When IRS Penalty Assertions Are Unlawful
- Internal Revenue Code Section 6751(b)(1) provides that "[n]o 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 … ."
- This Holland & Knight alert deals with the conditions that the IRS must satisfy in order to comply with Section 6751(b)(1) and the consequences of its failure to do so.
One of the most highly litigated issues in U.S. Tax Court is whether taxpayers are liable for certain penalties, additions to tax or additional amounts (each, a "penalty" and collectively, "penalties"). This should come as no surprise, as the IRS assessed nearly $40.5 billion in civil penalties in fiscal year 2019.1
Section 6751(b)(1) generally 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.2 Under Section 7491(c), the IRS bears the burden of production in any court proceeding with respect to any individual's liability for penalties.3
In December 2017, the U.S. Tax Court held that compliance with Section 6751(b) is properly at issue in a deficiency case and a part of the IRS' burden of production under Section 7491(c).4 Thus, the IRS bears the burden of production with respect to an individual's liability for penalties in any court proceeding.
To satisfy this burden of production, the IRS must produce the following written evidence to demonstrate that certain penalties are appropriate in the absence of available defenses:
- the identity of the individual who made the "initial determination"
- an approval, "in writing," of the specific penalty
- the identity of the person giving approval and his or her status as the "immediate supervisor," and
- evidence that the supervisory approval was obtained no later than the date the taxpayer was issued written formal communication that the IRS has completed its work and made an unequivocal decision to assert penalties5
If the IRS is unable to comply with this written approval requirement, a penalty subject to Section 6751(b)(1) cannot be sustained against the taxpayer.
Accordingly, a taxpayer who is under IRS examination or otherwise has a matter before the IRS, or who is deciding whether to file a petition with the U.S. Tax Court to dispute penalties, or who has already petitioned the U.S. Tax Court to dispute penalties (or who may be subjected to penalties by IRS counsel in the course of a Tax Court proceeding), should have a general understanding of the IRS' supervisory-approval requirement under Section 6751(b).6
Why does Section 6751(b)(1) require written supervisory approval of the initial determination?
Congress enacted Section 6751(b) because "penalties should only be imposed where appropriate and not as a bargaining chip."7 Section 6751(b) was designed "to prevent IRS agents from threatening unjustified penalties to encourage taxpayers to settle."8
According to the IRS, it utilizes penalties to encourage voluntary compliance by demonstrating the fairness of the tax system to compliant taxpayers and increasing the cost of noncompliance.9 Although the IRS may use penalties to encourage voluntary compliance, the intent of Section 6751(b) is to prevent the IRS from using penalties as a "bargaining chip" to encourage taxpayers to settle.
What is an "initial determination" of a penalty?
Under Section 6751(b)(1):
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 or such higher level official as the Secretary may designate.10
However, the phrase "initial determination" is only found in Section 6751(b)(1) and has not been defined by Congress or by regulations.
The U.S. Tax Court has looked to the dictionary defining the word "initial" as "having to do with, indicating, or occurring at the beginning."11 The court has further held that a "determination" carries "a sense of definiteness and formality" and "clearly is not a synonym for a mere suggestion or indication of a possibility that a penalty might be asserted."12 In this regard, "a 'determination' denotes a 'consequential moment' of IRS action,"13 which can be communicated to a taxpayer in a revenue agent report (RAR), 30-day letter, 60-day letter, notice of deficiency or an answer (or an amended answer).
Accordingly, an "initial determination" of a penalty does not require supervisory approval to be made on a particular form but it does requires a level of formality and finality.
Who can make an initial determination of a penalty?
In general, any IRS official (including an IRS Office of Chief Counsel attorney in reviewing the notice of deficiency or during litigation) who is authorized to assert may make an initial determination.
Where is the initial determination typically located?
The U.S. Tax Court held that, outside a judicial proceeding and in a deficiency context, "the 'initial determination' of a penalty assessment--the 'consequential moment' of IRS action … --is embodied in the document by which the Examination Division formally notifies the taxpayer, in writing, that it has completed its work and made an unequivocal decision to assert penalties."14
In a judicial proceeding and in a deficiency context, the IRS may assert the initial determination of a penalty in an answer (or amended answer).15
Regardless of whether the initial determination of penalties is made during or outside of a judicial proceeding, such initial determination must be supervisor approved (in writing) prior to being formally communicated to the taxpayer.
Recent case law demonstrates that whether the IRS has met its requirement under Section 6751(b)(1) is factually driven and should be evaluated on a case-by-case basis. To demonstrate how the IRS's initial determination of penalties may, or may not, be in compliance with Section 6751(b)(1), consider the following real-world examples:
- Example 1: During an audit, an IRS examiner sent to the taxpayers an RAR attached to Letter 4121 (Agreed Examination Report Transmittal). The RAR stated the amount of the taxpayers' "corrected" tax due and that the taxpayers were liable for a Section 6662 accuracy-related penalty. The examiner's immediate supervisor did not sign or otherwise approve, in writing, the Letter 4121, RAR or penalty liability stated therein.
