Second Circuit Reverses Imposition of Accuracy-Related Penalty; IRS Did Not Obtain Supervisory Approval

(Parker Tax Publishing April 2017)

The Second Circuit held that a taxpayer should have been permitted to raise as a defense to the imposition of an accuracy-related penalty by the IRS the fact that the IRS failed to obtain the written supervisory approval required under Code Sec. 6751 before assessing the penalty. The court also registered its disapproval with a divided 2016 Tax Court opinion which reached the opposite conclusion on the same issue, possibly signaling a shift in how much the courts will scrutinize IRS procedures used in assessing penalties against a taxpayer. Chai v. Comm'r, 2017 PTC 124 (2d Cir. 2017).

Facts

Jason Chai is an architect who was involved in at least 131 tax shelter arrangements. In 2003, he received a $2 million bonus payment from Delta Currency Trading, LLC, one of several corporations set up to market and advise the tax shelters. The payment was reported on Form 1099 for 2003, but Chai did not include the amount in taxable income. He took the position that it constituted the return of capital from his tax shelter investments. Chai's 2003 tax return also showed an overall loss of $11.5 million, consisting mostly of tax shelter partnership losses.

The IRS audited Chai's 2003 tax return and characterized the $2 million payment as self-employment income and asserted a deficiency in Chai's self-employment tax. The IRS also assessed a 20 percent accuracy-related penalty. Assessments relating to additional income tax were postponed due to partnership audit proceedings relating to the tax shelters that had to be completed before any income tax could be assessed. Chai took his case to the Tax Court.

Tax Court's Decision

Before the Tax Court, Chai argued that the $2 million payment was a return on investment and not compensation and, thus, was not subject to self-employment tax. Chai asserted that, as an investor, he agreed to serve as an accommodating party only in the hope of reaping investment gains. The Tax Court rejected this argument and said it was quite clear that Chai's primary purpose was to earn compensation in exchange for his services as an accommodating party.

Chai also argued that the IRS failed to meet its burden with respect to the imposition of the accuracy-related penalty. Specifically, he argued, compliance with Code Sec. 6751(b)(1)'s written-approval requirement was part of the IRS's burden of production to demonstrate compliance with that requirement in imposing the penalty. Because the issue was raised for the first time post-trial, the Tax Court declined to consider the argument, finding it untimely and that the IRS would be prejudiced by its consideration.

Code Sec. 6751(a) provides that the IRS must include with each penalty notice information with respect to the name of the penalty, the Code section under which the penalty is imposed, and a computation of the penalty. Code Sec. 6751(b)(1) generally requires supervisory approval of the initial determination of a penalty assessment. Specifically, it provides that no penalty can be assessed unless the initial determination of such assessment is personally approved (in writing) by the immediate supervisor of the individual making such determination or such higher level official as the Treasury Secretary may designate. However, Code Sec. 6751(b)(2)(A) provides that this rule does not apply to Code Secs. 6651, 6654, or 6655 penalties and Code Sec. 6751(b)(2)(B) provides that this rule doesn't apply to any other penalty automatically calculated through electronic means.

Chai appealed both holdings to the Second Circuit.

On appeal, the IRS offered two arguments with respect to the Code Sec. 6751 issue. First, it said that written approval was not required under the exception in Code Sec. 6751(b)(2)(B) for penalties assessed by electronic means. Second, it argued that the Tax Court had not abused its discretion in declining to consider Chai's post-trial argument because, under Graev v. Comm'r, 147 T.C. 16 (2016), it would have been premature to challenge the IRS's failure to satisfy its written-approval requirement until the Tax Court's decision on the penalty had become final. The IRS also cited the Internal Revenue Manual which, it said, instructs IRS personnel that a penalty is calculated by electronic means if the penalty is assessed free of any independent determination by an IRS employee as to whether the penalty should be imposed.

Citing the majority opinion in Graev, the IRS said Chai could not argue that the IRS failed to satisfy its written approval obligation under Code Sec. 6751(b)(1) until after the Tax Court's decision on the penalty became final and the IRS assessed the penalty. The Graev majority held that the written approval required by Code Sec. 6751 may be obtained at any time before the penalty is assessed, although five dissenters concluded that the written approval must be obtained prior to the initiation of Tax Court proceedings regarding penalties. The Graev majority found the absence of a time requirement to, unambiguously, mean that the written approval may be obtained at some, but no particular, time prior to assessment.

