Congress to Consign IRC 6751(b) to the Graev?

Carl Smith brought to my attention that one of the provisions in the tax bill currently working its way through Congress proposes to repeal IRC 6751(b) and he provided me with the title to this post.  I joked with others on the email thread that such a repeal could spell the end of our blog.  We have written so many posts on this poorly drafted law that having it repealed could significantly reduce the topics upon which we would write.

The other thought that went through my head was that the IRS had regained its voice in influencing tax legislation.  In the 1960s, 1970s, and into the 1980s perhaps up to the first Taxpayer Bill of Rights legislation, the IRS had less to fear from adverse judicial precedent because it could generally fix bad precedent by going to Congress to reverse the problem caused by adverse precedent.  This influence seemed particularly present when Wilbur Mills chaired the Ways and Means Committee.  I have wondered about the impact of his dip in the Tidal Basin with Fanne Foxe on tax legislation and its trajectory.  For the past couple decades, or more, the IRS seemed to have lost that ability, although there are some notable exceptions.  Maybe it is returning.  Congressman Neal, be careful where and with whom you go swimming.

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Congress passed 6751(b) as a part of the Restructuring and Reform Act of 1998 (RRA 98) in an effort to curb perceived abuse of penalty provisions to pressure taxpayers into conceding tax liabilities.  No doubt some IRS agents used penalties or the prospect of penalties to cajole taxpayers into settlements.  I never perceived this as a common practice, but I may not have been in the best position to observe behaviors regarding this issue.  Whether real or mostly imagined, the statute drafted to fix the alleged problem was drafted by someone with little or no knowledge of tax procedure.  It caused the Tax Court to twist itself into knots in order to interpret it and led Judge Holmes in dissenting from the interpretation in the Graev case to predict that the decision would led to many unpredicted and poor outcomes that he labeled Chai ghouls after the Second Circuit decision on this issue.  He was right, but that’s not to say the majority of the court got the Graev case wrong.  The statute is so poorly worded that no judge could draw the precise meaning.

One thing that saved the tax procedure world from 6751(b) for most of its life was that everyone ignored it.  Neither the IRS nor the bar seemed to pay attention to its requirements, whatever they were or are, for over 15 years.  Thanks to Nina Olson and the annual report to Congress and to Frank Agostino, litigation finally began to seek to provide meaning to the statute.  The cases have led to results that don’t necessarily follow the goal of the statute and that let many taxpayers off the hook for penalties, not because the IRS used them inappropriately as bargaining tools but because it failed to secure the appropriate approvals.  In some instances, the IRS would have had difficulty knowing what approvals would have been appropriate at the time of the imposition of the penalty since the court interpretation of the statute came several years thereafter.  Of course, the IRS could have headed this off with timely regulations that sought to interpret the provision and set up clear rules to follow but it did not create such regulations and suffered in several cases for its inaction.

Maybe this obit for 6751(b) comes too early.  Proposed legislation does not change the law.  Here is the language of the proposed repeal which contains its own surprise:

SEC. 138404. MODIFICATION OF PROCEDURAL REQUIREMENTS RELATING TO ASSESSMENT OF PENALTIES. 

(a) REPEAL OF APPROVAL REQUIREMENT.—Section 6751, as amended by the preceding provision of this Act, is amended by striking subsection (b).  

(b) QUARTERLY CERTIFICATIONS OF COMPLIANCE WITH PROCEDURAL REQUIREMENTS.—Section 6751, as amended by subsection (a) of this section, is amended by inserting after subsection (a) the following new subsection:  

‘‘(b) QUARTERLY CERTIFICATIONS OF COMPLIANCE.—Each appropriate supervisor of employees of the Internal Revenue Service shall certify quarterly by letter to the Commissioner of Internal Revenue whether or not the requirements of subsection (a) have been met with respect to notices of penalty issued by such employees.’’.  

(c) EFFECTIVE DATES.—  

(1) REPEAL OF APPROVAL REQUIREMENT.—   

The amendment made by subsection (a) shall take effect as if included in section 3306 of the Internal Revenue Service Restructuring and Reform Act of 1998.  

(2) QUARTERLY CERTIFICATIONS OF COMPLI ANCE WITH PROCEDURAL REQUIREMENTS.— 

The amendment made by subsection (b) shall apply to notices of penalty issued after the date of the enactment of this Act.