The RAR included a signature box that, if signed by the taxpayers, would have provided their consent to immediate assessment and collection of the tax and penalties shown on the RAR. Enclosed with the RAR was Publication 3498 (The Examination Process), which provided details in the event that the taxpayers did not agree with the examiner's proposed changes and stated that the taxpayers would receive a "30-day letter" notifying the taxpayers of their rights to appeal the proposed changes.
Approximately two weeks later, the examiner issued Form 4549-A, Income Tax Examination Changes (Unagreed and Excepted Agreed), attached to a 30-day letter. That same day, the examiner's immediate supervisor approved, in writing, the Section 6662 accuracy-related penalty.
The U.S. Tax Court held that the RAR sent with Letter 4121, and not Form 4549-A attached to the 30-day letter sent approximately two weeks later, constituted an "initial determination" under Section 6751(b)(1). Accordingly, because supervisor approval was not secured before the RAR was issued to the taxpayers, the U.S. Tax Court held that the Section 6662 penalty did not meet the requirements of Section 6751(b).16
- Example 2: An IRS revenue agent audited a partnership's federal tax return. During the audit, the revenue agent discussed the possible application of penalties with her supervisor. Shortly thereafter, the revenue agent sent Letter 1807 to the partnership's tax matters partner (TMP), along with a summary report, inviting the TMP (and other partners) to a closing conference to discuss the IRS' proposed adjustments. Letter 1807 indicated that "[a]ll proposed adjustments in the summary report will be discussed at the closing conference" and instructed the TMP to "send a copy of the summary report to each partner," together with information concerning the conference. The revenue agent's immediate supervisor did not sign Letter 1807.
The summary report proposed a penalty under Section 6662(h) and alternatively proposed two separate penalties under Section 6662. The summary report also included an explanation as to possible defenses against the three proposed penalties that might be available. The IRS exam team and the partnership's representatives attended an initial conference but ultimately failed to reach an agreement.
The revenue agent subsequently prepared a Civil Penalty Approval Form indicating her recommendation of the three proposed penalties. The case file, including the Civil Penalty Approval Form, were forwarded to the revenue agent's immediate supervisor, who approved the three penalties by signing the Civil Penalty Approval Form. The IRS subsequently issued to the partnership a "TMP 60-Day Letter" (60-day letter). The 60-day letter offered the partnership options of accepting or appealing the adjustments. The partnership unsuccessfully appealed the adjustments, resulting in the IRS Appeals Office issuing to the partnership a final partnership administrative adjustment (FPAA).
Based on the facts of the case, a heavily divided U.S. Tax Court held that Letter 1807 and the enclosed summary report did not include initial determinations of penalties; rather, the summary report included only "tentative proposals" that the partners were invited to discuss with the IRS and was not an unequivocal communication informing the partnership that penalties will be proposed.
Accordingly, because the Civil Penalty Approval Form was signed by the revenue agent's immediate supervisor prior to the issuance of the FPAA, the U.S. Tax Court held that the three penalties approved on the Civil Penalty Approval Form were in compliance with Section 6751(b)(1).17
- Example 3: The IRS commenced an examination of the taxpayers' (husband and wife) 2011 Form 1040. Following a meeting with the taxpayers and their CPA, the IRS revenue agent and her immediate supervisor referred the taxpayers' case to an IRS fraud technical advisor (FTA).
Upon the request of the FTA and IRS Criminal Investigation Division, the revenue agent and immediate supervisor issued an administrative summons to the taxpayers to again appear before the revenue agent. The taxpayers requested postponement of the summons interview due to the birth of their second child and, as a result, another letter was issued to the taxpayers to compel their appearance before the revenue agent at a later date, which was attended by the taxpayers, their CPA, the revenue agent, the immediate supervisor and an IRS group manager.
The meeting constituted the taxpayers' closing conference. After asking the taxpayer husband a series of prepared questions, the revenue agent presented to the taxpayers an RAR and a copy of Publication 3498. The RAR, which was prepared before the closing conference, included a fraud penalty with a stated amount and the revenue agent's signature.
The taxpayers declined to sign the RAR because they disagreed with the fraud penalty and also declined to extend the limitations period on assessment for their 2011 tax year. The revenue agent informed the taxpayers that they would forego their appeal rights, their case would be closed and the IRS would issue a notice of deficiency.
Two days later, the revenue agent sent to her immediate supervisor the case file and a Civil Penalty Approval Form containing the fraud penalty, as well as an alternative assertion of a Section 6662 accuracy-related penalty, which was signed by the supervisor that same day.
Less than two weeks later, the IRS issued a notice of deficiency that included the fraud penalty without modification to the RAR, as well as the accuracy-related penalty. The taxpayers filed a petition with the U.S. Tax Court and thereafter filed a motion for partial summary judgment challenging only the fraud penalty.
The U.S. Tax Court held that the completed RAR presented to the taxpayers at the closing conference, coupled with the context surrounding its presentation, was a formal communication of the revenue agent's initial determination of a fraud penalty under Section 6751(b)(1). Thus, because the immediate supervisor did not provide written approval until after the closing conference, the IRS failed to meet its burden of production to assert the fraud penalty.18
As demonstrated by the above examples, in some cases an RAR does not include an initial determination of a penalty (Example 1); in other cases, it does (Example 3). In some cases a court may find that there was no initial determination of a penalty at a closing conference (Example 2); in other cases, the court may find there was an initial determination of a penalty at a closing conference (Example 3).
