Tax Court: IRS Can't Assess 40% Penalty After Failing to Get Approval for 20% Penalty

(Parker Tax Publishing October 2020)

The Tax Court held that an IRS Letter 5153 and a revenue agent's report formally communicated to a taxpayer the IRS's determination to assert a 20 percent penalty on four alternative grounds, including a substantial understatement of income tax under Code Sec. 6662(b)(2) and engaging in a transaction lacking economic substance under Code Sec. 6662(b)(6); therefore, the IRS was required to obtain timely supervisory approval for those penalties under Code Sec. 6751(b)(1) and failed to do so. The court further held, on an issue of first impression, that the IRS's imposition of a 40 percent penalty under Code Sec. 6662(i) for a failure to report a transaction lacking in economic substance is not a separate distinct penalty from the 20 percent penalty imposed under Code Sec. 6662(a) and Code Sec. 6662(b)(6), and therefore, since the IRS did not obtain supervisory approval for either of those penalties, it also did not secure timely approval for the 40 percent penalty. Oropeza v. Comm'r, 155 T.C. No. 9 (2020).

Background

Jesus Oropeza was the owner of FIRM, Inc., a micro-captive insurance company organized as an S corporation. In March of 2014, an IRS revenue agent (RA) audited Oropeza's 2011 tax return, which was later expanded to an audit of subsequent tax years. The statute of limitations for 2011 was set to expire on April 15, 2015, and Oropeza's representative informed the RA that Oropeza would not agree to extend the limitations period.

On January 14, 2015, the RA sent Oropeza a Letter 5153 and attached Form 4549-A, Income Tax Discrepancy Adjustments, commonly known as a revenue agent report (RAR). The RAR proposed to increase Oropeza's distributive share of FIRM's income and his reported capital gain. The RAR also asserted a 20 percent penalty under Code Sec. 6662(a), attributable to one or more of the following: (1) negligence or disregard of the rules or regulations, (2) substantial understatement of income tax, (3) substantial valuation misstatement (overstatement), and/or (4) engaging in a transaction lacking in economic substance under Code Sec. 6662(b)(6). The RAR did not explicitly state whether the IRS was asserting one or more of these bases in particular, or was asserting all four as alternative bases for the 20 percent penalty. Although the RAR had a space in which the RA could have asserted a 40-percent penalty for one or more of the following: (1) gross valuation misstatement, (2) nondisclosed transaction lacking economic substance, or (3) undisclosed foreign financial assets, there was no indication anywhere in the RAR that a 40 percent penalty was being asserted as an alternative to the 20 percent penalty.

The Letter 5153 gave Oropeza three options: (1) agree to the adjustments in the RAR; (2) execute a Form 872, Consent to Extend the Time to Assess Tax, if he wished to have the IRS Office of Appeals (Appeals) review the case; or (3) decline the first two options. If Oropeza declined the first two options, the Letter 5153 advised that the IRS would issue a notice of deficiency that he could challenge in the Tax Court. Oropeza did not agree to the adjustments in the RAR and did not agree to extend the period of limitations.

On January 14, 2015 - the same day on which he mailed the Letter 5153the RA completed work on a Civil Penalty Approval Form. On January 28, 2015, the RA accordingly closed the case. The following day, his then-immediate supervisor, Group Manager Mead, signed the Civil Penalty Approval Form authorizing the assertion of a 20 percent penalty for a substantial understatement of income tax.

On May 1, 2015, the RA prepared a memo for IRS Chief Counsel Attorney Brandon Keim. The memo noted that Code Sec. 6662(i) increases the accuracy-related penalty to 40 percent for any portion of an underpayment that is attributable to a nondisclosed noneconomic substance transaction if the relevant facts are not adequately disclosed in the return. The memo stated that Oropeza disclosed no facts about the captive insurance arrangement on FIRM's return or on his individual return and accordingly recommended that a 40 percent penalty was appropriate for any portion of the underpayment attributable to the abusive captive insurance company transactions. The RA's then-immediate supervisor, Acting Group Manager Pringle, signed the memo on May 1, 2015. On May 6, 2015, the IRS issued a notice of deficiency to Oropeza. The income adjustments determined in the notice were substantially similar to those asserted in the RAR. However, the notice also determined a 40 percent penalty under Code Sec. 6662(i).

