Computer-Generated Penalty Exempt from Written Supervisory Approval Requirement

(Parker Tax Publishing March 2019)

The Tax Court held that penalties determined under Code Sec. 6662 by an IRS computer program without human review are automatically calculated through electronic means within the meaning of Code Sec. 6751(b)(2)(B) and thus are exempt from the written supervisory approval requirement of Code Sec. 6751(b)(1). The court found that its conclusion was consistent with the IRS's interpretation of its Code Sec. 6751 obligations as set forth in the Internal Revenue Manual, which the court found was amended in 2018 to explicitly provide that computer-calculated substantial understatement penalties are exempt from the supervisory approval requirement. Walquist v. Comm'r, 152 T.C. No. 3 (2019).

Background

In August 2017, the IRS sent Craig and Maria Walquist a notice of deficiency for 2014, determining a deficiency of approximately $13,800 and an accuracy-related penalty of $2,700. The Walquists filed a petition to challenge the notice. Although they lived in Minnesota, they requested Washington, D.C. as their place of trial.

Craig and Maria Walquist filed a tax return for 2014 reporting gross income of over $94,000. Against this sum, they claimed a deduction of around $86,000 which they labeled a "Remand for Lawful Money Reduction." After the standard deduction, they reported negative taxable income of approximately $5,700.

The IRS was alerted to the Walquists' underreporting by its computer document matching program and processed the examination of their return through its Automated Correspondence Exam (ACE) system, using its Correspondence Examination Automated Support (CEAS) software. The CEAS processes cases with minimal or no involvement by a tax examiner until a taxpayer reply is received.

In July 2017, the CEAS generated and issued to the Walquists a Letter 525, General 30-day letter. In cases like this one, where the understatement of income tax calculated by the program exceeds the greater of $5,000 or 10 percent of the tax required to be shown on the return, the program systematically includes in the letter a substantial understatement penalty. Accordingly, the program calculated a penalty of around $2,700, or 20 percent of the proposed deficiency of $13,800.

The 30-day letter informed the Walquists of the proposed deficiency and penalty and indicated that, if they disagreed with the proposed changes, they were to respond with any supporting information they wished the IRS to consider. Had the Walquists responded, a tax examiner would have considered their response and made any appropriate adjustments, but the Walquists declined to reply.

In August 2017, the CEAS generated and issued to the Walquists a notice of deficiency in a Letter 3219. This notice determined adjustments and a substantial understatement penalty as previously set forth in the 30 day letter. The notice invited the Walquists to send the information the IRS requested or call with questions, but they again declined to respond. The penalty was not reviewed by any human IRS examiner before issuance of the notice.

In November 2017, the Walquists submitted a purported Tax Court petition consisting of a copy of the notice of deficiency, on each page of which they had written "Refusal for Cause." They attached various documents containing assertions commonly advanced by tax protesters. At the court's direction the Walquists filed an amended petition in January 2018, which again stated they owed no taxes, but included no facts to support that position.

The IRS answered the amended petition, noting that Mr. Walquist had filed a complaint in the Minnesota federal district court making assertions resembling those appearing in the petition. A magistrate judge determined that every aspect of the Walquists' position was frivolous and the IRS advised the Tax Court that it was sending the Walquists a letter warning them that they could be subject to a penalty under Code Sec. 6673(a) for making frivolous arguments.

The Tax Court ordered the Walquists to comply with its rules or risk dismissal of their case, advising them that they were required to confer with counsel for the IRS to prepare the case for trial and that they stipulate facts and documents as to which there should be no reasonable dispute. The Walquists were again advised that a penalty of up to $25,000 could be imposed for taking frivolous positions. The Walquists ignored the Tax Court's order and did not contact the IRS's counsel. In September 2018, the IRS moved to dismiss for lack of proper prosecution by the Walquists. The Tax Court ordered the Walquists to show cause why the case should not be dismissed and again warned them that they risked dismissal if they did not respond.

The Walquists responded with a document captioned "True Bill of Indictment - Testimony Inherent" in which they repeated frivolous demands and asserted that the Tax Court lacked authority to decide their case. In October 2018, the case was called for trial in Washington, D.C. There was no appearance by or on behalf of the Walquists; counsel for the IRS appeared and urged that the IRS's motion to dismiss for lack of proper prosecution be granted.

Analysis

The Tax Court denied the Walquists' claimed deduction, granted the IRS's motion to dismiss, and imposed a penalty of $12,500 on the Walquists for repeatedly advancing frivolous arguments. With respect to the accuracy-related penalty, the Tax Court noted that, under Code Sec. 6751(b)(1), the IRS generally must show that its penalty determinations have been personally approved in writing by the immediate supervisor the individual making the penalty determination. Observing that, in this case, the penalty was automatically generated by the CEAS software, and that an exception to the supervisory approval requirement applies under Code Sec. 6751(b)(2)(B) for penalty determinations automatically calculated through electronic means, the Tax Court considered whether an accuracy-related penalty generated by the CEAS software without human review qualified for this exception -- an issue not previously decided in any published Tax Court opinion.

The Tax Court held that the penalties determined by the CEAS were automatically calculated through electronic means under Code Sec. 6751(b)(2)(B) and thus were exempt from the written supervisory approval requirement. The Tax Court noted that for individual taxpayers, the substantial understatement penalty applies if the understatement of tax exceeds the greater of (1) 10 percent of the tax required to be shown on the return, or (2) $5,000, and the penalty is calculated at a flat rate of 20 percent of the underpayment. The court concluded that the penalty is calculated mathematically, both in terms of whether it applies and the rate at which it is imposed.

The court found that, because the penalty was determined mathematically without the involvement of a human IRS examiner, the penalty was automatically calculated through electronic means. The Tax Court found that its conclusion was consistent with the IRS's interpretation of its obligations under Code Sec. 6751 as set forth in the Internal Revenue Manual (IRM). The court noted that in 2018 the IRM was amended to state explicitly that substantial understatement penalties determined by the CEAS software are exempt from the supervisory approval requirement.

The Tax Court reasoned that the statutory context in which the exception appears also supported its conclusion. The court noted that under Code Sec. 6751(b)(2)(A), additions to tax under Code Secs. 6651, 6654, or 6655 are also exempted from the supervisory approval requirement. The court found that these additions are mathematical in nature, can be computed through a simple formula, and are generally calculated automatically by a computer. In the court's view, computer-generated substantial understatement penalties resemble additions to tax because they are also determined mathematically according to a statutory formula.

In the Tax Court's view, Congress intended the supervisory approval requirement to prevent the IRS from threatening unjustified penalties to encourage taxpayers to settle disputes and reasoned that an automatically-determined penalty which is never reviewed by a human being could hardly be considered a bargaining chip. Moreover, if supervisory approval were required for the substantial understatement penalty, the court found it difficult to conceive of what type of penalty would qualify for the exception in Code Sec. 6751(b)(2)(B). The Tax Court also found it difficult to imagine how the IRS would satisfy the approval requirement for a computer-generated penalty because there was no "individual making such determination" as described in Code Sec. 6751(b)(1).

For a discussion of the supervisory approval requirement, 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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