IRS Supervisory Approval Required Before First Formal Communication of Penalties

(Parker Tax Publishing January 2020)

The Tax Court held that the IRS's issuance to a taxpayer of a Letter 1807 and summary report setting forth the Examination Division's tentative proposed adjustments and inviting the taxpayer to a conference to discuss them did not constitute the initial determination of a penalty assessment requiring supervisory approval under Code Sec. 6751(b)(1). The Tax Court held that the 60-day letter issued to the taxpayer was the initial determination requiring supervisory approval because it formally communicated the Examination Division's definite determination to assert the penalties. Belair Woods, LLC v. Comm'r, 154 T.C. No. 1 (2020).

Background

Belair Woods, LLC (Belair) filed a Form 1065 for tax year 2009 on which it claimed a charitable deduction for the donation of a conservation easement. In 2012, the IRS sent Belair a Letter 1787, Notice of Administrative Proceeding, informing Belair that it was beginning an audit of Belair's 2009 return. The letter was signed by IRS revenue agent Ellie Pennington.

Pennington then sent Belair a Letter 1807 inviting its tax matters partner (TMP) and other partners to a conference to discuss the IRS's proposed adjustments. Pennington, not her immediate supervisor, signed the Letter 1807. The proposed adjustments were detailed in an attached summary report which proposed to deny Belair's charitable deduction in its entirety and apply either a gross overvaluation penalty under Code Sec. 6662(h) or, alternatively, penalties for negligence and substantial understatement of income tax under Code Sec. 6662(c) and (d). Addressing the gross overvaluation penalty, the summary report advised that in order to avoid the penalty, the facts and circumstances test of whether Belair acted in good faith would have to be taken into account. The summary report also said that Belair's purpose for entering the transaction may be considered and that each partner should establish the purpose for claiming the conservation easement deduction.

The IRS exam team and Belair's representatives attended an initial conference in February 2013 followed by a second conference in May 2014, but no agreement was reached. Pennington completed a Civil Penalty Approval Form recommending that the gross overvaluation penalty be applied and that the negligence and substantial understatement penalties be asserted as alternatives. She did not recommend assertion of a penalty under Code Sec. 6662(e) for substantial valuation misstatement. Pennington forwarded the case file, including the Civil Penalty Approval Form, to Cheryl Mixon, her then-supervisor. Mixon signed the form, approving the assertion of the three penalties. Pennington's original supervisor, Carl Schneider, did not approve the assertion of the three penalties in writing at any time.

In March 2015, the IRS issued Belair a 60-day letter to formally communicate the Examination Division's decision to assert the adjustments determined in the examination and the three penalties listed on the Civil Penalty Approval Form. Belair sought review by the IRS Appeals Office but the appeal was unsuccessful. In June 2017, the Appeals Office issued Belair a final partnership administrative adjustment (FPAA) disallowing the charitable contribution deduction in its entirety and determining a gross valuation misstatement penalty. In the alternative, the FPAA determined penalties for negligence, substantial understatement of income tax, and substantial valuation misstatement under Code Sec. 6662(e). This was the first time the IRS had communicated to Belair its intention to assert the Code Sec. 6662(e) penalty. The IRS conceded that it could not show supervisory approval for that penalty.

Under Code Sec. 6751(b)(1), the IRS may not assess a penalty unless "the initial determination of such assessment" is personally approved in writing by the immediate supervisor of the individual making the determination. Before the Tax Court, Belair's TMP argued that Pennington was required under Code Sec. 6751(b)(1) to obtain her supervisor's approval when she mailed the Letter 1807 inviting the TMP and other partners to a conference to discuss the exam team's proposed adjustments. The TMP also argued that Schneider, as Pennington's original supervisor, should have approved the Civil Penalty Approval Form and, alternatively, that Mixon's signature was a nominal act that did not reflect meaningful review.

Tax Court's Analysis

The Tax Court held that the Letter 1807 and summary report, which set forth the Examination Division's tentative proposed adjustments and invited Belair to a conference to discuss them, did not constitute the initial determination of a penalty assessment necessitating prior supervisory approval under Code Sec. 6751(b)(1). The Tax Court further held that the IRS satisfied the Code Sec. 6751(b)(1) requirements with respect to first three penalties because Pennington secured Mixon's written approval on the Civil Penalty Approval Form before the 60-day letter was issued.

The Tax Court found that the 60-day letter formally communicated to Belair the Examination Division's definite decision to assert penalties, thus concluding the Examination Division's consideration of the case. In the court's view, the Letter 1807 was not a determination because it only notified Belair of proposed adjustments and was not an unequivocal communication advising Belair that the Examination Division had completed its work and made a definition decision to assert penalties. The court cited its decisions in Clay v. Comm'r, 152 T.C. No. 13 (2019) and Kestin v. Comm'r, 153 T.C. No. 2 (2019) in reaching its decision. In Clay, the court held that a 30-day letter which formally communicated to the taxpayers its definite decision to assert penalties. In Kestin, the court concluded that a Letter 3176C advising taxpayers of the possibility of frivolous submission penalties did not constitute an unapproved initial determination because, although it warned of the IRS's intention to impose a penalty, its purpose was actually to invite the taxpayer to make a correction that could result in the penalty not being asserted.

The Tax Court rejected Belair's arguments regarding the supervisory approval of the Civil Penalty Approval Form because it found that Code Sec. 6751(b)(1) does not require approval by a specific person in a particular way. The court did not agree that Pennington's original manager had to sign the form. The court also disagreed with Belair's contention that the IRS had to demonstrate the depth or comprehensiveness of the supervisor's review. The court noted that it had held in numerous cases that the group manager's signature on the Civil Penalty Approval Form is sufficient to satisfy the statutory requirements.

Observation: In one dissenting opinion, a judge reasoned that the Letter 1807 was the initial determination because it informed Belair in writing that the IRS intended to impose a penalty. In another dissent, a judge said that the majority's reasoning seemed to require approval not of an initial determination but only of a more formal final determination by the Examination Division, a conclusion that went against the statutory purpose of Code Sec. 6751(b)(1).

For a discussion of IRS procedural requirements that must be met before the IRS assesses 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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