Tenth Circuit: IRS Can Make Initial Determination of Penalty After Issuing Notice of Deficiency

(Parker Tax Publishing May 2019)

The Tenth Circuit affirmed the Tax Court and held that the IRS obtained supervisory approval of its initial determination of a 40 percent gross valuation misstatement penalty as required by Code Sec. 6751(b) after an audit, even though the IRS later issued a notice of deficiency setting forth a 20 percent penalty. The Tenth Circuit rejected the taxpayers' argument that the notice of deficiency was the initial penalty determination and that Code Sec. 6751(b) precluded the IRS from later reasserting the 40 percent penalty. Roth v. Comm'r, 2019 PTC 163 (10th Cir. 2019).

In 2007, John and Deanne Roth donated a conservation easement encumbering 40 acres of land they owned in Colorado. The easement was one of several so-called "gravel-pit cases" in which Colorado taxpayers claimed large deductions for donating conservation easements prohibiting the mining of gravel on what had historically been farmland. The IRS determined that these easements were effectively worthless, or worth drastically less than the taxpayers claimed, because the subject land was more valuable as farmland than it would be if mined for gravel.

On their 2007 income tax return, the Roths valued their easement at $970,000 and claimed a charitable deduction based on that amount. In 2011, the IRS audited the Roths' returns and hired an appraiser to provide an opinion of the value of the easement. The appraiser determined the easement to be worthless, although the Roths and the IRS later stipulated to a value of $40,000. After the audit, IRS Revenue Agent Denise Soss determined that the Roths were subject to a 40 percent gross valuation misstatement penalty under Code Sec. 6662(h). Soss's manager signed a form approving the penalty determination.

The Roths sought review of their case in the IRS Office of Appeals. Appeals Officer Mark Kawakami wrote a memorandum concluding that the penalties should be "fully sustained," but his memo concluded that the Roths were liable for a 20 percent penalty under Code Sec. 6662(a). The IRS later explained the change as a clerical error. Kawakami's supervisor signed the memo to indicate her approval of the 20 percent penalty. The IRS sent the Roths a notice of deficiency setting forth the revised 20 percent penalty.

In 2012, the Roths filed a Tax Court petition to contest the IRS's determinations. In response, the IRS filed an answer reasserting the Roths' liability for the 40 percent gross valuation misstatement penalty. The answer was signed by Sara Barkley, Senior Counsel for the IRS, and her supervisor, Robert Varra. The Roths and the IRS eventually agreed to a stipulated set of facts, and asked the Tax Court to decide whether the IRS complied with the written-approval requirement under Code Sec. 6751(b) before attempting to impose a gross valuation misstatement penalty.

The Tax Court ruled in the IRS's favor, reasoning that any of three instances could be interpreted as fulfilling the "initial determination" written-approval requirement in Code Sec. 6751(b). First, the Tax Court noted that Soss obtained written approval of her supervisor for a 40 percent penalty at the conclusion of the IRS's audit. Second, Kawakami obtained written approval supporting his conclusion to "fully sustain" the proposed penalties, even though his memo actually calculated a 20 percent penalty, Finally, Barkley asserted in the IRS's answer that the Roths should be liable for a 40 percent penalty. On this final point, the Tax Court considered itself bound by Graev v. Comm'r, 149 T.C. 485 (2017), and Chai v. Comm'r, 2017 PTC 124 (2d Cir. 2017), which, together with Code Sec. 6214(a), allow the IRS to assert additional penalties in an answer to a taxpayer's petition.

The Roths appealed to the Tenth Circuit, arguing that Soss merely proposed the 40 percent penalty and that the notice of deficiency was the IRS's initial determination. Because the notice included only a 20 percent penalty, the Roths argued, Code Sec. 6751(b) prevented the IRS from attempting to impose any other penalty.

The Tenth Circuit affirmed the Tax Court and held that Code Sec. 6751(b) does not limit the IRS's initial determination with respect to a penalty assessment to the penalty included in the notice of deficiency. The court found that the Roths' argument was not supported by the statutory context of Code Sec. 6751(b). The court pointed out that Code Sec. 6212(a) authorizes the IRS to send a notice of deficiency but does not require the notice to contain the IRS's determination. The court pointed out that, in fact, the statute contemplates that the IRS's determination will precede the sending of a notice. The court also noted that Code Sec. 6214(a) explicitly authorizes the Tax Court to redetermine a deficiency and any penalties stated in the notice and, because a Tax Court proceeding necessarily occurs after the taxpayer has received a notice, some initial determinations of penalty assessments will not be contained in a notice of deficiency.

The Tenth Circuit found that the IRS's initial determination of a 40 percent penalty could have been made either by Soss or Barkley, and that it was logical to conclude that Soss made the initial determination. The Tenth Circuit noted that the Tax Court concluded that Kawakami's statement that Soss's proposed penalties "are fully sustained" was an initial determination that a 40 percent penalty should apply. The Tenth Circuit explained that, to the contrary, Kawakami had determined to apply a 20 percent penalty, but found that it did not need to decide whether such an inconsistent document could satisfy Code Sec. 6751(b) because it concluded that the statute could have been satisfied by either Soss or Barkley.

The court rejected the Roths' argument that Soss's conclusions were merely proposed, noting that the same argument had been rejected by the Tax Court in Graev. Moreover, even if Soss did not make the initial determination, Barkley's answer to the petition, signed by her supervisor and asserting the 40 percent penalty, satisfied Code Sec. 6751(b), according to the court. The Tenth Circuit said that the central premise of the Roths' argument was that the IRS could make only one initial determination of a penalty, and it rejected that contention.

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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