitioners did not accept the settlement offer in the 2007 letter.”

The Revenue Agent mailed a second letter 20 months later in 2009 when the taxpayers did not respond to the initial letter.  Similar to the first letter, the 2009 letter did not identify a tax period, form number, or underpayment amount and did not request petitioners’ consent to assessment and collection. The letter explained that if petitioners did not accept the settlement terms, the IRS would “complete its examination and fully develop the facts” of petitioners’ case and “impose applicable penalties under the Internal Revenue Code.”

Both letters went out prior to the determination by the agent’s immediate supervisor regarding the penalty as part of a larger determination by the IRS on how to treat penalties in this situation.  The agent and the manager’s hands were bound by the overall agency decision on how to treat these cases.  (In that regard this case has some similarities to the recent decision in Minemyer v. Commissioner that ended up with a different result.)

Because the taxpayers did not respond to the second letter, the revenue agent proceeded to examine their return.  In doing so he determined that they owed tax and both an accuracy related penalty under IRC 6662(h) as well as a penalty under 6662A.  He obtained the approval of his immediate supervisor who was acting in the position in December 2009.  A notice of deficiency was sent in 2012.  This case has been in the Tax Court since March of 2013.  Here is a link to the docket sheet if you want to follow along the slow path this case has taken to decision for liabilities on the years 2003 to 2007. 

The court describes three arguments raised by the Thompsons.  First, they argued that the settlement letter served as an initial determination and required the approval of the revenue agent’s supervisor, since it raised the issue of penalties.  Second, they argued that the approval was signed by an acting immediate supervisor who would not have provided meaningful review.  Third, they argued that to the extent of any ambiguity, because this is a penalty situation, the ambiguity should be resolved in their favor.  The court addressed and rejected each argument. 

With respect to the need for the IRS to obtain supervisory approval prior to sending out the settlement letter, the court provided a very reasoned basis for explaining why the statute did not require the IRS to do so prior to sending this type of letter:

The offer letters in this case do not reflect an “initial determination” because they do not notify petitioners that Exam had completed its work. Rather than determining that petitioners are liable for penalties of specific dollar amounts, subject to review by Appeals or the Tax Court, each letter offers to settle penalties arising from the DAT transaction on certain terms, including substatutory penalty rates, which are based not on an audit but on Announcement 2005-80. When petitioners failed to accept the offers, RA Damasiewicz still had work to do — the 2009 letter explicitly says the IRS had not completed its examination or fully developed the facts of petitioners’ case. Furthermore, the 2009 letter warns that declining the settlement offer would result in “applicable penalties,” without stating which penalties, if any, might end up being “applicable” to petitioners’ facts. An offer letter like the ones at issue does not require supervisory approval because it is not a “determination” at all, but a preliminary proposal of the revenue agent within an ongoing examination.

The court’s reasoning makes good sense to me.  The opposite result would create quite a shakeup at the IRS in the way it processes tax shelter settlement offers.  Just because it would shake up the long-standing practice does not make the practice one that requires preserving, but the letters sent in cases such as this do not tell the taxpayer exactly what the IRS has decided in their case, other than that their case is one the IRS has identified as a tax shelter.  The taxpayers probably already knew that when they invested in the shelter and signed numerous documents acknowledging the risk.  The initial letter lets the taxpayer know the risk has increased significantly but provides few specifics. 

The second issue regarding the significance of having the supervisory approval form signed by an acting supervisory rather than a permanent supervisor gets very little comment from the court.  If the IRS had to get penalty forms signed by permanent supervisors rather than actors, probably half of the agents could not move forward with their cases.  Acting supervisors are everywhere.  While they may or may not offer the same level of review as permanent supervisors, the statute does not prohibit acting supervisors from being the ones to approve the penalty form.  The court’s short treatment of this argument makes sense to me.

The third issue concerns the rule of lenity and the court cites the Rand case where Andy Roberson argued for the application of this rule.  The court finds that the situation in this case does not operate as one where the rule of lenity can stop the application of the penalty.  The decision provides no surprises in this regard.  Tax shelter investors will have a hard time invoking this rule.  The level of sympathy they evoke does not equal that of the low income taxpayers involved in the Rand case, who saw the IRS impose a penalty upon them for claiming the earned income tax credit in a way they could not support.

The Thompson case adds another interpretation to the Graev situation and receives precedential status as a result.  We now know that general letters offering a broad settlement initiative that includes penalties do not require the type of supervisory approval described in 6751(b).  I understand why petitioners would want to make this argument.  The case presents a situation like the Minemyer case, where hanging around in the Tax Court for long enough can allow a taxpayer to benefit from creative arguments that come out long after the filing of the petition.  Here, the taxpayers do not benefit from the creative argument but testing out the possibility certainly made sense.

