Lesson From The Tax Court: A Practical Interpretation Of The Penalty Approval Statute § 6751

Section 6751 is a poorly written statute that has caused no end of headaches for taxpayers, the IRS and the Tax Court.  It requires supervisory approval of tax penalties at some point before those penalties are assessed.  But that statute does not say at what point.  Last week a surprisingly divided Tax Court created a relatively bright line for taxpayers and the IRS to know by when the IRS must conform to the supervisory approval requirements.  The Tax Court did so by giving the statute a practical rather than hyper-textual construction.  The cases are: (1) Belair Woods, LLC, et al v. Commissioner, 154 T.C. No. 1 (Jan. 6, 2020) (Judge Lauber writing for a majority of nine); (2) Tribune Media Company v. Commissioner, T.C. Memo 2020-2 (Jan. 6, 2020) (Judge Buch).  Details below the fold.

Law: The Evolution of §6751(b)
Section 6751(b) says that “[n]o penalty under this title shall 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 Secretary may designate.”

Congress enacted §6751(b) in 1998 as part of the IRS Restructuring and Reform Act.  The provision was in response to complaints that Exam employees would stuff penalties into a proposed deficiency just to gain bargaining power over taxpayers.  In the “Reasons For Change” section of its report, the Senate Finance Committee explained that the purpose of the statute was to ensure that penalties would “only be imposed where appropriate and not as a bargaining chip.”  S. Rept. No. 105-174, at 65 (1998).  In the “Explanation of Provision” section, the Report describes how the provision is supposed to work: “The provision also requires the specific approval of IRS management to assess all non-computer generated penalties unless excepted.”  Id.

The folks who wrote the statute in 1998 were not stupid people, but they were woefully ignorant of tax procedure.  As someone who was a fly on the wall during that legislative process I can tell you many stories of that woeful ignorance.  Those familiar with tax procedure will immediately see that one of the problems with the statute is the phrase “initial determination of such assessment.”  The problem with that phrase is that an assessment is act of recording a taxpayer’s liability on the books of the IRS.  Cohen v. Gross, 316 F.2d 521 (3rd Cir. 1963).  An assessment is a culmination of a process.  There simply is no “initial determination” of an “assessment.”  Instead there are initial determinations of items to include in an assessment.

If you squint hard at the words you can get to the idea that Congress wanted supervisory approval of penalty determinations at some point before the penalties were assessed.  And Congress wanted that supervisory check because of a concern that rogue IRS employees were trying to beat up taxpayers by inappropriately proposing to assess outrageously large penalties.

The problem is that the statute does not tell us at what point in time the supervisory approval has to occur before the assessment is made.  Sure, there must be supervisory approval of the “initial determination” but the statute does not say when that approval must be obtained.  What does that silence mean?

For years and years and years and years the Tax Court agreed with the IRS’s hyper-textual position that the silence meant there was no prescribed time limit: supervisory approval could come at any time up until the day before assessment and still comply with the statute’s requirement that the approval be secured before assessment.  Therefore, just because the required supervisory approval had not been secured before the NOD did not make the penalties proposed in the NOD invalid because the IRS still had time to comply with the statute before assessing.  See Graev v. Commissioner, 147 T.C. 460, 475-476 (2016) (called “Graev II” because it was the second published opinion in the same docketed case).

In 2017 the Second Circuit Court of Appeals decided Chai v. Commissioner, 851 F.3d 190 (2^nd Cir. 2017).  There the Court of Appeals rejected a hyper-technical construction of the statute and instead sought to balance the ambiguous text of the statute with the intent of Congress to prevent misuse of penalties.  At the very least, the Court said, §6751(b) requires the written approval to occur before the IRS sends the NOD to the taxpayer. ("Thus, we hold that §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 such penalty.") 851 F.3d at 221.

The Tax Court took the Chai lesson to heart in Graev v. Commissioner, 149 T.C. 485, 500 (2017) ("Graev III”) and decided to apply it to all deficiency cases.  I highly recommend folks read Judge Holmes’ concurrence in Graev III.  I think it is perhaps his finest opinion (to date) and explains why he believed the Tax Court was incorrect to reverse its prior position.  He agreed with the idea of giving the statute a practical construction, rather than hyper-technical construction.  But he explained why a practical approach also supported the Tax Court’s prior interpretation.  The key insight in Judge Holmes’ opinion was that §6751(b) makes little sense in contexts where the Tax Court is reviewing the proposed assessment but makes much more sense in contexts where the assessment of penalties require no prior judicial approval, such as the Assessable Penalties in Chapter 68, Subchapter B, Sections 6671 et seq.