Second Circuit's Decision

The Second Circuit affirmed the Tax Court's order upholding the self-employment tax deficiency. However, it reversed the Tax Court's order upholding the accuracy-related penalty finding that the IRS was required to obtain written supervisory approval before issuing the notice of deficiency and did not do so.

First, the court determined that Chai's penalty did not fall within the exception to the written supervisory approval requirement for penalties automatically calculated through electronic means. The court found no evidence that the penalty, which under Code Sec. 6662(b) can be attributable to one or a combination of causes, was or could have been made electronically. To the contrary, there was evidence that the penalty determinations were made either by an IRS manager or a revenue agent working under the manager's authority.

Second, the court found that the IRS was required under Code Sec. 6751(b)(1) to show that it obtained written supervisory approval of the initial penalty determination no later than the date the IRS issued the notice of deficiency, or filed an answer or amended answer asserting the penalty. The court determined that compliance with Code Sec. 6751(b) is part of the IRS's burden of production and proof in a deficiency case in which a penalty is asserted, and that the IRS failed to meet its burden with respect to the accuracy-related penalty it sought to impose on Chai.

Finding the language of Code Sec. 6751(b) ambiguous and reviewing the legislative history to determine Congress's intent, the Second Circuit agreed with the Graev dissenters. Where the Graev majority found the absence of a time requirement to, unambiguously, mean that the written approval required in Code Sec. 6751(a) may be obtained at some, but no particular, time prior to assessment, the Second Circuit disagreed. Because "the assessment" is the formal recording of a taxpayer's tax liability in the IRS's records, the court said, it is essentially the last of a number of steps before the IRS can collect a deficiency. Thus, the court found the term "initial determination of such assessment" in Code Sec. 6751(b)(1) to be ambiguous. The IRS can determine a deficiency, the court said, but it cannot determine an assessment.

The court noted that Code Sec. 6751(b)(1) says that no penalty can be assessed unless the "initial determination of such assessment" is approved in writing by a supervisor. On its face, the court said, the statute does not require the approval at any particular time before assessment.

Turning to Congress's intent, the court found that the purpose of the statute is to prevent IRS agents from threatening unjustified penalties in order to encourage taxpayers to settle. But, as the Graev dissent pointed out, once an unapproved penalty has been upheld by the Tax Court, the supervisor's approval of the initial determination would add nothing to the process, and such approval in a case where the Tax Court had held the taxpayer not liable for the penalty would be completely moot. Nor, the Second Court noted, would the Tax Court's decision to uphold a penalty determination be sufficient to solve the problem. The IRS could still use the threat of penalties as a bargaining chip in settlement negotiations. If successful, the Tax Court would be none the wiser since the taxpayer would have settled rather than file a Tax Court petition to litigate the propriety of the penalty.

The court also reasoned that if supervisory approval is required, it must be obtained when the supervisor has the discretion to give or withhold it. Once the Tax Court decision is final, that discretion is lost because at that point, Code Sec. 6215(a) provides that the entire amount redetermined as the deficiency "shall" be assessed. Moreover, for the supervisor's approval to be given force, it must be issued not merely before the Tax Court proceeding ends but before it is initiated. Code Sec. 6751(b) requires supervisory approval of the "initial" determination. The statute would not make sense, the court said, if it permitted written approval of the initial determination up until and even contemporaneously with the IRS's final determination, because the IRS might still have discretion during the proceeding to concede a penalty.

According to the court, the last moment the approval of the initial determination actually matters is immediately before the taxpayer files suit or penalties are asserted in a proceeding. And, because a taxpayer can file a petition at any time after receiving notice of a deficiency, the truly consequential moment of approval is the IRS's issuance of the notice of deficiency, or the filing of an answer or amended answer asserting penalties. The court thus held that Code Sec. 6751(b)(1) requires 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.

For a discussion of the procedural requirements for computing penalties, see Parker Tax ¶262,195.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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