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.
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.