Can the IRS Approve a Penalty Too Soon?

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

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

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

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

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

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

We discussed the Laidlaw case here.

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

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

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

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

The Court states that:

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

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

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

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

Ninth Circuit Reverses Tax Court Interpretation of IRC 6751(b)

The question of when a supervisor must give approval for imposition of a penalty has created much litigation in the Tax Court as taxpayers try to remove a penalty proposal by using the failure of the IRS to comply with the IRC 6751(b) approval process.  In Laidlaw’s Harley Davidson Sales v. Commissioner, No. 20-73420 (9th Cir. 2022) the court reversed the decision of the Tax Court in a precedential opinion reported at 154 T.C. 68 (2020) (knocking out the penalty for failing to follow the approval process required by the statute.)  We discussed the Tax Court decision here

The Ninth Circuit decision casts into doubt the approach the Tax Court has developed through litigation over the past several years.  It remains to be seen whether the Tax Court will reverse its approach based on the Ninth Circuit opinion, an outcome I view as unlikely, or stay the course creating an exception and perhaps a split that will require resolution in the Supreme Court.  Of course, all of this is against a backdrop of Congress seriously considering eliminating IRC 6751(b) reported here and here

Laidlaw involves the reportable transaction penalty imposed under IRC 6707A.  This penalty can be quite large.  As mentioned in the earlier post, the year at issue is 2008 before petitioners and the IRS began focusing on IRC 6751(b).  Bryan Camp has written an excellent post on the Ninth Circuit’s opinion which you can read here.  His post provides good background on the issue of approval timing in general and discusses two recent TC Memo opinions on the topic. 

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Laidlaw participated in a listed transaction but failed to alert the IRS about its participation.  The Revenue Agent auditing Laidlaw’s return issued a 30 day letter notifying Laidlaw of the intention to impose the IRC 6707A penalty.  The Agent did not obtain a supervisor’s signature prior to the issuance of the 30 day letter but the supervisor did sign off on the penalty thereafter once Laidlaw filed its protest to the letter.  The administrative appeals did not succeed and the IRS assessed the penalty which led to collection action.

Laidlaw submitted a Collection Due Process (CDP) request and petitioned the Tax Court after receiving a determination upholding the proposed levy action.  The Tax Court held that the IRS had not met the requirement of IRC 6751(b) that the supervisor approve the penalty prior to the 30-day letter.  The Ninth Circuit described the Tax Court decision as follows:

The Tax Court rejected the Commissioner’s argument that § 6751(b)(1) requires that the IRS secure supervisory approval only before the assessment of a penalty. The Tax Court reasoned that the statute’s legislative history, as analyzed in Chai v. Commissioner, 851 F.3d 190 (2d Cir. 2017), “strongly rebuts” the Commissioner’s argument because the statute “would make little sense if it permitted approval of an ‘initial’ penalty determination up until and even contemporaneously with the IRS’s final determination.” The Tax Court also rejected the Commissioner’s argument that under Chai the timeliness of written supervisory approval hinges on whether the supervisor retained authority to give approval because “[t]o so suggest would be to ignore the paramount role that the legislative history of section 6751(b)(1) played in Chai’s analysis.”

The fact that the IRS appealed the decision speaks to the importance of the issue to the IRS and to the government’s deeply held disagreement with the Tax Court’s approach to the timing of supervisory approval.  In addition to disagreeing with the Tax Court’s legal conclusion, the issue has significant administrative importance because of the amount of money at stake and the impact of letting so many taxpayers who committed inappropriate actions with respect to their taxes off of the hook.

Before the Ninth Circuit the IRS argued:

The Commissioner argues that in this case § 6751(b)(1) permitted written supervisory approval at any time before the assessment of the penalty. However, the Commissioner acknowledges that because the initial determination must be “approved” by a supervisor, a penalty cannot be assessed unless supervisory approval occurs at a time when the supervisor still has discretion whether to approve the subordinate IRS official’s initial penalty determination.