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

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

Section 6751(b)(1) generally provides that no penalty can be assessed unless the initial determination of such assessment is personally approved in writing by the immediate supervisor of the individual making such determination or such higher level official as the Secretary may designate.  Written supervisory approval is not required to impose a penalty under Section 6651, 6654, or 6655.  Written supervisory approval also is not required to impose a penalty that is automatically calculated through electronic means. 

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

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

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

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

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

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

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

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

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

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

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

Privilege and Proving Penalty Approval

By now you are no doubt tired of reading cases of penalty approval and whether the IRS did what it needed to do in order to approve a penalty.  Just when you tire of this genre of cases and you start to question why PT would write yet another blog post on this subject, a case with facts that could not be made up happens to be assigned to the Tax Court’s most eloquent writer on this subject (and many other subjects as well). 

Here’s the teaser from the first lines of a recent order entered by Judge Holmes:

In it [a motion for summary judgment filed by the IRS], the Commissioner acknowledges that he must show supervisory approval of a penalty determination. But he does so with a document entirely blacked out because he claims deliberative-process privilege for its contents. To preserve that privilege neither Cannon [the corporate petitioner in the case] nor the Court have been allowed to peek behind the mask covering the document that, we are told, contains the required approval.

Does this work?

The answer is no.

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 Cannon claimed credits on its 2011 return that it earned in 2007 through 2010.  In an earlier ruling on summary judgment the Tax Court had ruled in favor of the IRS on the timing issue while noting that Cannon’s arguments were nontrivial.  That decision on the merits left only the accuracy penalty to be decided in the case and the IRS moved for summary judgment on that as well.

The Court notes that a penalty determination usually turns on whether the taxpayer acted reasonably and in good faith and determinations of that type generally require fact gathering not susceptible to summary judgment motions.  Of course, in asserting the penalty, the issue of the appropriate timing of the approval is now a part of the arsenal of any taxpayer seeking to fend off having to pay the penalty. 

The Court starts by discussing burden.  IRC 7491(c) enacted in the same legislation as the penalty approval provisions in IRC 6751(b) puts the burden of production in penalty cases on the IRS if the taxpayer is an individual.  Here, the taxpayer is a corporation and so the burden of production rests with the taxpayer.  The Commissioner of the IRS, however, seeks the summary judgment so “he must show that “there dispute as to any material fact and that a decision may be rendered as a matter of law.” Rule 121(b); see also Sundstrand Corp. v. Commissioner, 98 T.C. 518, 520, aff’d, 17 F.3d 965 (7th Cir. 1994).”

This case raises the same timing issues for penalty approval raised in Clay v. Commissioner, 152 T.C 223 (2019), appeal docketed, No. 19-14441 (11th Cir. Nov. 6, 2019).  See our post on Clay here.  The IRS can show that the appropriate supervisor approved the penalty prior to the sending of the notice of deficiency; however, in Cannon the IRS mailed the same type of letter to Cannon that it mailed to Clay, which caused the problem in that case.  The IRS needs to show that it approved the penalty prior to the mailing of this letter but it does not need to show that the approval took any special form. 

Before the IRS sent the crucial letter to Cannon, the agent’s supervisor sent to the agent an email telling the agent she had reviewed the draft, suggesting changes and directing where to send the Form 886-A within the IRS.  The IRS argues in its summary judgment motion that the email meets the necessary criteria for supervisory approval prior to the mailing of the letter to the taxpayer in which the IRS proposes to impose a penalty.  The email could work to satisfy the prior approval language in the statute.

But he [the Commissioner] also claims that this attachment to Hussain’s email is protected by the deliberative-process privilege.2 This assertion of the deliberative-process privilege may or may not be justified (Cannon hasn’t moved for in camera review or disclaimed any intent to object to its introduction at trial). But the Commissioner’s assertion of the privilege does prevent us from verifying that the changes Hussain recommended or the language that she possibly approved without change would qualify as supervisory approval.

Without being able to see the Form 886-A draft, Cannon makes the reasonable point that this email might just cover editorial changes to Guenther’s draft without actually approving the penalty. It also makes the very good point that the Commissioner’s assertion of a predecisional privilege means that the drafts were just drafts, and not a final anything, much less the required decision or approval made by a supervisor. It may well be that Hussain [the supervisor] made no actual decision to approve Guenther’s [the agent] determination to assert the I.R.C. § 6662 penalty.

So, the Court denies the motion for summary judgment.  Of course, this does not mean that the IRS will not succeed in the trial on the penalty.  It does not mean that the IRS will not relent and show more of the document.  It also does not mean that when revealed the document will support the prior approval assertion.  The case shows yet another issue that arises in penalty approval, both in its alleged approval through an email exchange and its alleged approval in a privileged document. 

Because the IRS has appealed the Clay decision, the outcome in the 11th Circuit could also impact the outcome in Cannon.  Unfortunately, it looks like 6751(b) will continue to provide fodder for PT for some time to come.

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.