While §6662(a) seems to impose a single accuracy-related penalty, a recent case teaches that it actually imposes a panoply of penalties for purposes of the §6751(b) supervisory approval requirement. We learn that if the IRS is either careful or lucky, it can cure one defective §6662 penalty approval by later asserting a different §6662 penalty amount.
In Jesus R. Oropeza and Fabiola Anaya Oropeza, T.C. Memo. 2020-111 (July 21, 2020) (Judge Lauber), the IRS first proposed a 40% §6662 penalty in a pre-NOD document but failed to obey §6751(b)(1). Despite that failure, the Court upheld a later NOD’s alternative 20% §6662 penalty. Details below the fold.
Law: The §6662 Accuracy-Related Penalty Regime
Section 6662 seems like it is a single penalty. After all, it is titled in the singular: “Imposition of Accuracy-Related Penalty on Underpayments.” Congress wrote §6662 in 1989, as part of the Omnibus Reconciliation Act, 103 Stat 2106, 2388, in order to consolidate a bunch of different penalties into one section.
Section 6662(a)’s text is also singular. It provides that “there shall be added to the tax an amount equal to 20 percent of the portion of the underpayment to which this section applies.”
However, consider how the leading treatise on tax procedure describes §6662: “In place of these five penalties, a single accuracy-related penalty for five [now eight] different types of misconduct was enacted.” Saltzman & Book, IRS Practice and Procedure, ¶7B.03 (no free link, sorry).
So we have a “single” penalty imposed for “different types of misconduct”? That’s confusing. This structure of §6662, as well as its history as a consolidation of previously separate penalty statutes, creates ambiguity on whether this section imposes one or multiple penalties.
First, at least eight different types of sometimes overlapping behaviors can trigger the subsection (a) penalty. For example the penalty can be based on “negligence or disregard of rules of regulations.” §6662(b)(1). It can also be based on “any substantial understatement of income tax.” §6662(b)(2). So it looks like eight different penalties. Not one.
Second, the IRS can apply different parts of §6662 to different parts of a return’s understatement, again making it seem like separate penalties. At the same time it cannot impose different levels of the penalty to the same understatement. Notice how this excerpt from the Saltzman & Book treatise continues to describe §6662 in both singular and plural terms: “Different types of misconduct can cause different portions of the total underpayment; therefore, the Service can impose the penalty on different portions of the understatement for a single tax year. *** For example, a taxpayer might have overvalued property for purposes of a charitable deduction and negligently omitted interest income. Thus, a 20 percent penalty can be imposed on the portion of the underpayment caused by the overvaluation and another 20 percent penalty on the portion of the underpayment caused by the negligently omitted interest.” Saltzman & Book, ¶7B.03.
Third, the 20% penalty amount gets bumped up to 40% for certain types of inaccuracies, such as a gross valuation misstatements, §6662(h), or nondisclosed noneconomic substance transactions, §6662(i), or underpayments linked to undisclosed foreign financial assets, §6662(j). It looks like the same penalty because those subsections just substitute 40% for the 20% in subsection (a). But it also looks like multiple penalties because, once again, we have three additional behavioral triggers.
So, how do we deal with these ambiguities? Does §6662 impose a single accuracy-related penalty that simply varies in amount, or does it impose eleven different penalties, one for each of eight different types of misconduct listed in §6662(b) and three for the three bump-ups in subsections (h), (i), and (j)?
The answer seems to be “why do you want to know?” Only one of the variations in §6662 can be imposed on any given portion of a taxpayer’s underpayment of tax. So if you want to know for penalty calculation purposes, the answer is basically “one penalty, varying in amount.” But today’s cases teach us that the answer is “multiple penalties” for purposes of the supervisory approval requirement in §6751(b).
Law: Supervisory Approval Requirement of §6751(b)(1)
Section 6751(b)(1) creates a supervisory approval requirement for penalties. Basically, the provision prohibits the IRS from assessing a penalty against a taxpayer unless the penalty was properly approved by a supervisor during the pre-assessment process. For those who want the more detailed background, I summarize the legal history of the provision in “Lesson From the Tax Court: A Practical Interpretation Of The Penalty Approval Statute § 6751.”