Notice in subsection (c)(1) of the proposed legislation that it repeals 6751(b) back to 1998.  Wow!  While wiping this statute off the books makes Congress look better and gets rid of a provision that makes it look incompetent, few examples exist of such a period of retroactivity.  Might the repeal itself, assuming it occurs, create yet more blog post opportunities for Procedurally Taxing?  Maybe the repeal is a good thing for the blog since the number of different permutations of 6751(b) may be dwindling, reducing the number of future posts if the current law continues unchanged.  A repeal such as this could be just the ticket for an additional round of posts as taxpayers whose cases are currently pending at some point on the continuum of audit or litigation will want to fight for the right to have their penalty removed.

Note also that section 6751(a), which provides that “The Secretary shall include with each notice of penalty under this title information with respect to the name of the penalty, the section of this title under which the penalty is imposed, and a computation of the penalty,” would not be repealed by the proposed legislation. The legislation would merely replace subsection (b) with a certification requirement within the IRS by managers on a quarterly basis as to their employees’ general compliance with subsection (a) – something likely of no use to taxpayers.

What about the sentiment that caused the essentially unanimous passage of RRA 98 regarding using penalties as an inappropriate bargaining chip?  Has the IRS cleaned up its act in this regard over the past quarter century?

We almost never write about pending legislation but with the opportunity to use the title to today’s post coupled with the possible loss of one of the most productive post producers, it seemed appropriate in this instance.  Now that you know about the proposal, you can start your lobbying efforts on behalf of the legislation or against it.  No matter which way this plays out, 6751(b) has to remain among the top few provisions as the worst ever drafted in the tax procedure realm.

Applying the Penalty Approval Provision to a Conservation Easement Case

In Oconee Landing Property LLC et al v. Commissioner, Dk. No. 11814-19 the Tax Court entered a very substantive order granting partial summary judgment to the IRS on the issue of penalty approval.  If the Court still designated orders, I suspect it would have designated this one.

The IRS in this case uses a tactic that has become common in penalty approval cases – seeking partial summary judgment on the penalty issue before heading to trial.  The IRS seeks to lock down that it properly followed the procedures for penalty approval required by IRC 6751(b).  The order entered in this case allows it to do so.

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The taxpayer does not argue in this case that the IRS did not obtain the penalty approvals prior to the communication with it that the IRS had asserted a penalty.  Although the prior approval issue exists in most IRC 6751(b) cases, here the issue focuses on the form and manner of the approval, particularly as it relates to summary judgment.  It asserts that the penalty lead sheet in the file “does not identify Ms. Smithson’s [the immediate supervisor] role … or even a date of signature.”

In this case, the approval occurred through email rather than by a signing of the same paper by the agent and the immediate supervisor.  This type of approval has no doubt become quite common during the pandemic while many employees and managers have been working remotely.  It could also be common in situations where the employee and the manager work out of different offices.  Obtaining acceptance of this type of approval is important for the IRS.  One hurdle it has here and in many other cases involves proving that the person signing the approval is, in fact, the immediate supervisor of the employee imposing the penalty.

To prove this relationship in the summary judgment setting, the IRS had both the supervisor and the agent produce affidavits attesting to their respective roles.  The court finds this adequate.

To prove the date of the approval and, therefore, prove that the penalty received the appropriate approval before being formally communicated to the taxpayer, the IRS provided emails which documented the timing of the approval.  The court finds that the emails provide sufficient corroboration of the timing.

The taxpayer also complained that the approval does not show any analysis of the penalties and, therefore, was inadequate.  The court points to the statute and to earlier cases interpreting the statute, making clear that all that is required is written approval and not a demonstration of the “depth or comprehensiveness of the supervisor’s review.”

The taxpayer argues that the Chief Counsel attorney who reviewed the case and suggested additional penalties to the agent did not obtain supervisory approval to make the suggestion.  That might seem like a wild argument but enough taxpayers have benefited from IRC 6751(b) arguments that no one thought would go anywhere that I applaud the effort.  Unfortunately, the Tax Court does not buy this as a statutory requirement.  The court finds that the additional penalties suggested by the Chief Counsel attorney were appropriate to apply in this case; however, the decision to assert these additional penalties, at least at the stage of the proceeding at which the suggestion occurred, was with the revenue agent and his manager.  The revenue agent did not have an obligation to accept the advice.  Having accepted it, he obtained the appropriate approval in a timely manner.

