The Statute

No penalty under the Code[1] may be assessed unless the initial determination of such assessment is personally approved in writing by the immediate supervisor of the individual/agent making such determination (or another appropriate higher-level official).[2] This approval requirement, introduced in 1998, was the subject of only three substantial decisions prior to 2020. This year, however, was a boon for taxpayers, and the full opinions of the Tax Court defined the metes and bounds of the prior written supervisory approval requirement of IRC § 6751(b)(1).

History of Statute

IRC § 6751 was added to the code in 1998,[3] but it did not really hit its stride until 2017 and the two decisions in Chai v. Commissioner[4] and Graev v. Commissioner (Graev III).[5]

In Chai, the Second Circuit held that IRC § 6751(b)(1) requires written approval of the “initial penalty determination” no later than the date that the IRS issues the notice of deficiency (or files and answer or amended answer) asserting such penalty. Following suit, the Tax Court in Graev III held that the initial determination occurred no later than the notice of deficiency or amended answer, which is to say the first time an IRS official “introduces the penalty into the conversation.”

In Clay v. Commissioner,[6] the Tax Court interpreted IRC § 6751(b)(1) to require supervisory approval to be secured by the earlier of (1) the date on which the IRS issues a notice of deficiency, or (2) the date on which the IRS “formally communicates” to the taxpayer the IRS’s initial determination of a penalty assessment and notifies the taxpayer of his right to appeal that determination.

Belair Woods

In the January 2020 decision of Belair Woods, LLC v. Commissioner,[7] the Tax Court held that a summary report setting out tentative proposed adjustments, and cordially inviting petitioner to a conference to discuss the proposal, does not constitute an initial determination of a penalty assessment pursuant to IRC § 6751(b)(1), because the report did not indicate that conference was the end of the examination, with the petitioner’s only recourse being to appeal the decision of Exam.

Thus, the Tax Court concluded in Belair Woods that the initial determination of a penalty under IRC §6751(b)(1) is embodied in the document by which Exam formally notifies the taxpayer, in writing, that it has completed its work and made an unequivocal decision to assert penalties. In Belair Woods, this took the form of a 60-day letter in which Exam formally indicated that the petitioner’s arguments had been rejected, that Exam’s work was concluded, and that the only recourse for the petitioner was to file a protest with Appeals.

Frost

One day after Belair Woods, the Tax Court issued the opinion in Frost v. Commissioner.[8]  The Frost decision applies the standard set forth in Graev III and Clay, but the Tax Court is more concerned with the question of who bears the burden to show that the procedural requirements of IRC § 6751(b)(1) have been satisfied.  Ultimately, the Tax Court held that the burden of production to show that IRC § 6751(b)(1) has been met rests initially with the IRS pursuant to IRC § 7491(c), concomitantly with the IRS’s burden of production with respect to the taxpayer’s liability for penalties.

Laidlaw’s Harley Davidson Sales, Inc.

Nine days after the Tax Court issued the decision in Frost, it again addressed the requisite timing of supervisory approval prior to the initial determination of the penalty to be assessed against the taxpayer in the case of Laidlaw’s Harley Davidson Sales, Inc. v. Commissioner.[9] In Laidlaw’s Harley Davidson, the Tax Court held that the issuance of the Revenue Agent’s Report (RAR) and a 30-day letter embodied an initial determination for purposes of IRC § 6751(b)(1), because 30-day letter formally communicated to the taxpayer that penalties definitively would be assessed and that the taxpayer’s only recourse was to file a protest with Appeals.

The importance of the Laidlaw’s Harley Davidson case is not necessarily the timing of the initial determination, but the type of penalty with which the Tax Court held that the IRS must comply pursuant to IRC § 6751(b)(1). Prior to Laidlaw’s Harley Davidson, this section had not been applied to “assessable penalties,” i.e., those penalties contained in IRC §§ 6671-6725 that are not subject to deficiency procedures. The Tax Court held that the phrase “all penalties under [the Code]” meant just that, and prior written supervisory approval was necessary for the assessment of any penalty under the Code whether subject to deficiency procedures or not.

