Ford v. Commissioner: A step forward in the shadow of Graev III

I.R.C. § 6751 states that no penalty 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.” Exceptions from the requirement of supervisory approval are for penalties under § 6651 (failure to pay and file) and §§ 6654 and 6655 (failure to make estimated tax penalties by individuals and corporations). See I.R.C. § 6751(b)(2).

Ford v. Commissioner involves the petitioner, Mrs. Joy Ford, who with her deceased husband, Mr. Sherman Ford, formed a country music label called Country International Records in 1974. They also started the Bell Cove Club in Hendersonville, Tennessee, just outside Nashville, in the late 1980’s. Bell Cove – still in operation – has been an important venue for up and coming country music stars to take the stage and perform before talent scouts and agents in the competitive Nashville music scene.

In each of 2012, 2013, and 2014, Bell Cove sustained significant losses which appear to have been reported on Schedule C of Mrs. Ford’s Form 1040 and which offset her income from other sources. The IRS audited Mrs. Ford’s individual income tax returns and proposed to deny the losses, arguing that Bell Cove was not an activity engaged in for profit under I.R.C. § 183, but rather a hobby for Mrs. Ford. The IRS also sought to deny NOL deductions on two years of tax returns. Finally, it proposed an accuracy-related penalty for negligence under I.R.C. § 6662. Mrs. Ford’s case went to trial before Judge Foley in May 2017.

The seven-page memorandum decision addresses three issues. The first was whether the Bell Cove was an activity engaged in for profit or a hobby in 2012, 2013, and 2014, and the second was whether Mrs. Ford was entitled to net operating losses (NOL) deductions from earlier years. In the decision, Judge Foley quickly disposed of the first two issues. Albeit with an approving nod to the mission and contributions of Bell Cove to the Nashville music scene, he determined that the operation of Bell Cove was “primarily motivated by personal pleasure, not profit, and simply used the club’s losses to offset her [other] income.” T.C. Memo. 2018-8, Slip Op. at 6. He noted that the handwritten ledger did not match business expenses reported on the returns, that Mrs. Ford frequently used her personal bank account to pay Bell Cove’s expenses, and that the amount paid to performers generally exceeded the revenue from ticket sales. Judge Foley also sustained the respondent’s disallowance of NOL deductions for lack of substantiation.

The remaining issue, and the one relevant here, concerns the accuracy-related penalty. The decision states:

We do not, however, sustain the section 6662(a) accuracy-related penalties relating to negligence for the years in issue. Respondent failed to present any evidence that the penalties were “personally approved (in writing) by the immediate supervisor of the individual making such determination.”… Accordingly, he did not meet his burden of production, and petitioner is not liable for the determined penalties.

The IRS has the burden of production under § 7491(c) for certain penalties in a deficiency case, including showing compliance with the requirements of § 6751(b). See Graev III. The penalty at issue in Ford, and a common penalty for many petitioners, is the accuracy-related penalty under § 6662(a).

Over the last year, the Tax Court and Second Circuit Court of Appeals have sought to define what the IRS must show in order to prove the petitioner is liable for penalties, and when the IRS must show it. See Graev v. Commissioner, 147 T.C. No. 16 (November 30, 2016) (“Graev II”), Chai v. Commissioner, 851 F.3d 190, 221 (2d Cir. 2017), and Graev III. There have also been a series of excellent posts by Keith (here, here, and here) and Carl Smith (here) about these cases and their impacts on this site. These posts are worth reading and this post will not re-span the ground they cover other than to identify the landscape post-Graev III, and how Ford builds on it.

Graev III, issued December 20, 2017, held that in a deficiency case, the IRS’s burden of production under § 7491(c) for certain penalties includes showing compliance with the requirements of § 6751(b). Graev III was significant in that it overruled the earlier decision in Graev II and rejected that majority’s holding that the written approval may be obtained at any time before the penalty is assessed, and any challenge under § 6751(b) must be made after assessment of the underlying tax liability. This would effectively postpone challenges under § 6751(b) until after the deficiency dispute has been decided, whether by settlement or at trial. The Graev III court seems to adopt the timing standards set forth by the Second Circuit in Chai v. Commissioner. This rule says that the IRS must “obtain written approval of the initial penalty determination no later than the date the IRS issues the notice of deficiency (or files an answer or amended answer) asserting such penalty.”

Following Graev III, Tax Court judges issued a number of orders asking parties to weigh in on whether and how Graev III affected them. Ford is the first decision issued post-Graev III addressing whether the IRS met its burden of production by showing compliance with the requirements of § 6751(b). As noted above, in Ford Judge Foley held that respondent failed to put on evidence sufficient to meet this burden. This was good for Mrs. Ford and appears to be a good sign for petitioners going forward.

I hesitate to overstate the significance to Ford, but it demonstrates the Court’s willingness to sua sponte require the IRS to show compliance with § 6751(b) in at least some cases involving penalties. We know that Mrs. Joy Ford was represented by counsel, but it’s not clear from the decision to what degree and on what basis her counsel challenged penalties and if the issue of compliance with § 6751(b) ever came up. Therefore, on its own, Ford does not give us clear guidance on what this means for pro se litigants, or even represented petitioners with pending cases involving penalties where § 6751(b) compliance issues were not raised.

If judges increasingly sua sponte require the IRS to show it complied with § 6751(b), then petitioners are likely to prevail on the issue of penalties unless respondent’s counsel immediately anticipates this challenge and puts on evidence that the § 6751(b) requirements were met. Assuming that Ford does not alter the landscape so much as to make it standard for judges to sua sponte require respondent to prove it complied with § 6751(b), another more practical question arises: how should petitioners’ counsel approach penalty challenges in light of the timing rule that respondent must obtain supervisory approval of penalties “until no later than the date the IRS issues the notice of deficiency (or files an answer or amended answer) asserting such penalty”?

Certainly Graev III and Ford empower petitioners and their counsel to raise the issue that the IRS has the burden of production under § 7491(c) to show compliance with the § 6751(b) procedures, and to argue that penalties at issue should not be sustained absent such a showing. But when is the best time to make this argument? More specifically, is this something petitioners should state in their petitions to Tax Court?

As noted above, the language in Chai which Graev III seems to have adopted, would give the IRS up until the notice of deficiency is issued or the Answer or Amended Answer is filed to obtain supervisory approval of penalties sufficient to comply with § 6751(b). Chai seems to suggest that for penalties asserted in a notice of deficiency, the IRS would need to have obtained approval of the penalties by a supervisor before the notice was issued. It also suggests that in instances where respondent’s counsel may seek to assert penalties not originally asserted in the Notice of Deficiency in the Answer (or Amended Answer), then supervisory approval must be obtained prior to the issuance of the Answer (or Amended Answer). At this point, it’s not clear from Chai or Graev III whether the IRS could go back and obtain supervisory approval of a penalty after a notice of deficiency is issued but before an Answer (or Amended Answer) is filed if the IRS determines that the requirements of § 6751(b) were not met prior to issuance of the notice of deficiency.

Because of this uncertainty, I question whether raising a § 6751(b) challenge in a petition would invite the IRS to obtain supervisory approval if it appears to be missing before the Answer is filed. While the students and staff in our clinic strive to be as transparent as possible in our dealings with IRS Counsel, we would not want to show all our cards in the petition if doing so could later preclude us from making an argument in our client’s favor. At this point, unless and until judges require the IRS to show it complied with § 6751(b) as a matter of course, it may be safest for petitioner to simply state she disagrees with the IRS’s proposed assessment of penalties in her petition and save any potential § 6751(b) arguments for later negotiations or trial, if necessary.