As we have discussed in many posts, IRC 6751(b) fails to provide clear guidance.  The Tax Court and the Ninth Circuit struggle to interpret the meaning of adjective “initial” which describes the determination by which the supervisor must provide a signed approval.  In rejecting the Tax Court’s interpretation of initial, the Ninth Circuit states:

the language of the statute provides no reason to conclude that an “initial determination” is transformed into “something more like a final determination” simply because the revenue agent who made the initial determination subsequently mailed a letter to the taxpayer describing it. We think “initial,” as used in § 6751(b)(1)’s phrase “initial determination,” more naturally indicates that a subordinate’s determination to assert a penalty lacks the imprimatur of having received supervisory approval, rather than that the determination has not yet been formally communicated to the taxpayer. Moreover, Taxpayer does not argue that the “determination” that Supervisor Korzec approved differed in any way from RA Czora’s initial determination to assert the § 6707A penalty. Finally, this case does not involve a notice of deficiency, which, as discussed above, could limit a supervisor’s discretion to prevent the assessment of a penalty.

The Ninth Circuit acknowledges that its interpretation allows a revenue agent to signal penalty imposition without first obtaining approval – the concern expressed by Congress in enacting the provision but it falls back on its conclusion that the law as written does not require approval before the matter procedurally moves out of the supervisors hands.  Here, the supervisor had the authority to approve or deny the penalty prior to assessment.

The IRS has more administrative leeway in imposing an assessable penalty than a liability handled by the deficiency process.  Up until the moment of assessment, the IRS can make decisions that impact the assessment.  By holding that the approval just needs to occur before assessment, the Ninth Circuit gives the IRS the approval it needs not only to save the penalty in the Laidlaw case but also numerous other cases involving assessable penalties. 

What impact will Laidlaw’s approach to interpreting when an “initial” determination arises in cases that are subject to deficiency procedures? In a deficiency case the IRS loses control long before the assessment occurs.  Once the notice of deficiency is sent, the taxpayer can file a Tax Court petition and the IRS has no more ability to control the assessment.  So, this decision makes a clear distinction between cases based on the procedural path they take toward assessment.  The Tax Court’s approach focuses on the 30-day letter as the initial determination moving the timing of the approval to a stage that can be well before assessment but at a point that could impact the discussion/negotiation of the outcome.  The Ninth Circuit, by focusing on assessment or the point at which the IRS has lost control of assessment provides a greater cushion for the IRS to come into compliance.

Assuming this taxpayer does not take the case to the Supreme Court or does not obtain certiorari, the possibility remains that on this legal issue of the interpretation of “initial” a future case may go up to the Supreme Court because of a split in the circuits.

2021 Year in Review – Graev

Maybe it’s too much to devote one year in review post to a single issue, but Graev has dominated case decisions the past few years and maybe, maybe not, is on its way out.  As we reported and blogged about here, the now stalled Build Back Better legislation has a provision that will eliminate Graev, not just going forward, but going back over 20 years.  Not since the retroactive elimination of the telephone excise tax has Congress tried to undo itself in such a grand way.  Since this may be the last hurrah for Graev, why not send it out in style or, if it remains, why not remind ourselves how a poorly worded piece of legislation can cause so much havoc.

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Since the IRS has noticed the existence of IRC 6751(b), it seems now to have procedures in place to ensure that the immediate supervisor of the employee imposing the penalty actually approves the penalty imposition.  If the IRS has finally figured this out, why then repeal the legislation now and why does it receive a relatively high score from Congress for repealing it?  One suggestion concerns a whole bunch of old shelter cases that exist out there in pre-notice of deficiency status in which the IRS failed to follow the now more clearly defined rules of IRC 6751(b).  If true, it becomes easier to see why the administration would push for retroactive repeal and why certain groups of taxpayers would push back.  While we contemplate what might happen in the future, let’s look at the more important Graev decisions of 2021.