Chadwick

Five days after the decision in Laidlaw’s Harley Davidson, the Tax Court issued the decision of Chadwick v. Commissioner,[10] in which the Tax Court was faced with the issue of whether the Trust Fund Recovery Penalty was subject to the prior written supervisory approval requirement of IRC § 6751(b)(1). The IRS’s argument was that the Trust Fund Recovery Penalty imposed a tax rather than a penalty, and therefore the Tax Court’s analysis in Laidlaw’s Harley Davidson was inapplicable.

The Tax Court saw through the smokescreen and held that the trust fund recovery penalty, contained in IRC § 6672, was an assessable penalty that the IRS could assess without regard to deficiency procedures.  As the Tax Court held previously, IRC § 6751(b)(1), by its terms, applies to the assessment of all penalties under the Code.[11] Thus, IRC §6751(b)(1) encompasses not only penalties subject to deficiency procedures but also “a great many so-called assessable penalties” contained in IRC §§ 6671-6725, including the Trust Fund Recovery Penalty under IRC § 6672(a).

With respect to when precisely the IRS must obtain prior written supervisory approval of a penalty against the taxpayer, the Chadwick decision followed the analysis in Belair Woods and held that Letters 1153 (“60-day letters”) were the documents in which the IRS first formally communicated to petitioner its definite decision to assert the Trust Fund Recovery Penalty. [12]

Thompson

In August 2020, the Tax Court issued its opinion in Thompson v. Commissioner,[13] which considered the question of whether an offer of settlement of the petitioner’s tax liabilities was an initial determination of a penalty pursuant to IRC §6751(b)(1). The Tax Court found that the offer letters did not reflect an “initial determination” because they did not notify the petitioners that Exam had completed its work. Rather than determining that the petitioners were liable for penalties of specific dollar amounts, subject to the review by Appeals or the Tax Court, each letter offers to settle penalties arising from the distressed asset trust transactions on certain terms, including lower penalty rates, which are based not on an audit but on Announcement 2005-80.

Critically, the letters clarified that if the petitioners did not accept the settlement, Exam still had work to do, insofar as the IRS would need to complete its examination prior to assessing additional tax and penalties. This is not the type of concrete, unequivocal determination that is contemplated by IRC §6751(b)(1) and its body of interpretive case law, including Belair Woods. As such, and offer letter like the ones that issued does not require supervisory approval because it is not a “determination” at all, but a preliminary proposal of Exam within an ongoing examination

Takeaways from Memorandum Opinions

The issue presented in Chicago Baseball Holdings v. Commissioner,[14] was whether prior written supervisory approval of penalties was required before the IRS communicates the penalties to the taxpayer for the first time, even if such communication was informal.  The petitioners argued that supervisory approval is required by or before the first time an IRS official “introduces the penalty into the conversation.”[15] The petitioners’ position relies on the phrase “first proposal,” that is, when did the IRS first propose the imposition of penalties to the taxpayer. The statutory language, however, uses the word “determination” not “proposal.”

Judge Buch noted in his concurring opinion in Graev that a “determination” is, by definition, authoritative or conclusive. A mere proposal is not.  Therefore, compliance with IRC §6751(b)(1) is not required for the IRS’s mere suggestion, proposal, or initial informal mention of the possibility of the assertion of a penalty; instead, it is the first formal, definitive, and conclusive written communication to the taxpayer that the IRS has determined that it will impose a penalty, which communication is generally (though need not absolutely be) accompanied by a notice of appeal rights, that triggers the prior written approval requirement.

With respect to the form of written penalty approval, no official IRS form is necessary. If the writing appropriately manifests the supervisor’s intent to approve the penalty, the Tax Court will honor the approval.[16] The Tax Court in Chicago Baseball Holdings was so deferential to the IRS that it is likely that a duly executed cocktail napkin would likely carry the day for the IRS.

