Recent Cases Clarify Penalty Supervisory Approval Requirement

In 2017, court decisions gave penalty relief to certain taxpayers. Since then, the courts have clarified the scope of these decisions. 

Second Circuit Sets the Standard

Under Code Sec. 6751(b) , certain penalties require that the immediate supervisor of the individual making the determination, or designated higher level official, personally approve “the initial determination of such assessment.” The approval must be in writing. However, Congress did not define what constitutes “the initial determination of such assessment.” The Second Circuit interpreted this language to mean that the individual making the determination must obtain written approval of the initial penalty determination no later than the date the IRS issues the notice of deficiency (or files an answer or amended answer) asserting the penalty.  

Comment: In reaching its decision, the Second Circuit relied on Congressional intent as expressed in the Senate Finance Committee Report. The report states, “The Committee believes that penalties should only be imposed where appropriate and not as a bargaining chip.”  

The Second Circuit rejected the Tax Court’s determination that the IRS was permitted to obtain written approval at any time before the penalty was assessed. After the Second Circuit issued its opinion, the Tax Court vacated its prior decision and adopted the Second Circuit’s reading as its own.  

Since these initial decisions, the courts have refined the rule. Cases addressing some of the more significant issues are summarized below. 

What Is an Initial Determination?

The following cases address what constitutes an initial determination. 

  • Initial determination of the penalty assessment was embodied in the 60-day letter by which the IRS formally notified the taxpayer that the Examination Division had completed its work and, after considering the taxpayer’s arguments, had made a definite decision to assert penalties (Belair Woods). 
  •  A 30-day letter with an attached revenue agent’s report constituted the initial determination to assess the penalties proposed in the letter (Clay). 
  •  Letter 5153 and the accompanying examination report that the IRS agent sent to the taxpayers communicated to them the initial determination to assess gross valuation misstatement penalties. The absence of 30-day letters did not indicate a lack of formality or finality in the determination (Carter). 
  • There was no  initial determination of a penalty in a letter granting the taxpayer an opportunity to withdraw her frivolous return and avoid the penalty (Kestin). 
  • Form 5701, Notice of Proposed Adjustment, is not a determination requiring approval. The heading of the form notes that it is a “proposed adjustment, falling short of a determination requiring approval” (Tribune). 

What Constitutes Approval?

The two cases below address methods that constitute approval: 

  1. Manager’s signature may be on the report’s cover letter; it does not have be on the same page as the penalty (PBBM-Rose Hill). 
  2. Supervisor’s name on the signature block of Form 4340, Certificate of Assessment and Payments, is sufficient evidence of supervisory approval (Blackburn). 

What Penalties Are Subject to or Exempt From the Supervisory Approval Requirement?

Trust fund recovery penalties

Trust fund recovery penalties (TFRPs) are penalties within the meaning of  Code Sec. 6751(b)(1), and thus subject to its supervisory approval requirements.  While TFRPs are “in substance” a tax, the plain language of Code Sec. 6672(a) indicates that a TFRP is a penalty (Chadwick). 

Automatic penalties

Code Sec. 6751(b)(2) provides an exception to the supervisory approval requirement for automatic penalties under Code Secs. 665166546655, or any other penalty automatically calculated through electronic means. Several decisions have addressed what types of penalties are subject to this exception.  

The late S corporation return penalty of Code Sec. 6699 falls under this exception. The Tax Court noted that “the penalty was, according to the IRS transcript, a ‘computer generated assessment'” (ATL). 

The Tax Court reached a similar conclusion in Walquist , concerning the accuracy-related underpayment penalty. The Tax Court held that penalties determined under Code Secs. 6662(a)  and (b)(2) by an IRS computer program without human review are “automatically calculated through electronic means” and thus are exempt from the written supervisory approval requirement. 

However, in Laidlaw, the Tax Court found the supervisory approval requirement applied to the Code Sec. 6707A penalty for failure to report a “reportable transaction.” In this case, the revenue agent—not a computer—made the initial determination to assert the penalty. Therefore, this was not an instance in which “the penalty was determined mathematically by a computer software program without the involvement of a human IRS examiner.”    

Frivolous position penalty

The Code Sec. 6673(a)(1) penalty for frivolous positions is not subject to the supervisory approval requirement. The Tax Court imposes this penalty. The supervisory approval requirement was intended to apply only to IRS determinations (Williams). 

When Is the Burden of Production Met?

The IRS’s initial burden of production includes producing evidence that it complied with the supervisory approval requirement. In Frost, the Tax Court addressed the question of when the burden shifts to the taxpayer to show otherwise. The court held that if the taxpayer has challenged the Commissioner’s penalty determinations, the IRS must come forward with evidence of penalty approval as part of its initial burden of production. Once the IRS makes that showing, the taxpayer must come forward with contrary evidence. 

Issues Clarified

Thus, as can be seen from the cases above, court decisions since 2017 have answered questions and clarified a number of issues surrounding the penalty supervisory approval requirement. The courts have addressed both the scope of the requirement and the mechanics of approval. 

By Robert Recchia, J.D., M.B.A., C.P.A.

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CCHTaxGroup

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