It’s not often the IRS loses a case in Tax Court. In fact, it’s rather rare. The Taxpayer Advocate’s 2019 Annual Report to Congress includes an appendix which contains a table of the most litigated issues between taxpayers and the IRS and whether the court ruled in favor of the IRS, in favor of the taxpayer, or whether there was a split decision. The vast, vast majority were ruled in favor of the IRS. Looking at the table, it becomes readily apparent that there is one subset of cases where the taxpayer prevails more frequently than other issues, that being the assessment of Accuracy-Related Penalties under IRC §6662(b)(1) and (2). §6662 authorizes the IRS to impose a penalty if a taxpayer’s negligence or disregard of rules or regulations causes an underpayment of tax required to be shown on a return, or if an audit uncovers a substantial understatement of tax (generally, the greater of $5,000 or 10% of the tax required to be shown on an individual’s return). The penalty generally equals 20% of the resulting underpayment.
The Taxpayer Advocate Service identified 79 times that issues related to accuracy-related penalties were litigated between taxpayers and the United States between June 2018 and May 2019. Of those 79 cases, taxpayers prevailed in 32% of the cases (an additional two cases were split decisions). In 19 of the instances where the taxpayer prevailed, the Tax Court has frequently overturned accuracy-related penalties because the IRS did not satisfy its burden with respect to the supervisory approval requirement under IRC §6751(b)(1).
Section 6751(b)(1) provides, “In general, 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.” It further provides an exception to this rule for additions to tax under Section 6651 (failure-to-file), 6654 (failure to pay estimates), or 6655 (failure by corporation to pay estimates), as well as any other penalty automatically calculated through electronic means.
Oropeza v. Commissions, a recent Tax Court decision released on October 13, 2020, demonstrates that the failure to obtain written supervisory approval prior to proposing accuracy-related penalties is still an ongoing issue for IRS examiners and litigators. On January 14, 2015, the Revenue Agent conducting an examination of the taxpayer’s 2011 tax return issued the taxpayer a Letter 5153 and Form 4549-A (commonly referred to collectively as a Revenue Agent’s Report, or “RAR”) asserting a 20% accuracy-related penalty “attributable to one or more of” negligence, a substantial understatement of income tax, a substantial valuation misstatement, and a “transaction lacking economic substance.” Subsequently, on January 29, 2015, the Revenue Agent’s immediate supervisor signed a Civil Penalty Approval Form, authorizing the assertion of a 20% penalty for a substantial understatement of tax. On May 1, 2015, the RA recommended assertion of an IRC §6662(b)(6) penalty, calculated at a 40% rate under IRC §6662(i), for a “transaction lacking economic substance” not disclosed on the taxpayer’s originally-filed return. The RA’s supervisor signed that memo, and on May 6, 2015, the taxpayer was issued a notice of deficiency determining a 40% penalty under IRC §6662(b)(6), which was contested by the taxpayer in Tax Court.
After reviewing the record, the Tax Court ruled in favor of the taxpayer. Of note, the court found:
The RAR issued to the taxpayer in January 2015, and which included standard IRS boilerplate advising of the IRS’s intent to assert accuracy-related penalties, constituted an “initial determination” to assess the penalties;
Because the Revenue Agent did not get supervisory approval prior to the issuance of the RAR proposing the 20% penalty, the IRS was subsequently barred from later asserting the penalty 20% accuracy-related penalty;
Although the 40% penalty imposed for engaging in a “transaction lacking economic substance not disclosed on a return” was first proposed in the notice of deficiency sent to the taxpayer in May and received prior supervisory approval, because the 40% penalty authorized by §6662(i) is merely a modification to the penalty amount applicable to the 20% accuracy related penalty under §6662(b)(6), a penalty which had been initially proposed in the RAR without prior supervisory approval, the IRS was also barred from asserting the 40% penalty under §6662(i).
The primary purpose of the enactment of the supervisory-approval requirements of §6751(b)(1) was to prevent low-level IRS employees from using the threat of penalties as a bargaining chip, or to force taxpayer compliance or acquiescence during the course of an examination or other proceedings. As the court in Oropeza opines, “if we permitted the IRS to impose a 40% penalty in the circumstances here, the IRS could penalize a taxpayer more severely despite its own mistake. If the IRS recognized the failure to comply with section 6751(b)(1) for a 20% penalty, it could later assert (and get approval for) the same penalty at a 40% rate under section 6662(i). The taxpayer would then confront the dilemma of having to make concessions or risk that the penalty would be doubled. This was precisely the sort of problem that Congress aimed to prevent by enacting section 6751(b)(1).
It is difficult to say exactly how much the Revenue Agent’s error in this case cost the US Treasury, but considering the examination resulted in an increase of $1,250,000 to the taxpayer’s share of S-corporation income and an increase of $650,000 to the taxpayer’s capital gain for the year, it seems likely that the failure of the RA to obtain supervisory approval prior to the issuance of the RAR cost the Treasury (and saved the taxpayer) well in excess of $100,000 in accuracy-related penalties.
With the issuance of the Taxpayer Advocate Service’s 2019 report highlighting the issue of the IRS failing to obtain supervisory approval before making an initial penalty determination, one would hope that the IRS would put corrective measures in place to ensure that RA’s obtain supervisory approval in the future. However, taxpayers continue to prevail in Tax Court on the issue. While challenging an IRS determination in Tax Court can be a lengthy and costly endeavor, it’s generally not required if a taxpayer timely contests the proposed assessment via IRS Appeals. Having a tax attorney represent you during the course of an audit can ensure that your appeal rights are protected and that if the IRS fails to follow proper procedures, the IRS will be held accountable for their mistakes. The supervisory-approval requirement under 6662(b)(1) is also applicable to a whole host of other penalties, including foreign informational return penalties for Forms 5471 and Forms 3520. If the IRS has proposed assessing a penalty against you, please contact us to determine whether an avenue exists to challenge the penalty assertion on procedural grounds or for reasonable cause.