Graev and the Fraud Penalty

I posted on a decision that troubled me because when the IRS pursues a taxpayer criminally, the case goes through a myriad set of approvals.  Yet in Minemyer v. Commissioner, T.C. Memo 2020-99 – a case that took 10 years to decide – the Court found that the IRS did not follow IRC 6751(b) and stripped off the civil fraud penalty following a criminal tax case.  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.

The Tax Court followed up the Minemyer case with a precedential decision in Beland v. Commissioner, 156 T.C. No. 5 (2021), where 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 five years after the case was filed. 

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 on the penalty, but the statute has a specific structure applicable to all penalties.  Striking the fraud penalty in this situation may be part of what’s causing Congress to rethink its passage of IRC 6751(b), but for the reasons discussed in a post by Nina Olson, that seems too radical a fix to a problem that it could resolve with better statutory language.

Graev and the Early Withdrawal Excise Tax

Pulling money out of a retirement account before reaching 59 and ½ and without meeting one of the statutory exceptions in IRC 72(t) triggers a 10% excise tax usually referred to as a penalty and determined by bankruptcy courts to be a penalty for purposes of priority classification.  In Grajales v. Commissioner, 156 T.C. No. 3 (2021), the Tax Court determined that the 10% exaction imposed under IRC 72(t) is not a penalty for purposes of whether the IRS must obtain supervisory approval prior to its imposition.  The amount at issue in this precedential opinion was $90.86 and the case was litigated by Frank Agostino, the godfather of IRC 6751(b) litigation. See Frank’s brief here, and the government’s here.  Frank lost this one but given the way that most people look at this exaction, his arguments were not illogical.

Conservation Easement Cases

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 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.

When is Supervisory Approval Necessary

In Walquist v. Commissioner, 152 T.C. No. 3 (2021), the issue focused on 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.”

This decision creates a dichotomy between low-income taxpayers whose cases are regularly handled by somewhat automated processes and higher income taxpayers whose cases are not.  The Court did not need to issue a precedential opinion in a case in which the taxpayers were unrepresented tax protestors, yet decided to do so despite the inability of the adversarial process to work effectively.  The Court heard only from the government and clearly expressed displeasure at the unfounded arguments advanced by these taxpayers.  The decision leaves a bad taste in my mouth for the way it casually treats an issue involving many low-income taxpayers without giving lawyers for low-income taxpayers the opportunity to present arguments explaining why this result should not attach.  I have a working paper on the topic of precedential opinions in pro se cases and possible solutions to the creation of precedent where only the government has a real voice.

Throwing the Baby Out with the Bathwater – the Proposed Repeal of IRC § 6751(b) Supervisor Approval of Penalties

Avid readers of Procedurally Taxing know that we have been closely following the litigation over IRC § 6751(b) and the Graev line of cases.  This litigation has also received attention from Congress in the Build Back Better Act, H.R. 5376, in which § 138404 repeals this provision and replaces it with a toothless requirement of quarterly certification to the Commissioner.  The repeal is retroactive to its enactment in the Internal Revenue Service Restructuring and Reform Act of 1998 (RRA 98).

I’m not going to go through all the cases raising this issue – you can read about them here and here and here and here and here and so forth.  Suffice it to say that for nigh on to twenty years the IRS just ignored the language of § 6751(b), which provides:

No penalty under this title shall be assessed unless the initial determination of such assessment is personally approved (in writing) by the immediate supervisor of the individual making such determination or such higher level official as the Secretary may designate.

IRS issued no regulations or other guidance on this point, and it wasn’t until the Treasury Inspector General for Tax Administration (TIGTA) issued a report in 2013 noting the IRS was not complying with the provision that Frank Agostino decided to challenge the imposition of a penalty in Graev because there was no written approval by a supervisor.