In addition to the questions raised about the penalties asserted by the revenue agent before the case arrived at the Tax Court, this case also involves a new penalty asserted by Chief Counsel in the answer.  The answer was signed by the line attorney and the acting manager.  Taxpayer argues that summary judgment is inappropriate because of a need to cross examine the attorney and the manager about the assertion of this penalty.  The court finds that cross examination is unnecessary because the answer clearly shows the appropriate approval.

In conjunction with this objection, taxpayer also sought to disqualify the attorney who prepared the answer and his supervisor as necessary witnesses.  The court finds disqualification unnecessary as the answer shows the appropriate approval.  I question what advantage disqualification would bring the taxpayer.  Perhaps it simply served as a part of the request to cross examine the Chief Counsel attorney.  The court notes that obtaining disqualification is “subject to particularly strict judicial scrutiny” because of the possibility of abuse.  I saw these motions a handful of times while working at Chief Counsel.  Almost always they fail.  Even if they succeed, the victory generally brings little or nothing for the taxpayer.  Making this particular motion can taint an otherwise good argument.  Use caution in trying to disqualify the IRS attorney.

Another Twist on Death and Taxes

In Catlett v. Commissioner, T.C. Memo 2021-102 the Tax Court dismisses a case for lack of prosecution over seven years after the petitioner filed the case.  He participated actively in the case – at least he was active in seeking continuances and some discovery – until he died.  When he died, the Court and the IRS tried to find a family member to take over the case.  When no one would take over the case, the Court dismissed it for failure to properly prosecute.  I think it comes out as an opinion rather than an order because of the Court’s discussion of the burden on the IRS regarding the penalties it sought to impose.

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Mr. Catlett was a serious tax fraudster.  He partnered with an IRS employee to defraud the IRS by creating fictitious losses.  He helped over 250 clients reduce or eliminate their taxes through the fictitious loss scheme.  Eventually, he as caught, convicted by a jury and, in 2011, sentenced to 210 months of imprisonment.  That’s a long time for a tax crime.  He died in prison.

The case doesn’t talk about why the IRS does not seem to have made a restitution assessment.  The timing of his conviction came shortly after these types of assessments became available to the IRS and perhaps it did make a restitution based assessment but it also decided to give his returns a good, old fashioned audit.  As is customary in a criminal case, the IRS did not begin its audit until he was convicted.  So, the IRS decides to dedicate the precious resources of a Revenue Agent (RA) to audit someone who is in prison for almost 20 years and who owes almost $4 million in restitution.  Mr. Catlett fought the audit by refusing to provide documents and by challenging the summonses issued by the RA but the IRS overcame these challenges and obtained voluminous records which it used to reconstruct his income using the bank deposits method. 

Ultimately, the IRS issued a notice of deficiency for 2006-2010 and he petitioned the Tax Court in June, 2014.  Three times his case came up for trial – June 2015; March 2016 and December 2016.  Each time he requested a continuance.  The first two times it was granted.  Trying Tax Court cases involving incarcerated individuals creates many challenges.  It is difficult to get them out of prison and to the Court.  Often, the Court will continue these cases though for someone with a prison sentence the length of Mr. Catlett’s continuance of the case does not make as much sense.  The third time his case was on a calendar Judge Lauber was presiding, and he retained jurisdiction of the case rather than continuing it.  He ordered annual status reports.

That seems better than simply shuffling the case to the next judge when the person will be incarcerated for another 10 years, but 10 years is a long time to hold onto a case.  Judge Lauber is one of the most, if not the most, efficient and productive of Tax Court judges.  I am sure he was not excited about holding onto a case for so long but the choices in these situations are mostly bad choices.  Mr. Catlett’s death serves as the event that moves the case along.

