The Tax Court, in Hommel, TC Memo 2020-4, has determined that an individual who had a $1 million tax deficiency was not liable for an accuracy-related penalty because the IRS failed to prove it complied with the required procedures for imposing such a penalty.
A penalty is imposed for filing an inaccurate return based on substantial understatement of tax due (Code Sec. 6662(b)(2) or based on negligence or disregard of the rules. (Code Sec. 6662(b)(1)) An understatement is substantial if it exceeds the greater of $5,000 or 10% of the tax required to be shown on the return. (Code Sec. 6662(d)(1)(A))
Under Code Sec. 6751(b)(1) an accuracy-related penalty can't be assessed unless the initial determination of the 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.
The Tax Court has held that Code Sec. 6751(b)(1) requires written supervisory approval of the "initial determination" of a penalty no later than the earlier of when:
- the penalty determination is communicated to the taxpayer in the form of a notice of deficiency (NOD), or
- another form of formal communication is sent to the taxpayer that both:
(a) advises the taxpayer that penalties were determined, and
(b) gives the taxpayer the opportunity to appeal that determination. (Clay, (2019) 152 TC 223)
In Palmolive, (2019) 152 TC 75, the taxpayer argued that the IRS hadn’t proved exactly how or when the revenue agents made their initial determinations to assess penalties. The penalty-approval form in Palmolive did not bear the name of the revenue agent who made the initial determination, or any name at all, but the parties stipulated to the identity of the IRS employees involved in making the initial penalty determination.
The taxpayer, Jason Hommel, ran a business selling bullion and minting and selling coins. For 2009 the IRS determined that Jason had a $1 million tax deficiency because he understated his income from the business by almost $6 million. Based on this deficiency, the IRS sought to impose an accuracy-related penalty based on substantial understatement of income. However, the IRS failed to introduce any evidence at trial that the penalty had been approved by an IRS supervisor before the deficiency notice was sent to the taxpayer.
After the trial, the IRS sought to reopen the record to introduce evidence of supervisory approval of the accuracy-related penalty. The IRS wanted to submit declarations averring that Agent Strayer conducted Jason’s 2009 audit and initially determined to impose the accuracy-related penalty.
However, the penalty-approval form did not include Agent Strayer’s name, but the name of Agent Cunningham. The penalty-approval form also did not contain an origination date. The IRS claimed that the error in the penalty-approval form was a clerical error that occurred because the case was first assigned to Agent Cunningham and then reassigned to Agent Strayer.
Jason objected to the IRS’s attempt to reopen the record, arguing that he would be prejudiced by the IRS's late introduction of the declarations related to the penalty determination.
The Tax Court determined that Agent Cunningham's name on the penalty-approval form called into question whether Agent Strayer was, in fact, the individual who made the penalty determination and whether his report was even the initial determination of the penalty. Unlike the taxpayer in Palmolive, Jason did not stipulate that Agent Strayer made the initial penalty determination. Therefore, the only thing linking Agent Strayer to an immediate supervisor was his declaration swearing he indeed made the initial determination and got the written approval from his supervisor.
According to the Tax Court, the problem for the IRS was that the penalty-approval form didn't speak for itself, and the declarations that the IRS sought to have admitted regarding the penalty-approval form were hearsay.
The Tax Court agreed with Jason’s argument that he would be prejudiced by the admission into evidence of the IRS’s declarations regarding Agent Strayer without any opportunity for cross-examination. Therefore, the Court refused to reopen the record and found that Jason was not liable for the accuracy-related penalty.
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