United States

Tax Court issues opinions discussing penalty approval

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The U.S. Tax Court recently issued three opinions further clarifying the meaning of I.R.C. section 6751(b)(1). Section 6751(b)(1) provides that 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 purpose of this rule is to prevent an individual examiner from using the threat of penalty as a "bargaining chip" during an exam. Consequently, the rule does not apply to time based penalties such as failure to pay or file (section 6651), failure to pay estimated income tax (section 6654), failure by a corporation to pay estimated income tax (section 6655), or any other penalty automatically calculated through electronic means.  

In 2019, the Tax Court explained that the written supervisory approval must occur (1) no later than the date the IRS issues the notice of deficiency, or (2) no later than the date, if earlier, that the IRS formally communicates to the taxpayer that Exam Division determined to assert a penalty and notifies the taxpayer of a right to appeal. Clay v. Commissioner, 152 T.C. 223, 249 (2019). In the case of multiple penalties, the Tax Court decided each may have its own initial determination and the IRS employee’s initial determination is made at the time he solicits his supervisor’s approval on a civil penalty form or other similar document. Palmolive Bldg. Inv’s, LLC v. Commissioner, 152 T.C. 75, 88 (2019). In these cases, the court focused on the “when” an initial determination is made, but the question of “what is” an initial determination remained unanswered. 

In Belair Woods LLC, v. Commissioner, 154 T.C. No.1 (2020), the Court held that issuing a Letter 1807 and summary report, setting forth the Examination Division’s tentative proposed adjustments and inviting the taxpayer to a conference to discuss them, did not constitute the initial determination of a penalty assessment necessitating prior supervisory approval under section 6751(b)(1). The letter proposed an adjustment based upon denying a charitable contribution for a conservation easement and also mentioned an accuracy-related penalty that had not been approved in writing by a supervisor. After unsuccessful negotiations, Exam Division issued a 60-day letter formally asserting four penalties and providing rights to appeal.  The court held that the 60-day letter satisfied the requirements of section 6751(b)(1) for the first three penalties because the agent secured written supervisory approval on the Civil Penalty Approval Form before the 60-day letter was issued to the taxpayer, formally communicating to the taxpayer the Examination Division’s definite determination to assert those penalties. Thus, the court established a bright line rule that the “initial determination” under section 6751(b)(1) is when the IRS makes a “definite decision to assert penalties.” It is conveyed to the taxpayer in a written document in which Exam Division formally notifies the taxpayer that it completed its work and made an unequivocal decision to assert penalties. It is more than a mere discussion or tentative hypothesis during negotiations where penalties may be mentioned, but rather a “consequential moment.” Chai v. Commissioner, 851 F.3d, 190, 221 (2nd Cir. 2017). 

In Frost v. Commissioner, 154 T.C. No. 2 (2020), the Tax Court clarified that under section 7491(c), the IRS has the initial burden of production that it complied with section 6751(b)(1) supervisory approval requirement, but once it meets its burden, the burden shifts to the taxpayer to provide evidence the IRS did not comply with section 6751(b)(1). Here, the IRS could not produce evidence it obtained supervisory approval for asserted penalties in years 2010 and 2011, but it did produce such evidence for tax year 2012. Thus, the penalties for 2010 and 2011 were not sustained, but for tax year 2012, the taxpayer, not the IRS, had the burden to show that the approval was untimely, e.g., by showing that there was formal communication of the penalty prior to the approval. 

Finally, in Tribune Media Company v. Commissioner, T.C. Memo 2020-2, the court applied its decision in Belair to decide whether the initial determination to assert penalties was timely approved in writing by a supervisor. The IRS examined a transaction made by Tribune Media Co. that resulted in the formation of Chicago Baseball Holdings, LLC. The IRS believed that the transaction was a disguised sale, and the IRS determined that a 40% gross valuation misstatement applied. The IRS first mentioned to the taxpayer that there was a possibility of penalties during a 2016 meeting, and in communications proposing adjustments and penalties that lacked appeal rights. The IRS successfully argued that it did not need to obtain supervisory approval until there was a formal communication asserting the penalties. The court found that IRS complied with section 6751(b)(1) because the initial determination was not made during the discussions and meetings, but rather when the first formal communication was made. A communication was considered formal when it granted appeal rights, and when the communication conferred a sense of finality, rather than merely communicated a proposed penalty. Here, the court concluded it was when the IRS issued the notice of deficiency and final notice of partnership adjustment. 

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