Executive summary: IRS shaping the contours of penalty approval
The IRS recently issued proposed regulations to clarify the supervisory approval requirement of section 6751(b) under various scenarios. Currently, U.S. Tax Court precedent states that approval must occur prior to the first formal communication of the intent to assess a penalty. However, the Eleventh and Ninth Circuit Courts of Appeals have rejected this rule and held that approval can occur any time prior to assessment, which is a plain reading of the statute. Following the appellate courts, the IRS proposes three different timing rules for managerial approval. Under the proposed regulations, the timing of approval depends on whether the penalty is or is not subject to Tax Court deficiency jurisdiction, or whether the penalty was raised for the first time by the government in a Tax Court pleading. The proposed regulation further explains the exception to the supervisory approval requirement and defines key terms such as, ‘initial determination,’‘immediate supervisor,’ ‘higher agency official’ and ‘written approval’. The proposed regulations set forth five examples to illustrate the rules and definitions.
The IRS issued a notice of proposed rulemaking to clarify the rules for supervisory approval of penalties under section 6751(b). Section 6751(b)(1) provides, “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.” The timing of the ‘initial determination’ and ‘supervisory approval’ has been the subject of litigation in the U.S. Tax Court and the Circuit Courts of Appeals over the last several years. This litigation produced different rules in different jurisdictions. Refer to RSM Alert discussing the litigation history and the Eleventh Circuit’s recent reversal of the Tax Court timing rule. The proposed regulation section 301.6751(b)-1 creates three timing rules, clarifies the exceptions, provides definitions for key terms and illustrates the proposed rules through five examples.
Proposed Timing Rules
The proposed regulation distinguishes three separate penalty situations and explains when the IRS would satisfy the approval requirement of section 6751(b)(1).
1. Penalties not subject to pre-assessment review in the Tax Court. The first rule applies to any penalty not subject to pre-assessment review in the Tax Court. In this situation, the IRS satisfies section 6751(b)(1) when the immediate supervisor (or designated higher level official) of the person who first proposed the penalty personally approves the penalty in writing before the penalty is assessed. Example 1 illustrates the rule with Section 6707(A) (Failure to disclose a reportable transaction), which is not subject to pre-assessment review in the Tax Court. Example 2 illustrates the rule with section 6662(b)(2), which could be subject to pre-assessment review but for the taxpayer consenting to the penalty and agreeing to its assessment. In both examples, the IRS satisfies section 6751(b)(1) if the supervisor approves any time before the penalty is assessed.
2. Penalties subject to pre-assessment Tax Court review. The second rule applies to penalties listed on pre-assessment notices such as a statutory notice of deficiency under section 6212, a notice of final partnership administrative adjustment under former section 6223, and a notice of final partnership adjustment under section 6231. In these situations, the IRS satisfies section 6751(b)(1) when the immediate supervisor (or designated higher-level official) of the person who first proposed the penalty personally approves the penalty in writing on or before the IRS mails the notice.
3. Penalties raised in the Tax Court after a petition. The third rule applies to docketed Tax Court cases. In this situation, the IRS satisfies section 6751(b)(1) when the immediate supervisor of the person who first proposed the penalty personally approves the penalty in writing no later than the date on which the Commissioner requests that the court determine the penalty. The Commissioner may raise a penalty in Tax Court for the first time and does so through filing an answer, an amendment to the answer or amended answer that includes the penalty. Example 4 illustrates the rule. In this example, the IRS considered but did not propose a section 6662(c) penalty because the assessment statute was running out and instead issued the notice of deficiency without the penalty. The IRS chief counsel attorney assigned to case proposed the penalty in the answer, which included both the assigned attorney and their supervisor’s signatures on the pleading. The signature of the IRS chief counsel attorney’s supervisor satisfies section 6751(b)(1) because written approval occurred prior to the filing.