In the case of Koh v. Commissioner,[17] the Tax Court examined the issue of whether Chief Counsel must satisfy the requirements of IRC § 6751(b)(1), and, if so, how Chief Counsel can do so.  The Tax Court held that if the IRS asserts penalties in an answer to a petition, which is appropriate, Chief Counsel must have obtained prior written supervisory approval before filing the answer. The Tax Court observes that where the attorney’s immediate supervisor personally approved in writing the assertion of a penalty that was first raised in the answer, as evidenced by the signature of respondent’s associate area counsel on the pleading, the requirement is met. See Roth v. Commissioner.[18]

In the case of Minemyer v. Commissioner,[19] the Tax Court refers back to the Frost decision in which the Tax Court noted that the IRS may obtain written supervisory approval of a document asserting penalties against the taxpayer subsequent to the actual formal communication of the penalties to the taxpayer. Thus, the Tax Court makes it clear in Opinion in the case of Minemyer that prior (that is, prior to the initial determination) written supervisory approval must be obtained with respect to the actual document in which the initial determination is communicated with the taxpayer, and not a later document when the IRS actually gets their act together and obtains written supervisory approval.

With respect to the question of who must provide supervisory approval, in of Duffy v. Commissioner,[20] the Tax Court held that, the IRS has not established compliance with the supervisory approval requirement of IRC § 6751(b)(1), because the civil penalty approval form did not establish that it was “the immediate supervisor of the individual,” who made the determination to assess penalties.[21] Indeed, the claim that the individual “supervised a number of revenue agent’s” did not establish that the individual supervised the particular revenue agent that communicated the initial determination to the taxpayer.

Concluding Thoughts

It is shocking to me how many petitioners escaped sometimes million-dollar penalties due to the IRS’s failure to obtain prior written supervisory approval of the initial determination of such penalties. The bar is so very low that the IRS should very easily be able to overcome the hurdle. Apparently, however, the bar is just high enough that Exam trips on it whilst chewing bubblegum, puffing out its administrative chest, and musing to itself of the damage that it will inflict upon an unwitting taxpayer.

Footnotes:

[1] Except penalties under IRC § 6651 (failure to file), IRC § 6654 (failure to pay estimated tax), and IRC § 6655 (failure for corporation to pay estimated tax), as well as any other penalty calculated automatically through electronic means.

[2] See IRC § 6751(b)(1).

[3] Internal Revenue Service Restructuring and Reform Act of 1998, Pub. L. 105–206, title III, § 3306(a), July 22, 1998, 112 Stat. 744

[4] 851 F.3d 190, 220-21 (2017).

[5] 149 T.C. 485, 493 (2017).

[6] 152 T.C. 223, 249 (2019).

[7] 154 T.C. No. 1 (Jan. 6, 2020).

[8] 154 T.C. No. 2 (Jan. 7, 2020).

[9] 154 T.C. No. 4 (Jan. 16, 2020).

[10] 154 T.C. No. 5 (Jan. 21, 2020).

[11] Graev III, 149 T.C. at 495 n.17.

[12] It should be noted, as well, that the Internal Revenue Manual (IRM) requires supervisory approval of TFRPs always to precede issuance of the Letter 1153. See IRM § 5.7.4.6, 5.7.4.7.

[13] 155 T.C. No. 5 (August 31, 2020).

[14] T.C. Memo. 2020-2 (Jan. 6, 2020).

[15] See Graev, 149 T.C. at 501 (Lauber, J., concurring).

[16] See Palmolive Bldg. Inv’rs v. Commissioner, 152 T.C. 75, 85-86 (2019).

[17] T.C. Memo. 2020-77 (June 4, 2020).

[18] T.C. Memo. 2017-248, at *11, aff’d, 922 F.3d 1126 (10th Cir. 2019).

[19] T.C. Memo. 2020-99 (July 1, 2020).

[20] T.C. Memo. 2020-108 (July 13, 2020).

[21] See IRC § 6751(b)(1).

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