When Mr. Catlett died in 2020, word eventually reached the Tax Court and the IRS.  Here’s what happened at that point:

After an expansive search respondent located three members of petitioner’s family. Respondent’s counsel explained to each of them the posture of this litigation, but they indicated that they wanted nothing to do with the case. When respondent advised them that he intended to file a motion to dismiss, they again confirmed that they would not participate. We gave all three family members notice of the trial and offered them the opportunity to appear. They declined to appear, and no other representative appeared on petitioner’s behalf. Under these circumstances we have no choice but to dismiss the case for lack of prosecution. The decision that we enter will sustain all adjustments insofar as petitioner bears the burden of proof. See Branson v. Commissioner, T.C. Memo. 2012-124, 103 T.C.M. (CCH) 1680, 1684-1685.

It’s hard to blame the family members for not wanting to get involved, and it’s not at all clear that their involvement would be meaningful.  The Court does not talk about any assets owned by Mr. Catlett, but I suspect there were none.  The result of this Tax Court case was almost certain to be an assessment with no prospect of collection.  You might ask yourself why the IRS would dedicate the precious resources of the RA in this pursuit not to mention the time spent by the Chief Counsel attorney over the years and the Tax Court.  Yet, that’s what I think this case was about – assessing an uncollectible tax when the Government already had a $4 million restitution order and was paying to house and feed Mr. Catlett for almost a decade.

My suggestion would have been to skip the audit and all of the efforts of the persons working for the Government over the past decade and focus on collecting the restitution order but that was not the choice made.  Once Mr. Catlett passed away and no family member stepped forward, the IRS moved to dismiss the case for lack of prosecution.  Because it had imposed numerous penalties (additions to tax) on Mr. Catlett, including the fraud penalty, and because of the burden of production with respect to these liabilities was on the IRS, the Court could not simply dismiss the case but had to weigh whether the IRS met its burden.

The Court finds that the IRS did meet its burden.  This exercise requires yet more work for the Chief Counsel attorney and the Court.  It finds the IRS manager gave the appropriate penalty approval required by IRC 6751(b).  It finds the factors necessary to prove fraud for some of the years and negligence for others.  It finds he owes other penalties and provides reasons for each finding. 

The system works.  In this case the system seems like a colossal waste of time.  Now a Revenue Officer will be assigned to this case and an uncollectible assessment will stay on the books for 10 years with required annual reminders and other actions that will not add additional revenue to the coffers.  I hated to work these types of cases because it seemed like such a waste of time and resources.  I can’t imagine those working on the Catlett case feel differently.

“With every move he makes, another chance he takes”

Today we have the pleasure of looking at an IRC 6751(b) opinion written by Judge Holmes.  For long time readers of this blog, the link between Judge Holmes and Graev consequences of not following the statutory language requiring approval of the immediate supervisor are well known.  His warning of Chai ghouls continues to haunt the IRS as different scenarios regarding the imposition of various penalties arise.  In CFM Insurance, Inc. v. Commissioner, Dk. No. 10703-19 (Order entered June 16, 2021), a case involving a microcaptive insurance company the IRS has targeted as abusive, he issues an order denying the IRS motion seeking summary judgment on the issue of penalty approval.  As with many of the cases seeking to interpret IRC 6751, the facts in CFM do not follow a straight line.  The title of the blog comes from a line in the footnote by Judge Holmes citing to the famous, for those of us of a certain age, recording by Johnny Rivers entitled “Secret Agent Man”.  Use the link to listen to the song if you are not familiar with it or if you have curiosity about vintage recordings.

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So, from the many prior rulings on the issue of proper imposition of a penalty we have learned that the IRS needs the immediate supervisor of the agent imposing the penalty to personally approve in writing the penalty before the IRS first formally notifies the taxpayer of a proposed penalty.  If the IRS fails to obtain the written approval in time, then it loses the right to impose the penalty, as has occurred in many cases.  That’s why the IRS files a motion for summary judgement on this issue before trial in order to lock down the fact that it has followed the correct procedural steps before it gets to the merits of the penalty.  In some ways, this motion for summary judgment seems like a motion in limine.

Here, the IRS asserts in the Tax Court case that CFM owes a 20% accuracy related penalty created in IRC 6662(a) for negligence.  The Court looks to see when it notified CFM of this penalty and what steps the IRS had taken before notification.  The first issue the Court addresses concerns the notification.  It notes that a couple possibilities exist for when this occurred.  The IRS sent a 30-day letter which in prior cases the Court has treated as the official notification.  This letter tells the taxpayer of the examination division’s position and offers the taxpayer a chance to file a protest and go to the Independent Office of Appeals to discuss the matter.  The 30-day letter was signed by the revenue agent’s immediate supervisor which would seem to end the inquiry on the point of notification, except for one small problem.  The 30-day letter proposes the imposition of a 40% penalty, not the 20% penalty included in the notice of deficiency.  So, correct notification form but a shift in penalty before issuance of the notice of deficiency.  How does that impact satisfaction of the statutory requirement?

