Can the IRS Assert IRC Section 6676’s Erroneous Refund Penalty on Protective Refund Claims?

We once again want to bring to your attention the Internal Revenue Service’s (IRS) new favorite penalty provision: Internal Revenue Code (IRC) Section 6676. We have reported on this provision several times before (See here, here and here), but this time we’re analyzing it in the context of protective refund claims.

As background, IRC Section 6676 was enacted in 2007 in response to the high number of presumed meritless refund claims being filed at the time. It imposes a 20% penalty to the extent that a claim for refund or credit with respect to income tax is made for an “excessive amount.” An “excessive amount” is defined as the difference between the amount of the claim for credit or refund sought and the amount that is actually allowable. For example, if a taxpayer claims a $2 million refund and the IRS allows only $1 million, the taxpayer can still be penalized $200,000 (e.g., 20% of the amount of the refund that was disallowed). Significantly, IRC Section 6676 does not require the IRS to show any fault or culpability on the part of the taxpayer (e.g., negligence or a disregard of rules or regulations). Neither the IRC nor the regulations provide for any defense to the Section 6676 penalty other than “reasonable cause.” Moreover, the penalty is immediately assessable, and generally taxpayers cannot fight the IRS on the penalty in a prepayment forum like it can the US Tax Court. Instead, the taxpayer must first pay the penalty and seek redress in a refund forum in either the relevant US federal district court or the US Court of Federal Claims.

Now that the IRS is asserting the IRC Section 6676 penalty more frequently, taxpayers are asking whether the penalty can apply to a protective refund claim. A protective refund claim is a judicial creation under which a taxpayer files a “protective” refund claim that is expressly contingent on a specified future event, like a taxpayer-friendly holding in a relevant court case. The Supreme Court of the United States has endorsed protective refund claims to toll the statute of limitations on the refund claim and thereby protect the taxpayer’s right to claim the refund if the favorable event should occur. (See, e.g., United States v. Kales, 314 US. 186 (1941), and CCA 201136021 (describing protective claims in detail).)

So, does the IRC Section 6676 penalty apply to a protective refund claim? Based on IRS internal guidance from 2022, the IRS believes that the IRC Section 6676 penalty applies to any filing that constitutes a “claim for credit or refund” of income tax, including a protective refund claim. To apply the penalty, the IRS would have to process the protective refund claim, deny the claim and then assert the IRC Section 6676 penalty.

Processing and denying a protective refund claim go against most tax practitioners’ experience and understanding of how the IRS treats protective refund claims. Typically, the refund claim is filed pending the outcome of a court case (e.g., if the Supreme Court is hearing a particular tax case). If the contingency resolves favorably for the tax position, the taxpayer then “perfects” the protective refund claim and asks the IRS to process it. If the contingency resolves unfavorably, the protective refund claim is not perfected or acted upon.

It should be noted that the IRS’s internal guidance on the potential application of IRC Section 6676 penalties to protective refund claims directs IRS examiners to coordinate with IRS counsel before asserting the penalty, highlighting the uncertainty surrounding – and lack of precedent supporting – the imposition of the penalty to a protective refund claim.

We have been unable to find any authority or precedent that supports applying an IRC Section 6676 penalty to a protective refund claim.

Practice Point: When determining whether to file a protective refund claim, consider consulting with a tax advisor on the pros and cons of filing. If you decide to file a protective refund claim, it may make sense to put yourself in a position to have a reasonable cause defense if the IRS asserts an IRC Section 6676 penalty.

Kevin Spencer
Kevin Spencer focuses his practice on tax controversy issues. Kevin represents clients in complicated tax disputes in court and before the Internal Revenue Service (IRS) at the IRS Appeals and Examination divisions. In addition to his tax controversy practice, Kevin has broad experience advising clients on various tax issues, including tax accounting, employment and reasonable compensation, civil and criminal tax penalties, IRS procedures, reportable transactions and tax shelters, renewable energy, state and local tax, and private client matters. After earning his Master of Tax degree, Kevin had the privilege to clerk for the Honorable Robert P. Ruwe on the US Tax Court. Read Kevin Spencer's full bio.

Edward L. Froelich
Edward L. Froelich represents domestic and foreign public corporations, privately held companies, partnerships, trusts and individuals across the spectrum of federal tax controversies, including audits, trials and appeals. Ed’s clients include businesses, business owners and investors with operations and interests in the financial services, technology, real estate, healthcare and other industries. Read Edward Froelich's full bio.

Samuel J. Preston
Samuel J. Preston focuses his practice on US and international tax matters. Read Samuel Preston's full bio.




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