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Sells v. Commissioner (T.C. Memo. 2021-12)

On January 28, 2021, the Tax Court issued a Memorandum Opinion in the case of Sells v. Commissioner (T.C. Memo. 2021-12). The main issue presented in Sells was whether the conservation easement deduction was appropriately denied, but it is the prior supervisory approval that we’ll focus on below.

Background to the Penalty Issue

The IRS asserted penalties for both the conservation easement and the timber donation. However, the parties stipulated that the IRS had a “penalty-approval form” only for two of the five petitioners. Both these penalty-approval forms were approved by a “Group Manager” and dated before the two petitioners received their notices. The penalty-approval form for one petitioner shows approval of penalties for substantial understatement and gross misvaluation, but it doesn’t approve a penalty for negligence or substantial misvaluation. This form doesn’t specifically mention either the easement or the timber, but states that the “contribution deduction appear[s] overstated by the valuation.” The revenue agent who drafted the penalty-approval form for the other petitioner clearly wanted penalties for negligence and substantial understatement, but also checked a box on a row that says this: “IRC § 6662(h) Substantial Valuation Misstatement.” One can immediately see a problem—IRC § 6662(h) defines gross misvaluation; it’s IRC § 6662(b)(3) that defines substantial misvaluation.

Genera of Penalties

There are two genera of penalties here. One is commonly called the “accuracy related” or “IRC § 6662(a)” penalty. The Code lists several species within this genus in IRC § 6662(b), and three are involved here: IRC § 6662(b)(1), which penalizes understatements due to negligence or intentional disregard of rules and regulations; section 6662(b)(2), which penalizes “substantial understatement” of the tax due; and IRC § 6662(b)(3), which penalizes “substantial” valuation misstatements. All of these carry a 20% penalty, and the Commissioner has to hit with only one of the three to win.

Then there is a 40% penalty.

IRC § 6662(h) imposes this megapenalty for “gross” misstatements of value on a return. It might seem odd that unlike, for example, manslaughter and murder, a “substantial” misvaluation is not a lesser-included offense of “gross” misvaluation. In Oropeza v. Commissioner, 155 T.C. No. 9, slip op. at 18 (Oct. 13, 2020), the Tax Court held precisely that IRC § 6662(i) does not impose a distinct penalty; it simply increases the rate imposed for the penalty determined under IRC § 6662(a) and (b)(6). The Tax Court concluded that without supervisory approval for the penalty under IRC § 6662(b)(6), approval of a penalty under IRC § 6662(i) was procedurally inadequate.

Distinction between Substantial- and Gross-Misvaluation

In Palmolive Bldg. Inv’rs, LLC v. Commissioner, 152 T.C. 75, 79 n.3, 83-84 (2019), the Tax Court concluded that the substantial- and gross-misvaluation penalties were distinct with each requiring supervisory approval. As the Tax Court plainly reiterated in Campbell v. Commissioner, T.C. Memo. 2020-41, at *32, the IRC § 6662(a) and (h) penalties are distinct (despite the title of IRC § 6662 referring to a (singular) penalty), and the initial determination under each subsection must be separately approved for purposes of IRC § 6751(b)(1). See also Rogers v. Commissioner, T.C. Memo. 2019-61, at *20.

What was Approved?

Approval of one species of penalty doesn’t mean approval of any other. In Palmolive, the Tax Court stated that though the title of IRC § 6662 refers to a singular “penalty,” that section in fact creates several distinct penalties. Palmolive, 152 T.C. at 87. One consequence is that the Commissioner must show approval of each penalty separately to show that he has complied with IRC § 6751(b)(1). Id.; see also McCarthy v. Commissioner, T.C. Memo. 2020-74, at *28-*29; Campbell, T.C. Memo. at *32-*33.

Amendment of Returns to Raise IRC § 6662(h)

The IRS amended its answers in these cases to formally communicate for the first time that it sought IRC § 6662(h) gross-misvaluation penalties against each petitioner (save one).  Each amended answer was signed by both the lead attorney in these cases and his associate area counsel. See Roth v. Commissioner, T.C. Memo. 2017-248, at *10-*11 (stating that an answer that asserts penalties, signed by both counsel and the area counsel, satisfies IRC § 6751(b)).

Good approval, right?  Not so fast, Skippy.

In Oropeza, the Tax Court reasoned that supervisory approval of a penalty under IRC § 6662(i) was necessary, but not sufficient without approval of a penalty under IRC § 6662(b)(6) and that the 40% penalty was an enhancement, not a penalty entire unto itself. Similar logic might well lead the Tax Court to hold in the future that supervisory approval of a 40% gross-misvaluation penalty under IRC § 6662(h) is likewise inadequate without approval of a substantial-misvaluation penalty under IRC § 6662(b)(3). There was none here.

Nonetheless, Judge Holmes notes that the Tax Court “reserve[s] that question for a later case where the parties argue it.”

(T.C. Memo. 2021-12) Sells v. Commissioner

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