–Or, Tax Court Burnt by Second Circuit’s Hot Chai
Yesterday the Second Circuit decided a very important decision in favor of the taxpayer pertaining to the Section 6571 requirement that a direct supervisor approve a penalty before it is assessed. In Chai v. Commissioner, the Second Circuit reversed the Tax Court, holding the Service’s failure to show penalties were approved by the immediate supervisor prior to issuing a notice of deficiency caused the penalty to fail. In doing so, the Second Circuit explicitly rejected the recent Tax Court holdings on this matter, including Graev v. Commissioner, determining the matter was ripe for decision and that the Service’s failure prevented the imposition of the penalty. Chai also has interesting issues involving TEFRA and penalty imposition that will not be covered (at least not today), and is important for the Second Circuit’s rejection of the IRS position that the taxpayer was required to raise the Section 6571 issue. It is lengthy, but worth a read for practitioners focusing on tax controversy work.
PT regulars know that we have covered this topic on the blog in the past, including the recent taxpayer loss in the very divided Tax Court decision in Graev v. Commissioner. Keith’s post on Graev from December can be found here. For readers interested in a full review of that case and the history of this matter, Keith’s blog is a great starting point, and has links to prior posts written by him, Carlton Smith, and Frank Agostino (whose firm handled Graev and also the Chai case). Graev was actually only recently entered, and is appealable to the Second Circuit, so I wouldn’t be surprised if the taxpayer in that case files a motion to vacate based on the Second Circuit’s rejection of the Tax Court’s approach in Greav.
read more... Before discussing the Second Circuit holding, I will crib some content from Keith, to indicate the status of the law before yesterday. Here is Keith’s summary of the holding in Graev: The Court split pretty sharply in its opinion with nine judges in the majority deciding that the IRC 6751(b) argument premature since the IRS had not yet assessed the liability, three judges concurring because the failure to obtain managerial approval did not prejudice the taxpayers and five judges dissenting because the failure to obtain managerial approval prior to the issuance of the notice of deficiency prevented the IRS from asserting this penalty (or the Court from determining that the taxpayer owed the penalty.) That paragraph from Keith’s post regarding the holding doesn’t cover the lengthy and nuanced discussion, but his full post does for those who are interested. The Second Circuit essentially rejected every position taken by the majority and concurrence in Graev, and almost completely agreed with the dissenting Tax Court judges (with a few minor differences in rationale). For its Section 6751(b) review, the Second Circuit began by reviewing the language of the statute. It highlighted the fact that the Tax Court did the same, and found the language of the statute unambiguous, a conclusion with which the Second Circuit disagreed. Section 6751(b)(1) states, in pertinent part: 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…[emph. added] The Tax Court found the lack of specification as to when the approval of the immediate supervisor was required allowed the immediate supervisor to approve the determination at any point, even after the statutory notice of deficiency was issued or the Tax Court reviewed the matter. The Second Circuit, however, found the language ambiguous, and the lack of specification as to when the approval was required problematic. The Second Circuit stated “[u]understanding § 6751 and appreciating its ambiguity requires proficiency with the deficiency process,” and then went through a primer on the issue. To paraphrase the Second Circuit, the assessment occurs when the liability is recorded by the Secretary, which is “essentially a bookkeeping notation.” It is the last step before the IRS can collect a deficiency. The Second Circuit stated the deficiency is announced to the taxpayer in a SNOD, along with its intention to assess. The taxpayer then has 90 days to petition the Tax Court for review. If there is a petition to the Court, it then becomes the Court’s job to determine the amount outstanding. As it is the Court’s job to determine the amount of the assessment, the immediate supervisor no longer has the ability to approve or not approve the penalty. The Second Circuit agreed with the Graev dissent that “[i]n light of the historical meaning of ‘assessment,’” the phrase “initial determination of such assessment” did not make sense. A deficiency can be determined, as can the decision to make an assessment, but you cannot determine an assessment. The Second Circuit then looked to the legislative history, and found the requirement was meant to force the supervisor to approve the penalty before it was issued to the taxpayer, not simply before the bookkeeping function was finalized. The Court further stated, as I noted above, if the supervisor is to give approval, it must be done at a time when the supervisor actually has authority. As the Court noted, [t]hat discretion is lost once the Tax Court decision becomes final: at that point, § 6215(a) provides that ‘the entire amount redetermined as the deficiency…shall be assessed.” The supervisor (and the IRS generally) can no longer approve or deny the imposition of the penalty. The Court further noted, the authority