In tax litigation, there are often (at least) two important categories of issues to consider: (1) substantive; and (2) procedural. A great deal of tax litigation will be focused on the substance of the Internal Revenue Service’s (IRS) adjustments (e.g., was a taxpayer entitled to a particular deduction?). But the procedural aspects should not be ignored. If the IRS did not abide by its procedural requirements before making a tax adjustment, consideration should be given to whether the IRS’s adjustment is procedurally invalid. Sometimes taxpayers win on these issues; other times they do not. The United States Tax Court’s (Tax Court) recent case, Graev v. Commissioner, is an example of the latter.
In Graev, an IRS Revenue Agent determined that a 40 percent gross valuation misstatement penalty should apply. The Revenue Agent prepared a “Penalty Approval Form” in accordance with Internal Revenue Manual (I.R.M.) procedures and submitted it to his immediate supervisor. The supervisor checked the form’s “Approved” box and initialed the form in its space for “Group Manager Initials.” The Revenue Agent then prepared a proposed notice of deficiency determining the 40 percent penalty and no other penalties.
The proposed notice of deficiency was referred to the IRS Office of Chief Counsel (Chief Counsel) for review, pursuant to I.R.M. procedures. The Chief Counsel attorney assigned to the case prepared a memorandum back to the Revenue Agent’s office with proposed revisions to the notice of deficiency. Specifically, the Chief Counsel attorney instructed the inclusion of an alternative 20 percent accuracy-related penalty. The Chief Counsel attorney signed the memorandum and his immediate supervisor initialed it.
The Revenue Agent revised the notice of deficiency to include the alternative 20 percent penalty, but his immediate supervisor did not approve it in writing. The IRS ultimately issued the revised notice of deficiency, which included a signature by an IRS Technical Services Territory Manager and a page on which the penalties were computed. Under the Internal Revenue Code (Code), the 20 percent and 40 percent penalties cannot be stacked. As a result, the computation for the 40 percent penalty was shown fully, but the computation for the 20 percent penalty was calculated as zero.
In Tax Court, the IRS conceded the liability relating to the 40 percent penalty, so only the liability relating to the 20 percent penalty remained at issue. The taxpayers raised issues relating to whether the IRS had complied with the procedural requirements of Code Section 6751(a) and (b)(1).
Code Section 6751(a) requires that the IRS notify taxpayers of the name of the penalty, the statutory authority for the penalty and a computation of the penalty. The taxpayers argued that the failure to include a separate computation for the 20 percent penalty precluded the imposition of that penalty. The court divided as to the correct result. The majority opinion, authored by Judge Michael Thornton and joined by eight other judges, disagreed with the taxpayers. Because the 20 percent penalty was initially an alternative position, the majority concluded that the notice of deficiency properly calculated the amount of the 20 percent penalty as zero. The majority also noted that under existing Tax Court and United States Supreme Court (Supreme Court) precedent even if the there was a procedural error, the notice of deficiency should not be invalidated unless there was prejudice to the complaining party.
Code Section 6751(b)(1) generally requires supervisory approval of the initial determination of assessment of penalties. The taxpayers argued that the Revenue Agent made the relevant “initial determination” and that his determination was to impose the 40 percent penalty, not the 20 percent penalty. In the taxpayer’s view, the Chief Counsel attorney was not authorized to determine a 20 percent penalty. Again, the majority disagreed. The majority reasoned that the taxpayer’s arguments were premature because there was only a proposed penalty assessment, not an actual assessment. (An assessment only occurs after the Tax Court’s decision becomes final). The court interpreted the statute to require written approval to be in place, only as of the time of the assessment—i.e., not at the time of the initial determination. The majority also rejected arguments that the taxpayers were not liable on the merits for the 20 percent penalty.
Although the majority rejected the taxpayer’s arguments in the deficiency context, in a footnote they left open “the possibility that a taxpayer who believes that a penalty has been assessed in violation of sec. 6751(b)(1) might raise this issue in a post assessment collection due process (CDP) hearing.”
Judge Joseph Nega’s concurring opinion, joined by two other judges, reached the same result but on narrower grounds. Judge Nega would have applied the earlier Tax Court and Supreme Court precedent and held that there was no prejudice to the taxpayers and any procedural errors did not invalidate the notice of deficiency.
Judge David Gustafson’s dissenting opinion, joined by four judges, staunchly disagreed with the majority. (It is interesting to note that Judge Gustafson was the trial judge in this case and an earlier opinion in the substantive issue in the case was issued by him in 2013, see here.) The dissent argued that the Code Section 6751(b)(1) issue was not premature and ignored the nature of the Tax Court’s role in deficiency cases. Specifically, the Tax Court’s deficiency jurisdiction is interposed between the IRS’s determination of a deficiency and its assessment of that deficiency. The dissent argued that where a rule such as Code Section 6751(b)(1) bars assessment, the Tax Court can and should hold that the liability cannot be assessed. In addition, the dissent argued that the Code Section 6751(b)(1) supervisory approval must be obtained before a Tax Court petition is filed. The dissent reasoned that any other result would lead to an impermissible construction of the statute. Once a Tax Court decision validates the IRS’s proposed penalty, Code Section 6215(a) mandates that the “entire amount” of the deficiency “shall be assessed.” Thus, there is no intermediate period in which supervisory approval could be obtained. The dissent also argued that majority incorrectly interpreted Code Section 6751(b)(1) to require supervisory authority of only the final determination, not the “initial determination” referenced in the statute. The dissent argued further that Code Section 7491(c) which places the burden of production on the IRS, brings supervisory approval of penalties into the purview of a deficiency case. The dissent made other arguments against the majority’s reasoning as well.
This is an interesting issue and the dissent makes strong arguments. Considering the divided nature of the Tax Court on this case, it is likely that the taxpayers will appeal the case to the Second Circuit, where the taxpayer resided at the time they filed their petition. A similar case, Chai v. Commissioner, Nos. 15-1653, 15-2414, is already on appeal with, and fully submitted to, the Second Circuit and the counsel in both cases is the same. Taxpayers that are anticipating filing a petition in Tax Court, or that are already in Tax Court, with this situation should follow these cases to see what result is reached by the Second Circuit.
Practice Note: As Graev demonstrates, taxpayers who are facing penalty assessments should consider whether they may have any procedural challenges to the IRS’s method of approval and assessment of penalties, in addition to considering the more standard, substantive defenses like reasonable cause. While these challenges are typically difficult to make, IRS procedural errors and omissions may constitute an important element of a penalty defense, under the right facts.