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Why did Congress see fit to enact this provision in the first place?   During the hearings leading up to the enactment of RRA 98, Congress heard from many sources that the IRS was using penalties as bargaining chips in audit and appeals context.  That is, as Gwen Moore wrote in a recent Forbes blog,

When the law was passed in 1998, the Senate Finance Committee explained the legislation was needed to correct glaring problems in tax administration and provide much-needed taxpayer protections. The first problem was that at that time, the IRS was not required to “show how penalties are computed on the notice of the penalty.”  S. Rep. 105-174, at 65 (1998). The second was that penalties were used as a bargaining chip, and “[i]n some cases, penalties may be imposed without supervisory approval.” Id. Section 6751 was added to the Internal Revenue Code because the Senate Finance Committee “believes that taxpayers are entitled to an explanation of the penalties imposed upon them,” and “that penalties should only be imposed where appropriate and not as a bargaining chip.” Id.

In fact, I was a witness at one RRA 98 hearing when penalties-as-bargaining-chips were discussed.  At that February 5th, 1998, hearing, no less an authority than Michael Saltzman (of IRS Practice and Procedure treatise fame) in his formal testimony wrote,

In practice, the penalty has become a penalty for “being wrong” in the opinion of the revenue agent.  Many practitioners also believe that the penalty is asserted at the district level solely to gain some bargaining advantage at the Appeals level.  This creates additional expense for taxpayers in fighting the penalty when all that may truly be in dispute is a frank difference of opinion as to what the law requires.  (IRS Restructuring, Hearings before the Senate Committee On Finance, S. Hrg. 105-529, at 372.)

Section 6751(b) was Congress’ response to these legitimate concerns, echoed by other witnesses, including Stefan Tucker, then Chair-elect of the American Bar Association Section of Taxation (see page 92 of the Hearing record).  Supervisor approval helps ensure consistent and equitable treatment for taxpayers.  As Michael Saltzman noted, each examiner approaches the job and issues with a little bit (or sometimes a lot) different mindset.  What one thinks is negligent or fraudulent will be different from what another thinks.  Laying a second set of eyes and judgement on the case can smooth out the edges of differing value systems and mindsets of examiners.  If done correctly, the supervisor should ask a few questions which could reveal gaps in the examiner’s exam procedures (such as the examiner failing to ask a salient question that might have clarified why the taxpayer did what they did, which might show a penalty isn’t warranted).  This process could eliminate some penalties but perhaps strengthen others where penalties are in order.  In this way, supervisor review promotes good tax administration and reinforces effective exam procedures.  A quarterly report is not going to accomplish that.

Now, the language of 6751(b) could be more clearly stated.  Courts have struggled with when the written supervisory approval should be obtained – before issuance of the notice of deficiency (NOD), or just before the tax is assessed.  And how does this provision apply to immediately assessable penalties or penalties not otherwise subject to deficiency procedures?  If supervisor approval must only occur before assessment, this approach gives the IRS plenty of time to correct a failure to obtain the approval earlier in the process, but it does nothing to avert the harm to taxpayers caused by use of penalties as negotiating tools, nor does it promote effective exam procedures discussed above.  Timing is important to achieve the goal of the statute, which was to ensure that someone was looking over front-line employees’ shoulders on the important issue of penalty imposition so that penalties are imposed for the appropriate reasons (to promote voluntary compliance and to discourage noncompliance).

Why would Congress now want to make this provision disappear – retroactively, back to enactment, as if the underlying concern never existed?  I would hazard a guess that someone suggested that well-heeled taxpayers were pulling a fast one over the IRS and avoiding appropriate penalties simply because of a technical foot-fault.

But penalties are not a foot-fault.  They can be a significant expense to taxpayers, and in most instances interest accrues on penalties daily, so that often, if a taxpayer has entered into an installment agreement, after years of paying, the actual remaining liability is made up of only penalties and interest.  Research I published as the National Taxpayer Advocate shows that improperly assessed penalties actually increases noncompliance in future years.  So it is well worth it for the IRS to take the extra time to ensure the appropriate application of penalties. 

To come back to the topic of well-heeled taxpayers getting off easy, I suggest you review two research studies published in the National Taxpayer Advocate Annual Reports to Congress in 2013 and 2019.  In these studies we looked at the IRS application of the IRC § 32(k) two-year ban of the Earned Income Tax Credit where the IRS made “a final determination that the taxpayer’s claim of credit was due to reckless or intentional disregard of rules and regulations.” 