The U.S. Tax Court has attempted to create as close to a bright-line rule as possible that was consistent with the statutory text of Section 6751(b). However, as the recent case law demonstrates, whether the IRS met its requirement under Section 6751(b) in asserting penalties is factually driven and should be evaluated on a case-by-case basis.
Courts continue to clarify and define the contours of Section 6751(b) and related burden of proof (i.e., production and persuasion) matters. In addition, several cases involving Section 6751(b) are docketed in various U.S. Courts of Appeal. Thus, it is important to closely monitor developments in these areas.
For additional information or questions about a specific situation, please contact the authors.
1 Internal Revenue Service Data Book, 2019 (Publication 55-B), at p. 59 (June 2020).
2 Unless otherwise indicated, all section references are to the Internal Revenue Code of 1986, as amended.
3 Section 7491(c) applies only to the liability of an individual for penalties; thus, the IRS does not have the burden of production in a court proceeding with respect to the liability of an estate, corporation, or partnership for penalties. See Estate of Jackson v Commissioner, T.C. Memo. 2021-48, at *248 (holding that Michael Jackson's estate, and not the IRS, bore the burden of production because an estate is not an individual); NT, Inc. v. Commissioner, 126 T.C. 191, 195 (2006) (holding that the IRS does not bear the burden of production regarding the liability of a corporation for penalties because Section 7491(c) applies only to an individual); Dynamo Holdings Ltd. P'ship v. Commissioner, 150 T.C. 224, 236 (2018) (holding that a Tax Equity and Fiscal Responsibility Act (TEFRA) partnership, and not the IRS, bore the burden of production). Whether the rationale of Dynamo Holdings continues to apply in matters arising pursuant to partnership audit rules enacted by the Bipartisan Budget Act of 2015 has not been addressed by the U.S. Tax Court.
4 Graev v. Commissioner, 149 T.C. 485, 493 (2017).
5 See Belair Woods, LLC v. Commissioner, 154 T.C. 1, 15 (2020); Palmolive Bldg. Investors, LLC v. Commissioner, 152 T.C. 75, 87 (2019). In this regard, the U.S. Tax Court focuses on the IRS communication to the taxpayer (i.e., an objective test) and not the subjective intentions of IRS personnel regarding imposition of penalties. See Oropeza v. Commissioner, 155 T.C. ___, ___ (slip. op. at 17) (Oct. 13, 2020).
6 The case law in this area continues to develop. Moreover, taxpayers involved in the same transaction may face different penalties as a result of the IRS compliance with Section 6751(b)(1). See, e.g., Sells v. Commissioner, T.C. Memo 2021-12, at *34-35 (holding that the IRS met its requirement under Section 6751(b)(1) with respect to penalties asserted against some, but not all, taxpayers involved in the same conservation easement transaction).
7 S. Rep. No. 105‐174, at 65 (1998).
8 Chai v. Commissioner, 851 F.3d 190, 219 (2d Cir. 2017), aff'g in part, rev'g in part T.C. Memo. 2015-42 (citing IRS Restructuring: Hearings on H.R. 2676 Before the U.S. Senate Committee on Finance, 105th Cong. 92 (1998) (statement of Stefan F. Tucker, Chair-Elect, Section of Taxation, American Bar Association)).
9 See Internal Revenue Manual pt. 184.108.40.206.1 (Oct. 29, 2004).
10 Section 6751(b)(1) (emphasis added). Certain penalties, including failure to file, failure to pay, estimated income tax and automatically calculated penalties, are excluded from the procedural requirements under Section 6751(b)(1). See Section 6751(b)(2). Accordingly, all penalties referenced in the context of Section 6751(b) are those penalties not excluded from the procedural requirements by Section 6751(b)(2).
11 Legg v. Commissioner, 145 T.C. 344, 349.
12 Belair Woods, 154 T.C. at 10-11.
13 Id. at 11 (citing Chai v. Commissioner, 851 F.3d at 220-21).
14 Id. at 15 (indicating this interpretation would be as close to an objective, bright-line rule and "may help achieve that goal in a manner consistent with the statutory text.").
15 See Koh v. Commissioner, T.C. Memo 2020-77, at *2; Chai v. Commissioner, 851 F.3d at 221.
16 See Battat v. Commissioner, T.C. Memo 2021-57.
17 See Belair Woods, 154 T.C. 1.
18 See Beland v. Commissioner, 156 T.C. ___ (March 1, 2021).
Information contained in this alert is for the general education and knowledge of our readers. It is not designed to be, and should not be used as, the sole source of information when analyzing and resolving a legal problem, and it should not be substituted for legal advice, which relies on a specific factual analysis. Moreover, the laws of each jurisdiction are different and are constantly changing. This information is not intended to create, and receipt of it does not constitute, an attorney-client relationship. If you have specific questions regarding a particular fact situation, we urge you to consult the authors of this publication, your Holland & Knight representative or other competent legal counsel.