The Court looks for approval of the 20% penalty as well as prior case law in situations in which the penalty shifted.  The Court describes its inquiry:

Our caselaw tells us to focus on the formal notice that a taxpayer gets. Did any of these documents give formal notice to CFM of the 20% penalty? Ordinarily, an Examination Report and 30-day letter is sufficient to clear the 6751(b)(1) hurdle. See, e.g., Thoma v. Commissioner, 119 T.C.M. (CCH) 1447, 1472 n.34 (2020). But in this case, there was no mention of a 20% penalty’s being asserted in the 30-day letter or any of the documents listed as enclosures; the Examination Report and Agreement Form both mention 40% penalties for each year pursuant to section 6662, but section 6662 allows for 40% penalties in only three instances: when an underpayment is due to a “gross misvaluation misstatement,” § 6662(h), a “nondisclosed noneconomic substance transaction,” § 6662(i), or an “undisclosed foreign financial asset understatement,” § 6662(j). The 20% penalties under section 6662(b)(1) for negligence or disregard of rules or regulations (or substantial understatement) are distinct from each of these 40% penalties and must receive separate supervisory approval to cross over the section 6751(b) threshold. See Sells v. Commissioner, 121 T.C.M. (CCH) 1072 (2021), T.C. Memo. 2021-12, at *11. “Formal notice” requires that the penalty be described with sufficient particularity so a taxpayer knows what he is accused of. See Legg v. Commissioner, 145 T.C. 344, 350 (2015) (“Congress enacted section 6751(b) to ensure that taxpayers understood the penalties that the IRS imposed upon them”). An Examination Report and 30-day letter that mention only a 40% penalty do not provide notice of a 20% penalty. See Oropeza v. Commissioner, 120 T.C.M. (CCH) 71, 72 (2020). As a matter of law, then, neither the 30-day letter nor any of the documents listed as enclosures provided CFM with formal notice of the 20% penalties under section 6662(b)(1).

The Court notes that at this point the outcome looks bad for the IRS but goes on to discuss a stuffer in the envelope transmitting the 30-day letter.  The stuffer, Form 886-A does mention a 20% penalty; however, the stuffer has problems:

That document correctly identifies the reasons for and subsections under which the penalties were being asserted, but incorrectly identifies the amount. And that’s not the only irregularity. An initial glance reveals that the text of the Form is shrunk so that each page only takes up about half the area of the paper it’s printed on. Closer inspection shows that it includes errors (e.g., the phrase “Error! Bookmark not defined” appears several times in the Form’s table of contents) and what appear to be highlights and comments made by someone reviewing the report using a “track changes” function. So, is this “formal notice?”

The Court finds that the Form 886-A was incomplete and that the record is incomplete whether or not the supervisor of the agent approved stuffing this form in the letter with the 30-day letter.  Among other things, the supervisor at the time of sending the letter is unknown, and the signature of that supervisor is not clearly identified in the material before the Court, causing the reference to the “Secret Agent Man.”  In the end, the Court denies the motion for summary judgment but does not toss out the penalty.  The IRS has a roadmap for what it needs to prove and it remains to be seen if it can prove it.

Another Chai ghoul appears as the stuffer saves the IRS to fight another day but does not insure that it will win the fight.  This case was docketed in 2019.  By that time, the Tax Court had provided the IRS with notice of the importance of IRC 6751(b).  This is not a case like some described in earlier posts where the case sat so long in the Tax Court that the knowledge and interpretation of the law shifted dramatically between the time of the penalty imposition and the decision.

Substantial Understatement Penalties and Supervisory Approval: Big Changes Coming?

