Thursday, March 11, 2021

Knowing How to Use IRS Supervisory Approval Rules To Fight Tax Penalties

According to Law360, each year, the Internal Revenue Service proposes millions of dollars in penalties against taxpayers. Knowing how to defend against proposed penalties is essential for taxpayers and their advisers, and they will fare better when they understand the tools in their penalty defense toolbox. 

The penalty approval provisions are contained in Internal Revenue Code Section 6751, which has proved to be helpful for many taxpayers to avoid penalties in instances where the IRS has failed to comply with procedural obligations imposed by Congress to combat the proposal of penalties as a bargaining chip.

IRC Section 6751(b) imposes procedural requirements that the IRS must follow before determining and assessing certain penalties. These requirements must be satisfied when the IRS seeks to impose certain penalties, including the discretionary and nonautomatically-calculated penalties. IRC Section 6751 was added to the code in the 1998 Restructuring and Reform Act to address Congress’ concern that the IRS was asserting penalties as a bargaining chip in cases where there was no basis for a penalty.
IRC Section 6751 imposes two requirements on the IRS:
  1. The IRS must “include with each notice of penalty ... the name of the penalty, the Section of the Code under which the penalty is imposed, and a computation of the penalty.” and
  2. An “initial determination of … [the] assessment” of certain penalties, including the section 6662[5] penalties, must “be personally approved (in writing) by the immediate supervisor of the individual making such determination.”
Failure To Comply With These Requirements
May Result In The Prohibition Of Any Penalties,
Regardless Of The Substantive Merits.

Because the term “initial determination” was not defined in the statute or the regulations, the plain language of the text left open to debate the question of when an initial determination must be made and supervisory approval obtained. Yet, it took almost twenty years before courts began interpreting this provision.
The Tax Court first addressed the meaning of the initial determination in 2016 in Graev v. Commissioner, 147 T.C. 460 (2016). In Graev, the court in a divided opinion rejected the taxpayer’s argument that supervisory approval was not properly obtained because it interpreted the term assessment to mean the recording of a penalty liability of a taxpayer after a court decision becomes final and unappealable. In other words, it was premature to determine whether the IRS has complied with IRC Section 6751 because there had not yet been an assessment. 
The following year, the U.S. Court of Appeals for the Second Circuit heard a similar case in Chai v. Commissioner, 851 F.3d 190 (2d Cir. 2017) , aff’g in part, rev’g in part T.C. Memo. 2015-42, 
and rejected the Tax Court’s holding in Graev, instead holding that the written approval requirement requires such approval no later than the date that the IRS issues a notice of deficiency (or files and answer or amended answer) asserting the penalty. After Chai, the Tax Court vacated its earlier decision in Graev (which was also appealable to the Second Circuit), and followed Chai. 
Since Graev and Chai, the supervisory approval requirement has been the subject of significant litigation and has resulted in several clarifications about the supervisory approval rule. These can be summarized as follows: 
  • Penalties determined based on a substantial understatement of tax ground are exempt from the supervisory approval requirement because such penalties are automatically calculated through electronic means.
  • Supervisory approval need not be made on a particular document, and different penalties can be asserted at different times so long as the approval requirements are met.
  • Supervisory approval must occur no later than the first communication that advises the taxpayer that penalties will be proposed and giving the taxpayer the right to appeal.
  • Notifying a taxpayer of a tentative proposed adjustments and inviting it to a conference to discuss does not constitute the initial determination; there must be a definite determination in a formal communication such as a 30-day letter, 60-day letter, notice of deficiency or notice of final partnership administrative adjustment.
  • The IRS bears the initial burden of production under IRC Section 7491(c)[14] to offer evidence of compliance with IRC Section 6751(b)(1).
  • The written supervisory approval requirement applies in deficiency, partnership, and collection due process cases, as well as situations involving assessable penalties.
Resulting in communication by the IRS in an informal document request or notice of proposed adjustment of a potential penalty does not constitute an initial determination that requires compliance with IRC Section 6751. This would appear to be true even if the informal document request or notice of proposed adjustment stated that the IRS had determined to apply a penalty but asked for the taxpayer’s position. In other words, preliminary communications of proposed penalties in these types of documents would not be sufficient to satisfy a conclusive requirement in the statute that affixes to the term "determination."

    As The Tax Court Has Stated, ‘Determination’ Is Not A Synonym For A Mere Suggestion, Proposal,
    or Initial Informal Mention of The Possibility
    of the Assertion of A Penalty.
The IRS often concludes that a penalty should be imposed well before communicating to the taxpayer its formal right to pursue IRS appeals or litigation in the Tax Court. The Tax Court has strived to create a more administrable bright-line test in this regard, but arguably the potential for using penalties as a bargaining chip remains under this test.
When the IRS asserts discretionary penalties subject to the supervisory approval requirement, taxpayers should ensure that the IRS has complied with the requirements of IRC Section 6751.
Possible ways to determine whether the penalty approval requirements have been met include requesting the administrative file from the appeals officer, or, if necessary, in filing a Freedom of Information Request or pursuing through discovery once in court. If the IRS cannot prove that it fulfilled these obligations in a timely manner, the taxpayer may be able to avoid the penalties in full.
In many older cases, because of the IRS’ failure to adhere to IRC Section 6751 requirements and the prior uncertainty in the law, some taxpayers have been able to take advantage of the IRS’ procedural foot-fault to avoid penalties. Going forward, the IRS presumably will be much more diligent in ensuring that IRC Section 6751 requirements are met before a penalty is formally communicated to a taxpayer.
But once a case reaches IRS appeals or litigation to remove any inappropriately determined penalties from the case  taxpayers should be proactive to increase any chances of a settlement on the merits.
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