What is important to know for today’s lesson is that the Tax Court reads §6751(b) as requiring supervisory approval at the point in the pre-assessment process where the IRS function proposing a penalty first formally tells a taxpayer that it---the relevant IRS function and not an individual IRS employee---will seek to impose a §6662 penalty. Belair Woods v Commissioner, 154 T.C. No. 1 (January 6, 2020). Generally, the relevant IRS function is the Exam Division. But it might also be another function, such as Appeals or IRS Office of Chief Counsel. The point is that required approval must occur before the relevant IRS office finishes its work and sends the taxpayer onto the next step in the process, whether that is to Appeals or Tax Court.
Facts of The Case
The Oropezas timely filed their 2012 return. The IRS selected it for examination.
In November 2015, the Revenue Agent sent the taxpayers Form 4549-A via transmittal Letter 5153. By then the end date of the 3-year assessment period in §6501(a) (typically called the “Assessment Statute Expiration Date” or ASED) was looming: April 15, 2016.
Form 4549-A is the Revenue Agent Report (RAR) which is used to tell the taxpayer the results of the examination. See IRM 220.127.116.11.4. The Form gives taxpayers the opportunity to protest the RAR to Appeals.
Letter 5153 transmits RARs when when the ASED expires in less than 240 days, and it conditions the trip to Appeals on the taxpayer agreeing to extend the ASED. It is not a 30-day letter. Instead, it gives the taxpayer 10 days to sign the ASED waiver (in the Form 872 series) and ask for an Appeals conference. If the IRS does not receive the taxpayer’s consent to assess or ASED waiver within 10 days, the Exam function transfers the case to Technical Services to prepare the NOD. See IRM 18.104.22.168.
Here, the main substantive problem with the taxpayers' return appears to have been a micro-captive insurance arrangement. Those can involve off-shore entities. The RAR proposed to assess an accuracy related penalty under §6662. But the agent was not quite sure why. So the agent just threw in all three of the 40% penalty triggers, hoping perhaps one would stick: the §6662(h) gross valuation misstatement penalty, the §6662(i) nondisclosed noneconomic substance transaction penalty, and the §6662(j) penalty for undisclosed foreign financial assets. The RAR, however, did not propose any 20% penalty as an alternative.
The Revenue Agent failed to obtained supervisory approval of the proposed §6662 penalty before sending out the RAR and the Letter 5153.
By the time Technical Services prepared and issued the NOD, the IRS decided the best reason for a 40% penalty was because the micro-captive insurance arrangement that the IRS thought was a tax dodge was a nondisclosed noneconomic substance transaction.
The NOD also, for the first time, proposed 20% penalties in the alternative. Thus, the NOD proposed the following: (1) a 40% penalty under §6662(i); or else (2) a 20% penalty for either (a) negligence or (b) substantial understatement.
The NOD received supervisory approval for all the penalties it proposed.
The taxpayers petitioned the Tax Court and the penalties were put into play as part of an IRS motion for partial summary judgment. Opposing the motion, the Oropezas argued that the entire scope of the proposed §6662 penalty was invalid because the Revenue Agent had sent out the RAR before securing supervisory approval.
Lesson: Section 6662 Contains Multiple Penalties for §6751(b) Compliance
Judge Lauber agreed that the IRS had not complied with §6751(b) in proposing the 40% penalty. The RAR, as transmitted by the Letter 5153, was the relevant first formal communication to the taxpayer that the Exam function had determined to impose a penalty. The Revenue Agent had not secured supervisory approval before sending out the RAR. That violation of §6751(b) meant the IRS could not impose a penalty of 40%.
The IRS tried to argue form-over-substance. It said that the package sent out here was not a 30-day letter or 90-day package, giving the taxpayer a clear path to Appeals or Tax Court.