In Graev III Judge Holmes predicted that the majority holding in would create a never-ending parade of litigation horribles.  It has certainly produced substantial litigation on a number of issues.  The keenest points of dispute has focused on the question of when, by what point during the examination process, must the IRS show compliance with §6751(b)?  That is this week's lesson.

In addressing the question of by when must the supervisory approval be made, the Tax Court has focused on the phrase “initial determination” as setting the line.  It has pretty much favored a practical approach that attempts to balance the text of the statute with its purpose while respecting the practicalities of tax administration.  For example, in Clay v. Commissioner, 152 T.C. 223 (2019) the Court held that the IRS had to comply with §6751(b) before it issued a 30-day letter because the 30-day letter was the “initial determination” for §6751 purposes.  What made the 30-day letter an initial determination for §6751(b) purposes was its function in the assessment process of being the first official statement of the Examination Division’s position that the taxpayer could then protest to Appeals. 

Last week's cases continue this trend towards the practical construction of 6751(b) evidenced by Clay.  The Court is taking close look at when, in the assessment process, is the appropriate time to require the IRS to have complied with §6751(b).

Facts
    Belair Woods
Belair Woods involves the proposed application of four penalties to a partnership whose charitable contribution deduction for a conservation easement was denied by the IRS, a denial sustained in part by the Tax Court in an earlier opinion. 

The IRS began a partnership audit of Belair Woods for its 2008 returns in October 2012.  In December 2012 the IRS Revenue Agent (RA) sent a Letter 1807 inviting the taxpayer to a closing conference with the RA to discuss the RA’s proposed adjustments, detailed in an attached summary report.  Among the proposed adjustments was a 40% gross overvaluation penalty under §6662(h).  As alternatives to the (h) penalty, the summary report also proposed smaller penalties for negligence and substantial understatement under §6662(c) and (d).  The Letter 1807 instructed the taxpayer on what information it needed to provide to avoid the penalties and explained that “all proposed adjustments” would be on the table for discussion at the closing conference with Exam.

The parties held an initial conference in February 2013 and the RA continued to work the case until mid-2014 at which time the RA sent the case file, including a Civil Penalty Approval Form for the three penalties, to her supervisor, who signed the Approval Form in September 2014. 

The IRS sent Belair Woods a “TMP 60-Day Letter” in March 2015.  Like a 30-day letter sent to individual taxpayers, the 60-day letter’s purpose here was to tell the Tax Matters Person the Examination Division’s determinations and to give the first opportunity to protest the entire case to Appeals.  Belair Woods did indeed take a protest but was unable to convince Appeals to modify the proposed adjustments.  Boy, you know that was a dog of a case if Appeals didn’t budge! 

Just as Appeals will issue an NOD when individual taxpayers protest a 30-day letter, so Appeals here issued the partnership equivalent to an NOD: a Final Partnership Administrative Adjustment (FPAA) in June 2017.  For the first time, the FPAA also included a proposal to impose the §6662(e) substantial valuation misstatement penalty. 

Tribune Media
Tribune Media also involves the proposed application of the big §6662 penalties, with some of the smaller penalties proposed as alternatives.  In that case, the IRS was auditing the 2009 returns of two taxpayers, Tribune Media, a corporation, and Chicago Baseball Holdings (CBH), a partnership. 

The RA examining Tribune Media orally suggested imposing some of the smaller 6662 penalties in 2014.  The RA’s idea of penalties was first presented to Tribune in a meeting with Exam and IRS Counsel in January 2016.  The RA drafted a Form 5701 Notice of Proposed Adjustment (NOPA) and sent it to Counsel for review.  As drafted, the NOPA included only the smaller §6662 penalties.  The IRS Chief Counsel attorney recommended putting in a big 40% penalty for gross valuation misstatement too.  The RA adopted the suggestion and included the 40% penalty in the NOPA to Tribune Media.  The RA did not obtain her supervisor’s approval of putting any penalties in the NOPA.