Under Code Sec. 6751(b)(1), the IRS cannot assess a penalty unless the initial determination of the assessment is personally approved, in writing, by the immediate supervisor of the individual making such determination. In Belair Woods, LLC v. Comm'r, 154 T.C. No. 1 (2020), the Tax Court held that the "initial determination" of a penalty was contained in a letter in which the IRS formally notified the taxpayer that the Examination Division had completed its work and had made a definite decision to assert penalties.

Oropeza filed a motion for summary judgment, arguing that timely supervisory approval had not been obtained for any of the penalties as required under Code Sec. 6751(b)(1). The IRS responded that the initial determination of the substantial understatement penalty was made in the notice of deficiency mailed to Oropeza on May 6, 2015 and, because the Civil Penalty Approval Form was signed by Group Manager Mead on January 29, 2015, the penalty approval was timely. The IRS also attempted to distinguish this case from Belair Woods on the grounds that the taxpayer in that case received a 60-day letter enabling it to go to the IRS Appeals Office, whereas Oropeza did not receive a 30-day letter enabling him to do so. The IRS also contended that the 40 percent penalty under Code Sec. 6662(i) received supervisory approval when Acting Group Manager Pringle signed the RA's memo to Attorney Keim on May 1, 2015. According to the IRS, since the notice was not mailed until May 6, timely approval was also secured for that penalty.

Analysis

The Tax Court granted summary judgment to Oropeza. First, the court noted that the January 15, 2015, RAR informed Oropeza that the IRS had determined a 20 percent penalty attributable to one or more of four specified grounds. In the court's view, the letter made clear that the Examination Division had completed its work and made a definite decision to assert penalties. The court reasoned that whichever option Oropeza chose for responding to the letter, the Examination Division's typical responsibilities from that point forward would be ministerial in nature. Thus, the court held that the Letter 5153 and RAR contained the initial determination of the substantial understatement penalty, and because supervisory approval for that penalty was not secured until January 29, 2015 (the date on which the RA's immediate supervisor signed the Civil Penalty Approval Form), the approval was untimely. The court rejected the IRS's argument that Oropeza did not receive a 30-day letter enabling him to go to Appeals, reasoning that a 30- or 60-day letter is one way of communicating to a taxpayer that the Examination Division has completed its work, but not the only way. The court also noted that the Letter 5153 clearly communicated the same message to Oropeza - that he could now go to Appeals, but only if he agreed to extend the limitations period.

With regard to the 40 percent penalty, the Tax Court held that the RAR asserted a 20 percent penalty for engaging in a transaction lacking economic substance, which did not receive timely approval, and since the base-level penalty was not timely approved, the IRS could not satisfy Code Sec. 6751(b)(1) by later determining that the 40-percent penalty rate under Code Sec. 6662(i) applied. The court reasoned that when a taxpayer receives an RAR asserting a penalty for one or more of four enumerated penalties, as Oropeza's RAR did, the taxpayer would assume that the RAR was asserting all four bases as alternative grounds for imposing a penalty, unless other portions of the communication explicitly limit the penalty determination to a subset of those grounds. The court further found that failure to disclose a noneconomic transaction on a return is not a separate penalizable offense, but rather is analogous to an aggravating factor in criminal law that justifies a harsher penalty for the basic offense. The court reasoned that, under Code Sec. 6751(b)(1), the penalty whose initial determination required approval was the penalty imposed under Code Sec. 6662(a) and Code Sec. 6662(b)(6) for engaging in a transaction lacking economic substance. Because that penalty was not timely approved, there was no applicable penalty for which the rate could be increased under Code Sec. 6662(i).

For a discussion of the accuracy-related penalty on underpayments of tax, see Parker Tax ¶262,120. For a discussion of the supervisory approval requirement for the initial determination of a penalty assessment, 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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