to approve really vanishes upon a taxpayer filing with the Tax Court, as the statute provides approval of “the initial determination of such assessment,” and once the Court is involved it would no longer be the initial determination. Continuing this line of thought, the Second Circuit stated that the taxpayer can file with the Tax Court immediately after the issuance of the notice of deficiency, so it is really the issuance of the notice of deficiency that is the last time where an initial determination could be approved. This aspect of the holding is important for two reasons. First, the Second Circuit is requiring the approval at the time of the NOD, and not allowing it to be done at some later point. Second, this takes care of the ripeness issue. If the time is set for approval, and it has passed, then the Court must consider the issue. Of potentially equal importance in the holding is the fact that the Second Circuit stated unequivocally that the Service had the burden of production on this matter under Section 7491(c) and was responsible for showing the approval. It is fairly clear law that the Service has the burden of production and proof on penalties once a taxpayer challenges the penalties, with taxpayers bearing the burden on affirmative defenses. The case law on whether the burden of production exists when a taxpayer doesn’t directly contest the penalties is a little more murky (thanks to Carlton Smith for my education on this matter). The Second Circuit made clear its holding that the burden of production was solely on the Service, and the taxpayer had no obligation to raise the matter nor the burden of proof to show the approval was not given. The Service had argued the taxpayer waived this issue by not bringing it up earlier in the proceeding, which the Second Circuit found non-persuasive. As to the substance of the matter, the Second Circuit held the government never once indicated there was any evidence of compliance with Section 6751. Since the Commissioner failed to meet is burden of production and proof, the penalty could not be assessed and the taxpayer was not responsible for paying it. A very good holding for taxpayers, and we would expect a handful of other case to come through soon. Given the division within the Tax Court, and the various rationales, it would not be surprising to see other Circuits hold differently.
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About time a court respected the law. FWIW, my 2015 article raised this very issue (with due thanks to Procedurally Taxing for bringing the issue to light in the first place!). See Improperly Burdened: The Uncertain and Sometimes Unfair Application of Tax Penalties. Here’s the SSRN: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2673570
I highly recommend Prof. Wright’s article for anyone who hasn’t read it yet.
I feel the Second Circuit got Chai mostly right: Chai essentially holds that the IRS should shoulder the burden of at least coming forward with the signed form approving the penalty in every case in which a taxpayer has at all put a discretionary penalty at issue — even if the taxpayer has not explained what defects there might be in the penalty. For example, the Tax Court has held that the merest mention of a contest to penalties (stating no particular defect) puts the IRS, say, to the burden in a 6654 penalty to prove whether the taxpayer filed a return for a prior year and what the amount of tax reported on that return was (all for purposes of figuring out the required quarterly estimated tax payment due). Wheeler v. Commissioner, 127 T.C. 200 (2006), affd. 521 F.3d 1289 (10th Cir. 2008). As I read Chai and Wheeler together, if anyone files a deficiency petition and says: “I contest the accuracy-related penalty”, but says nothing more, the IRS must now introduce the written approval form into the Tax Court record or simply lose the penalty. I was heartened to see that Judge Gustafson enforced 6751(b)(1)’s limitations in the Vigon CDP case that Keith blogged on twice, even though the pro se taxpayer there made no mention of a section 6751(b)(1) defect in his contest to the penalty.
But, I have two problems with Chai:
First, Chai also gratuitously says that 6751(b)(1)’s requirements can be met, when the IRS seeks a penalty in an answer or amended answer that was not sought in the notice of deficiency, by getting supervisory approval at that time. Obviously, at that time, the Counsel lawyer’s supervisor would be the one giving the approval. Even though I know that 6214(a) permits the IRS to seek a greater deficiency or penalty during a Tax Court case than was set out in the notice, to read that provision in harmony with section 6751(b)(1), to me, requires that no penalty covered by the statute (i.e., non-mechanically-asserted penalties) should be asserted or increased by answer or amended answer. Otherwise, the IRS is being allowed to use penalties as a bargaining chip in getting a better settlement — the exact concern mentioned in the legislative history of 6751(b)(1). Chai’s comment about asserting penalties in answers or amended answers was gratuitous because the notice of deficiency sought the 6662 penalty in Chai. While the IRS later tried to greatly increase the penalty through either its answer or amended answer (I’m not clear), the opinion reports that the IRS abandoned that additional penalty. So, the Second Circuit should not have expressed dicta about whether a new or increased penalty can be asserted by answer or amended answer.