Procedurally Taxing has been at the forefront covering the evolution of the “supervisory approval” requirements of IRC § 6751 (see posts here, here and here). The most recent post from Patrick Murray, a University of Minnesota Law student, argued that in its present, post-Walquist form, IRC § 6751 is of little help to low-income taxpayers. In a nutshell, this is because the IRS no longer needs supervisory approval for “automated” IRC § 6662(b)(2) penalties and the vast majority of low-income taxpayers experience fully automated examinations.

Mr. Murray’s post advocated for a Congressional fix, mandating that all IRC § 6662 accuracy penalties be subject to supervisory approval requirements as a way to level the playing field. I’ll reserve judgment on that, but instead ask whether a Congressional fix is actually needed for a level playing field. A scintillating footnote from a recent Tax Court opinion may reveal battle lines already being drawn on that issue.

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First off, my bet is a fair number of readers didn’t roll their eyes or do a double-take at the preceding phrase “scintillating footnote from a recent Tax Court opinion.” Please take a moment to reflect on that, as I have. Ok. Now let’s get into the fun stuff: a possible changing of the guard in IRC § 6751 supervisory approval requirements.

How do we get there? Through the idyllic (I’m assuming) town of Plentywood, Montana, its lone pharmacy and the case of Plentywood Drug, Inc. v. C.I.R., T.C. Memo. 2021-45. It is here we find that scintillating footnote I promised. Specifically, footnote 10 which provides:

“The Commissioner argues that the penalty for substantial understatement of tax at section 6662(b)(2) falls within the automatic-computation exception to section 6751. Because Plentywood Drug is the only party alleged to have under-stated its income tax and failed to carry its burden of production for the section 6751 issue, the Commissioner’s argument is moot and we will not address it.”

So we have a footnote, in a non-precedential memo opinion, where the Tax Court basically says “we aren’t touching that argument because it is moot.” You may fairly ask, “is that really ‘scintillating’?”

Yes, I’d say it is.

It is scintillating because it (potentially) represents the IRS taking a litigating position that would vastly expand the reach of Walquist. If the Plentywood examination was not fully automated this litigating position is a big deal because it takes the “automation” factor out of the equation. And there is at least some reason to believe the Plentywood exam was not automated. For one, it is a corporate taxpayer being audited on a Fair Market Valuation question -not the usual automation fodder of “our records show you have one more W2 than listed on your tax return, please explain.” For two, based on the information I was able to glean from the consolidated Tax Court dockets (Dkt. #s 17753 through 17755-16), the penalties as applied to the individual taxpayers did require (and have) proof of supervisory approval, and therefore were not automated. To me, it would be odd if the penalties against the corporation were automated but the penalties against the individuals were not.

So let’s assume this was not an automated exam. What would that mean? In essence, it would mean that the litigating position of the IRS appears to be that every “substantial understatement” penalty is “automatically computed” (and thus meets the exception of IRC § 6751(b)(2)) regardless of how the examination is initiated. In other words, Walquist would stand for “no supervisory approval needed for purely mathematical penalties, of which IRC § 6662(b)(2) is one example -regardless of whether it is a computer or a human that punches the numbers into the calculator.”

That would indeed be a step towards leveling the playing field between rich taxpayers and low-income taxpayers… by making things worse for everyone. All things considered, I’m basically fine with that.

My biggest complaint heretofore has been that under Walquist two identical taxpayers making identical mistakes, subject to identical IRC § 6662(b)(2) penalties are given different protections depending on how the IRS initiates the examination. You can see this played out, and this point made, in Bryan Camp’s post here. I think it is important that this issue be brought to the court’s attention, and especially if the taxpayer is represented.

As has been noted by both Judge Holmes in the Graev opinion itself and Professor Bryan Camp (here among other places), the statutory language of IRC § 6751 is problematic. I don’t envy the Tax Court’s role in parsing out the “real” meaning and requirements of an almost nonsensical statute -where ambiguity lies, a good lawyer will pick apart every word and nuance to advocate for their client.

And so the Tax Court has had to weigh in on timing issues (here), evidentiary issues (here), the definition of what a “penalty” is (here), and many other creative or at least plausible arguments put forth by zealous advocates.

And then you get Walquist. That case had zealots, but I’m not sure I would call them zealous advocates. The petitioners were pro se and advanced a raft of nonsense tax-protestor arguments that the Court dismissed. Maybe the outcome would have been the same with a lawyer, but I believe at the very least with competent counsel the contours of the decision would have been different. Perhaps if the IRS continues to raise the arguments it did in Plentywood we just may see that happen.