The RA examining the other taxpayer, CBH, also prepared a NOPA that proposed the various smaller §6662 penalties.  Again, the same Chief Counsel attorney recommended putting in a proposed 40% penalty.  The RA, however, disagreed, and so the NOPA to CBH did not include a proposal to assert a 40% gross valuation misstatement.  The draft FPAA for CHB also did not include the 40% penalty.  However, when the draft FPAA was sent to Chief Counsel for review, the same attorney proposed adding that penalty and his supervisor approved.  They sent the revised draft FPAA back to Exam.  The FPAA then went through the normal Exam approval process and was issued to CBH.  The issued FPAA included a proposal to assert a 40% gross valuation misstatement penalty.

Lesson: IRS Must Comply with §6751(b) Before The Horse Leaves Exam’s Barn
In Belair Woods, the taxpayer argued that the IRS was required to comply with the supervisory approval requirement before first communication to the taxpayer that the taxpayer might be subject to a penalty.  Judge Lauber’s opinion for the Court, in which seven  other judges joined, rejected that argument.  One judge concurred in the result only.  Seven other judges agreed with the taxpayer. 

Judge Lauber explains that the interpretive task is to reconcile the incoherent language Congress used to the purpose of the statute.  Actually, “incoherent” is my word.  Judge Lauber uses the more polite label of “ambiguous.”

Whatever label you prefer, the majority takes a balanced approach to the statute and rejects a hyper-textual approach.  The majority sees a practical requirement that undergirds the statute: supervisory approval must be made “at a time when the supervisor has the discretion to give or withhold it.”  Op. at 12 (quoting Chai).  That idea traces back to Judge Gustafson’s dissent in Graev II.  See 147 T.C. at 508. (“The statute can be construed only to require supervisory approval at a time when the supervisor has the ability to approve or disapprove the penalty — and no later.”)

For Judge Lauber that practical requirement means that so long as the matter is still bouncing around the Examination Division, there is still time for supervisors to approve proposed penalties.  Only once Exam has officially committed to the proposed adjustments---such as through a 30-day letter or an NOD or a FPAA---has the matter moved beyond the point where the supervisor has discretion.  Instead, the matter is now off to other functions within the IRS, notably the Appeals function.  Those other functions might alter the penalties, but by that point the evil which the statute seeks to prevent---the unconstrained actions of low-level employees threatening penalties as bargaining chips---will have already possibly occurred.  Put another way, the supervisor of the individual who first proposes the penalties needs to be able to act to constrain the low-level employee.  By the time the Exam function has crystallized its position in a formal document, it is generally too late for the supervisor to make a difference.  The horse has left that barn.

Bottom Line: The IRS must show supervisory approval of the initial determination of a penalty at a time before that initial determination “is embodied in a formal written communication to the taxpayer, notifying him that the Examination Division has completed its work and has made a definitive decision to assert penalties.”  That’s the rule.  That’s the lesson. 

As applied in Belair Woods, Judge Lauber says that rule means the March 2015 60-day letter was the line, the point when the matter had gone beyond the point where a supervisor's approval would be meaningful.  That was the formal written communication where the Examination Division informed Belair Woods of its “definite decision to assert those penalties, thus concluding the Examination Division’s consideration of the case.”  The December 2012 Letter 1807 was not the line because it was only the start of a conversation between Exam employees and the taxpayer.  As Judge Lauber explains “the Letter 1807 launched a lengthy communication and fact-gathering process during which Belair had the opportunity to present its side of the story.  Only after that process concluded did the Examination Division finalize its penalty determination by issuing the 60-day letter.”

Thus the three penalties approved before the 60-day letter were properly approved under §6751.  But the §6662(e) penalty that was put into the FPAA after the 60-day letter was not properly approved.

Judge Buch applied the lesson in Tribune Media.  Judge Buch was one of the Tax Court judges who joined the majority in Belair Woods.  In Tribune Media, he explained why the NOPAs issued to Tribune Media and CBH were like the Letter 1807 in Belair Woods.  They did not represent Exam's final decision as to penalties but were instead an invitation into further dialog.  Each NOPA explained that if the taxpayer had “additional information that would alter or reverse this proposal, please furnish this information as soon as possible.”  The NOPAs were not like a 30-day letter, or 60-day letter, much less like an NOD.  So the IRS did not have to show compliance with §6751(b) before the NOPAs were issued.