Second, I think it is high time that the Tax Court reject is opinion in Swain, 118 T.C. 358 (2002), where it held that the IRS has no burden of production on penalties when a taxpayer makes no mention of contesting penalties in his or her pleadings. I have blogged before on how Tax Court judges often ignore Swain and help out pro se taxpayers who haven’t at all mentioned penalties in their petitions, yet the judges still impose the penalty burden of production on the IRS. However, on other occasions, judges sometimes cite Swain — particularly against tax protestors. This disparate treatment of taxpayers based on how cooperative they seem with the court, frankly, stinks. Why not just adopt a uniform rule that in the case of any notice of deficiency petitioned to the court that shows a penalty, the IRS has the burden of production under 7491(c), even if the taxpayer doesn’t specifically mention the penalties in the taxpayer’s pleadings? I bet in 99% of pro se petitions, the taxpayer assumes that penalties are contested just by filing a petition — even if penalties are not specifically pleaded. Of course, overruling Swain in Chai would have been dicta, since I assume that Frank Agostino’s firm’s petition did mention a contest to the penalty, even if we know from the opinion that the 6751(b)(1) problems was only raised post-trial. So, I guess I am hoping that the Tax Court itself in some future pro se person’s case abandon Swain as a trap for the unwary. I simply don’t believe that Congress, in putting the burden of production on the IRS on penalties, thought, “Of course, there is no burden if some pro se taxpayer doesn’t know enough to mention the penalties.”
Do any other practitioners have experience with the IRS imposition of tax preparer penalties from EITC audits? I am representing a preparer (pro bono) who has been assessed these penalties for two years and would welcome input. Email: taxattorneydaily1@gmail.com.
Let me congratulate the lawyers for their dogged pursuit on this issue. The Second Circuit’s holding on this issue seems to me be right.
Chai raised the following issues in my mind related to Chevron.
1. The Second Circuit in Chai first had to find the statute ambiguous, whatever that means. That seems to be the same inquiry as Chevron Step One.
2. Is nonsensical the same as ambiguous? The statute uses a term of art “assessment” that even new students learn in the first or second week of a tax class and presumably the drafters of the text knew. So, how would a court determine ambiguity in the statute? Stated otherwise, simply because what the legislature did makes no sense does not mean that the legislature did not mean to do it as evidenced by the words it used. Certainly, a legislative prerogative is to do nonsensical things.
3. The court appears to have used statutory context (the SNOD to assessment process) to determine ambiguity, without resort to legislative history. It resorted to legislative history only after finding ambiguity. Gustafson’s dissent embraced by the Second circuit said in this regard: “If a statute is ambiguous, then we properly consult the legislative history to discern the statute’s purpose” and “Because the statute is thus ambiguous, we may look to the legislative history to determine Congress’s intent.” One leading author has noted that current state of play on this issue in the Chevron context: “[T]o the extent that the Court relies on legislative history at all, it may do so only [in Step Two] ‘to clear up ambiguity.'” John F. Manning, Chevron and Legislative History, 82 Geo. Wash. L. Rev. 1517, 1519 (2014).
4. So in looking to context rather than legislative history, the Court quickly moved through the steps to show why the statute was ambiguous (nonsensical). I like to think that any of my Tax Procedure students over the years could have made that same analysis. That is not to say that the Graev majority was off the page in its analysis, but it seems to me that, in terms of the fairness of the interpretation (which ultimately motivated the Second Circuit), the Tax Court majority’s intepretation is wrong.
5. Having brought up Chevron, as you know, there is a lot of commotion/angst among conservatives, libertarians and other government haters about transferring to the administrative state the power to make law through interpretation. These same constituencies prefer instead that courts make law through interpretation. Yet they also claim to want judges who do not make law. (And, of course, the consequence of transferring that power to make law to the courts is that the power is transferred from an institution (the agency) with deep knowledge and competence in the administrative area to an institution (the court) with uncertain and often unlikely deep knowledge and competence in that area.