One issue I would like to see raised by counsel for taxpayers is the bizarre policy effects of Walquist. If an exam is fully automated fewer protections are offered to the taxpayer. Fully automated exams are generally limited to relatively low-dollar issues. And these issues, in turn, tend to involve middle-and-lower income taxpayers. In a nutshell, as I tell my students, high-income taxpayers get agents and low-income taxpayers get automation. And since automated penalties don’t require supervisory approval, low-income taxpayers therefore don’t get supervisory approval prior to getting hit with penalties.

To me, this has the perverse effect of protecting most those who need it least.

Pause to think about this, for a moment, while I step down from my soapbox. Accuracy penalties are largely an automatic default for the least sophisticated taxpayers, while the most sophisticated get layers of review and contemplation before determining (maybe, not conclusively) a penalty should apply. If IRC § 6662(b)(2) penalties are really just a matter of math, why should that be the case? Why should there be any discretion at all, automated exam or not, as to whether IRC § 6662(b)(2) applies when the math says it does? There are some hiccups in the statutory language of IRC § 6751(b)(2) that would cause some issues: that the penalties must be calculated “through electronic means” seems to imply that a computer is running the whole show. But as with so many other aspects of that troublesome code section, there is room for debate.

Someday I may write about (or litigate) why I don’t think IRC § 6662(b)(2) is a “pure math” question amenable to automation. But for now, I am happy that Plentywood brings that issue to the forefront, and hopeful that it arises again.

Walquist Harms The Poor: Revisiting Supervisory Approval For Accuracy Penalties

Today’s post comes from University of Minnesota Law student, Patrick Riley Murray. Mr. Murray is not actually one of my students in my Federal Tax Procedure or the Federal Tax Clinic courses. However, Mr. Murray was referred to me by a student and previous Procedurally Taxing contributor Casey Epstein (see post here), as having written on a topic I may be interested in. Casey was correct: I have a deep and abiding interest in the Walquist case and will be making an additional post on it in the near future. This post was originally written for and posted on Minnesota Law Review’s De Novo Blog and edited by Minnesota Law Review’s Online Editors. -Caleb

The Internal Revenue Service (IRS) processes more than 250 million business and individual tax returns each year. The vast majority of these returns are correctly filed and end in either additional tax paid or a refund. When a taxpayer files a return with incorrect information, the IRS will typically assess a penalty. Naturally, the IRS must adhere to statutorily imposed procedural requirements when assessing these penalties.

For example, Code § 6751 requires supervisor approval before a penalty can be assessed against a taxpayer. But a significant exception to this rule exists: if a penalty is “automatically calculated through electronic means,” supervisory approval is not required. Given the modern processes of the IRS, many penalties—including those in audits concerning the Earned Income Tax Credit, a tax break for low- to middle-income taxpayers—are assessed via computer software. The IRS claims that these accuracy penalty assessments are automatic. Meanwhile, taxpayer litigants, who are often wealthy, have been able to escape accuracy penalties by arguing that the IRS did not follow § 6751’s procedural requirements.

In short, § 6751’s application has become convoluted. The result: poor taxpayers must pay penalties that rich taxpayers can avoid through litigation. This Post discusses recent case law on the issue of supervisory approval for § 6662 penalties and argues that § 6751 should be amended to require all penalties to have supervisory approval.

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I. CASE LAW SURROUNDING § 6751 DISPROPORTIONATELY AFFECTS POOR TAXPAYERS

Congress added the procedural requirements—including the requirement for supervisory approval for certain penalty assessments—of § 6751 to the Code in 1998 because of concerns that the IRS was using penalties as a bargaining chip with taxpayers even when no basis for a penalty existed. § 6751 was not significantly litigated for nearly twenty years, until the Second Circuit decided Chai v. Commissioner in 2017.

In Chai, the taxpayer failed to pay self-employment tax related to $2 million in payments from a tax-shelter scheme, and the IRS assessed penalties. In Tax Court, the IRS failed to provide sufficient evidence that IRS agents obtained supervisory approval before assessing penalties. The Second Circuit held on appeal that supervisory approval must be obtained before the IRS issues a notice of deficiency. Since Chai, the Tax Court has applied an “ad hoc” treatment to § 6751 cases.