Exceptions to Supervisory Approval
Section 6751(b)(1) contains two exceptions for which the IRS need not obtain supervisory approval. The first is a list of additions to tax under sections 6651 (failure to file or pay); 6654 (failure to pay estimated tax), 6655 (failure to pay corporate estimated tax; or penalties under sections 6662(b)(9) (any overstatement of the deduction provided in section 170(p)) and 6662(b)(10) (any disallowance of a deduction by reason of section 170(h)(7)). The proposed regulation adds section 6673 (Sanctions and costs awarded by courts) to the previously recognized exceptions not requiring supervisory approval. The second exception is for any other penalty ‘calculated through electronic means.’ The regulation makes clear that this applies to any penalty (defined as a penalty, addition to tax or additional amount under the code) that is automatically generated and proposed through computer means. However, if a taxpayer challenges the proposed penalty in writing, and an IRS employee considers the response, then it is no longer considered ‘automatically calculated through electronic means.’ Example 5 illustrates this definition. In this example, the IRS Automated Underreporter (AUR) computer program generated a notice to the taxpayer that included a proposed penalty under section 6662(d) (understatement). The taxpayer responded to the notice requesting more time but did not offer a challenge to the proposed penalty. Under these facts, the example concludes the penalty remains automatically calculated and not subject to written supervisory approval. The outcome would be different if the taxpayer submitted a written challenge to the proposed penalty. In that case, the IRS employee who considered the challenge would need supervisory approval before the IRS mailed the notice of deficiency containing the penalty.
The past litigation over section 6751(b)(1) focused on trying to define various statutory terms. For example, what constituted an initial determination and when? Who was an immediate supervisor? What constituted personal approval in writing? As a result, different courts developed conflicting rules. The proposed regulation attempts to define these terms more clearly.
1. Individual who first proposed the penalty. The regulation defines the person who makes the initial determination as the person who ‘first proposed the penalty.’ This person can propose the penalty directly to the taxpayer or to the proposing person’s supervisor or designated higher-level official. A request for additional information from a taxpayer or invitations to participate in general settlement initiatives is not considered ‘proposing a penalty,’ however, offering a taxpayer an opportunity to agree to a penalty not part of such initiative is considered a proposal. The initial determination is tied to the person proposing the penalty. Therefore, the definition offers flexibility should other IRS employees independently propose penalties.
2. Immediate supervisor. The regulation defines the immediate supervisor as any person who has responsibility to approve another person’s proposal without an intermediary’s approval. Given that the initial determination is specific, it will be easier to determine the immediate supervisor under the proposed regulation.
3. Higher level official. The regulation defines a higher-level official as any person who has been directed by the Internal Revenue Manual or assigned job duties to approve penalties before they are assessed, included in a pre-assessment notice, or an answer, amended answer or amendment to the answer.
Example 3 illustrates these definitions. In this example, the taxpayer is under exam and revenue agent A proposes an accuracy-related penalty for negligence under sections 6662(b)(1) and 6662(c). Immediate supervisor B is the issue manager. Case manager C has overall responsibility for the exam and may assign tasks to A or other members of the exam team and has approval authority over the exam. Under these facts, either B or C can approve the initial determination satisfy Section 6751(b)(1).
4. Personally approved (in writing). The regulation makes clear that this means any writing, even if it is in electronic form and it does not require any particular form of signature, analysis, words or procedure. The test is whether the circumstances of the writing reflect that it was intended as approval. The background section suggests that a supervisor’s signature on a cover memorandum or transmittal letter with a report containing penalties is sufficient approval.
The Eleventh Circuit (Florida, Georgia and Alabama) and the Ninth Circuit (Alaska, Arizona, California, Hawaii, Idaho, Montana, Nevada, Oregon and Washington) have held that the supervisory approval can occur any time prior to assessment because that is the plain language of the statute. See Kroner v. Commissioner, and Laidlaw’s Harley Davidson Sales, Inc. v. Commissioner. In both jurisdictions, the appellate courts rejected the U.S. Tax Court’s interpretation that the approval must occur prior to the first formal communication to the taxpayer of intent to assess penalties. See Clay v. Commissioner.
The proposed regulations align with the appellate courts’ decisions. However, these regulations cannot yet be relied upon by the IRS or the taxpayer because such reliance is not expressly stated in the proposed regulations. See section 7805(b), IRM 22.214.171.124.2 (08-02-2018). Taxpayers contesting a federal tax penalty should consult with their tax advisors to determine whether they can argue that an approval is invalid because it came after the first formal communication or whether they are constrained by the existing appellate court decisions.