In 2013, the Taxpayer Advocate Service (TAS) reviewed a representative sample of the 32(k) cases and found:

  • In almost 40% of the cases, the ban was imposed without the required “determination” of the taxpayer’s state of mind;
  • In 69% of the cases IRS employees did not obtain required managerial approval before imposing the penalty; and
  • In almost 90% of the cases, “neither IRS work papers nor communications to the taxpayer contained an adequate explanation of why the ban was being imposed.

Following our study, TAS negotiated with the IRS to update the Internal Revenue Manual provisions to include a requirement that auditors must note the reason for imposition in their workpapers.  Both the 2013 and 2016 IRMs required supervisory approval of 32(k) penalty revision.  Here’s what IRM 4.19.14.7.1 ban requires Correspondence Exam Technicians to do before asserting (or not) the 2 year ban:

● Review the documentation submitted by the taxpayer

● Determine whether the 2-year ban should be asserted based on applicable tax law and
1. the taxpayer’s documentation
2. taxpayer contact
3. IDRS research
4. Prior year CEAS workpapers

● Clearly document workpapers as indicated in 4.19.13.6, Workpapers for All Cases, including the decision and reason to impose or not impose the 2-year ban

● Get managerial approval on CEAS Non-Action note prior to asserting the 2-year ban

Note:

Do not use standard statements such as 2-year ban is applicable because taxpayer showed intentional disregard of the rules and regulations for EIC/CTC/ACTC/ODC or AOTC. Proper workpaper documentation should clearly outline the audit steps taken and fully explains the decision to assert or not assert the 2-year ban.

In 2019, TAS undertook an updated study to see how IRS examiners were complying with the new IRM procedures.  Here’s what TAS found:

  • In 54% of the cases, the auditor imposed the ban without the required managerial approval; and
  • In 84% of the cases, the explanation provided to the taxpayer on Form 886-A for imposition of the ban was inadequate.
  • In over half of the cases where taxpayers submitted documentation and the ban was imposed, it appeared from the documentation taxpayers believed they were eligible for the credit (thus negating the requirement of reckless and intentional disregard).

It is not clear why Congress would want to let the IRS off the hook here.  The TAS studies show the amount of 32 (k) penalty imposed (disallowance of future EITC) can be as much as 23 percent of taxpayers’ adjusted gross income.  It is one thing to violate the IRM, but why should we reward the IRS for ignoring the statutory mandate, especially where the imposition can create financial havoc for the taxpayer?

This is a problem of the IRS’s own making.  It could have issued clear guidance back in 1999 following the enactment of RRA 98 and established quality review procedures to ensure adherence to this guidance.  (I know this is possible – at times in TAS we imposed 100% supervisor or analyst review of certain aspects of casework where we determined those elements were critical to the fair and accurate treatment of taxpayers.  It can be done.  That is Management 101.)  It could have saved itself (and the public fisc) millions of dollars in litigation costs had it taken these steps decades ago.  The IRS finally got around to issuing IRM guidance in October, 2020 addressing the timing of supervisory approval (IRM 20.1.1.2.3.1) which PT discusses here.

Because the IRS ignored the statutory protection for two decades, the problem that existed in 1998 is still present – the IRS imposes penalties as punishment and without adequate explanation, to itself or its taxpayers, and it doesn’t seem to care enough to fix it on its own.

It doesn’t have to be this way – we don’t need to repeal 6751 to address the issue of “foot faults.”  All that Congress needs to do is amend 6751(b) to make clear that supervisory approval must occur before the issuance of a notice of deficiency where one is required, or with respect to immediately assessable penalties or those not subject to deficiency procedures, “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,” as the current IRM requires.  Further, direct the Secretary to issue guidance as to the level and process of supervisory approval.  Then the litigation will have had a salutary effect, and accomplished what Congress tried to do the first time around.

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.