The Tax Court recently found against taxpayer litigants in Walquist v. Commissioner. At issue in Walquist was the IRS’s Automated Correspondence Exam (ACE) software. ACE automatically processes taxpayer returns. In many cases, ACE handles returns from receipt to closing with “minimal to no tax examiner involvement.” In Walquist, ACE processed the taxpayer’s 2014 tax return, assessed a § 6662 penalty, and issued the notice of deficiency automatically and without any human interaction. The Tax Court found that because the penalty was determined mathematically by a computer software program without the involvement of a human IRS examiner, the penalty was “automatically calculated through electronic means.”

Walquist has potential to harm many poor taxpayers. ACE software is designed to process taxpayer returns that claim the Earned Income Tax Credit (EITC)—a tax break for low- to middle-income taxpayers. In light of the Walquist decision, taxpayers who incorrectly claim the EITC, maliciously or not, can receive significant penalties on their tax returns without any human interaction, much less supervisory approval, from the IRS.

This seems ostensibly fair. If the IRS does not obtain approval, the taxpayer can simply challenge the penalty assessment. But this line of reasoning does not hold up when considering the resources available to tax litigants. Wealthy taxpayers often have the time and resources to challenge and litigate their penalties. For example, Graev v. Commissioner featured twelve years of litigation. And Chai v. Commissioner involved a taxpayer who made millions from their tax-shelter scheme. Poor taxpayers simply do not share that luxury. In practice, automatic penalty assessments against poor taxpayers are final, and these taxpayers have no avenue for challenging their penalties.

II. CONGRESS SHOULD AMEND § 6751 TO REQUIRE SUPERVISORY APPROVAL FOR ALL ACCURACY PENALTIES

At least two solutions exist for this problem: (1) the Tax Court could overturn Walquist and (2) Congress could amend the tax code. Since the former suffers from a number of defects, this Post advocates for the latter solution.

The first solution, in which the Tax Court would overturn Walquist, is problematic. First, the Walquist court’s statutory interpretation of § 6751’s “automatically calculated through electronic means” exception leaves little room for argument; after all, the IRS’s ACE software automatically calculates accuracy penalties. Only a statutory interpreter willing to disregard the Code’s text completely in favor of normative concerns could advance a good faith argument to overturn the court’s statutory interpretation. It is unlikely that this strained argument would prevail at court and even more unlikely that it would survive appeal. Second, the Tax Court dismissed the taxpayer’s case in Walquist for refusing to comply with Tax Court rules. Since it is unlikely that Walquist’s litigants will see their case relitigated, this exact issue would have to come before the Tax Court again before the court could overturn its decision. This leaves poor taxpayers with no recourse for years potentially.

The second solution is far more helpful to lower-income taxpayers. This proposed solution is simple: Congress amends § 6751 to require supervisory approval for all accuracy penalties, and excuse taxpayers from their penalties if this requirement is not met. This could mechanically be accomplished by simply eliminating the exceptions in § 6751(b)(2) and by adding statutory language specifically listing out the consequences of IRS noncompliance. This solution is normatively preferable. While taxpayers should pay penalties for noncompliance with the tax code, the IRS should ensure that every step in its audit process is accurate. If noncompliance is met with severe penalties on the taxpayer’s side, noncompliance on the IRS’s side should also be met with severe penalties. And since President Joe Biden has indicated that tax reform is on his agenda, this solution could see timely implementation. Finally, this solution offers a bright-line rule for courts and the IRS to follow, leaving little room for significant litigation. Overall, this solution is vastly superior.

CONCLUSION

The recent boom of litigation surrounding § 6751’s procedural requirements has left the Tax Court searching for answers regarding supervisory approval of penalties. This has allowed wealthier taxpayers and bad actors to escape liability through litigation, leaving poor taxpayers—who often do not have the resources to litigate their penalties—at the mercy of the IRS’s whims. With tax reform on President Biden’s agenda, there is the possibility for relief. One normatively preferable solution consists of Congress amending the tax code to require supervisory approval for all accuracy penalties, excusing taxpayers from their penalties in the event of IRS noncompliance. While taxpayers should pay penalties for willful noncompliance, the Government must safeguard their rights.

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.