Notice that as to CBH, the 40% penalty was proposed first in the FPAA.  That looks a bit like the fats in Belair Woods.  The difference, however, is that as to CBH it was the IRS Chief Counsel attorney, no the RA, who first proposed the 40% penalty.  And then the attorney’s supervisor approved of the inclusion prior to the FPAA being returned to Exam.  That approval was timely because the FPAA was the first document sent to that taxpayer where the matter had moved beyond the point where the supervisor of the individual employee who was pushing the penalty had discretion to act.

Comments: Making Sense of Nonsense
In these (and other) §6751 cases, the Tax Court is confronted with the difficult task of making sense of statutory nonsense.  Remember the problem: the statute requires that at some point before assessment, the supervisor of the individual who first proposes a penalty must approve that proposed penalty.  But the statute does not say when that approval must occur.  For the first 20 years, the Tax Court went towards one extreme, holding supervisory approval could occur at any time before the actual assessment.  Therefore, the Tax Court did not need to police compliance with the statute.  That interpretation relied on a hyper-textual application of the statute (focusing on the word “assessment” and ignoring the rest) and was criticized for ignoring the purpose of the statute. 

The dissenters in last week’s cases want to push the Tax Court to the opposite extreme: they would require the IRS satisfy the supervisory approval before the first time an IRS employee even talks to the taxpayer or tells the taxpayer that the employee is proposing to impose penalties.

Like the extreme position taken by the Tax Court for almost 20 years, the extreme position advocated by the dissenters in last week’s case also relies on a hyper-textual interpretation divorced from practicalities.  They focus on the phrase “initial determination” and Judge Gustafson adds to that the word “individual.”  Judge Marvel thus writes: “Since Graev II we have recognized that identifying the moment of ‘initial determination’ requires an inquiry into ever-earlier timeframes.”  Op. at 31.  Similarly, Judge Gustafson writes that “the statute applies to an ‘initial determination’ by an ‘individual.’”  Op. at 35.  Both dissents then spend their energies explaining the meaning of “initial determination.”  They then assume the supervisory approval must occur before that initial determination.

That is not what the statute says.  The dissents miss the relevant question, which is by when must supervisory approval occur?  Both dissents simply assume that supervisory approval must occur before that initial determination.  They do not explain how their interpretation furthers the statutory purpose.  For example, Judge Marvel writes “We should instead require only that which Congress meant to require: that the IRS agent obtain written penalty approval before putting a penalty into play by issuing the first written report to the taxpayer proposing a penalty.”  She does not explain (1) how she knows her reading is what Congress meant to require; (2) what it means to put a “penalty into play” or even (3) why the relevant communication must be written!  Notice that was a difference in Tribune Media between how the RAs communicated their desire to impose penalties.  The RA for Tribune Media did it informally at a meeting, but the RA for CBH did it in the FOPA.

Similarly to Judge Marvel, Judge Gustafson asserts that the majority’s rule “perversely relieves such an unapproved initial determination of the consequence that Congress intended.”  Again, Judge Gustafson does not explain how his assumption that supervisory approval of the initial determination must come before the initial determination itself hooks into Congressional intent.  Nor does he attempt to fit his opinion here with his own idea in his Graev II dissent: the importance of deciding when in the process it is too late for the supervisor whose approval is required to act.

The dissents’ focus on text to the exclusion of practicalities ignores the teachings of Chai, Graev III and, surprisingly, Judge Gustafson’s own dissent in Graev II.  The question is not when does an initial determination occur.  The question is by when must the relevant IRS supervisor approve the initial determination in order to effectively check unruly IRS employees.  The statutory text no more requires approval before the initial determination than it permits delay of approval until the day before assessment.  The Tax Court has now eschewed both extremes and has instead adopted an approach that focuses on a practical inquiry: when would the supervisory approval no longer have any practical function.  Not to beat a dead horse, but that would be when the horse has left the barn. 

It is true that Judge Lauber’s opinion puts weight on the term “determination” in the statute.  But I do not read his opinion as being driven by the text.  Instead, he looks at text to see if the text has room for the practical construction.  It does because it speaks of a “determination.”  Judge Lauber explains the practical reasons for his interpretations and the practical problems that would result from adopting the dissents’ views.  In my reading of his opinion, it is the practicalities that drive textual interpretation.  That is a very reasonable approach when dealing with such a poorly drafted statute. 

Bryan Camp is the George H. Mahon Professor of Law at Texas Tech University School of Law