Judge Lauber easily rejects that argument. His substance-over-form analysis explains how the Form 4549-A and Letter 5153 package truly represented the conclusion of the Examination function’s work. It sent the taxpayers on their way just as much as a 30-day or 90-day letter. They were just sent off on a different path because of the imminent ASED.
As to the NOD’s proposed 20% penalties, however, Judge Lauber concluded that the IRS had complied with §6751(b). That is because the first imposition of those penalties came in the NOD, which was properly approved. The NOD was the first time the IRS, as an institution, had notified the taxpayers of its “definite decision to assert the 20% penalties.” Op. at 8. And Judge Lauber knew the NOD was proposing different penalties because the RAR made no mention of 20% penalty amount, just a 40% penalty amount.
Comment 1: The Benefit To Taxpayers?
The purpose of §6751(b)(1) was to prevent over-enthused IRS employees from using penalties as bargaining chip in Appeals, forcing taxpayers into Appeals to get rid of dubious penalties. You might tell that story here. The RO gave the taxpayer an RAR that threatened to impose a §6662 penalty of 40% but just threw out all the possible reasons, settling on none. The RO was throwing the book. Like the famous French Defender, the RO was blowing his nose in the taxpayer’s direction. Apparently the RO did this without securing timely approval from the group manager. And, in fact, when his group manager later signed a Penalty Approval Form, the approval was only for a 20% penalty and not for a 40% penalty. As a result the IRS was disabled from moving forward with 40% penalty amount. So at first blush it would seem that §6751(b)(1) worked here as intended.
However, that story ignores the RO’s point of view. Because the taxpayer refused to extend the ASED, the RO may not have had sufficient time or information to determine why a 40% penalty was appropriate. So the RO likely went with intuition and threw in all the reasons for a 40% penalty to apply to cover bases. Yes, that forced the taxpayer to work it out later, either in Tax Court or in Appeals. But from the RO's perspective, the taxpayer made that decision by refusing to extend the ASED.
By the time the NOD was issued, the RO (or someone else) had worked out the best reason for a 40% amount. That is why the NOD just gives one basis for the 40% amount.
Comment 2: The Benefit for the IRS?
Implicit in Judge Lauber’s decision is a view that the 20% amounts were not simply variations on “the” single penalty authorized by §6662(a), but are multiple penalties. Throughout the opinion Judge Lauber consistently refers to “the 40% penalties” as something different than “the 20% penalties.”
It might well be that I am late to this party. Perhaps it is well settled that §6672 is really a collection of multiple penalties. It would not be the first time I’m behind the curve.
But I wonder how finely do we split up the §6672 penalty for §6751(b)(1) compliance purposes. Is it just that the 40% penalties are different from the 20% penalties? Or is each reason for imposing a 40% amount a separate penalty, and each reason for imposing a 20% amount a separate penalty?
For example, assume the RAR here had just proposed a 40% penalty amount under subsection (h) for gross valuation misstatement. Then the NOD switches the basis to subsection (j). Would the NOD now be the “first” proposal (“initial determination” is the §6751(b)(1) language) of this separate penalty or would it just be a second proposal for a 40% amount with a shift in rationale?
Similarly, what about an RAR that proposed a 20% negligence penalty without having the requisite supervisory approval. Does that now preclude the IRS from issuing an NOD proposing a 20% substantial understatement penalty? Or would the NOD be the second proposal to impose a §6662 penalty but just a shift in rationale.
Reading §6672 as containing multiple penalties helps the IRS here because the procedural failure in the RAR did not completely foreclose assertion of some penalty for the taxpayer's behavior. There may be considerable movement in penalty proposals in the course of an examination and subsequent thereto. It’s a art, not a science, and it depends on what information is available at what stage.
Locking the IRS out of imposing an appropriate penalty at a later stage because of a procedural error at an earlier stage does not seem fair, either to careful and honest taxpayers or to those other careless or dishonest taxpayers against whom the IRS proceeded correctly.
Bryan Camp is the George H. Mahon Professor of Law at Texas Tech University School of Law. He invites readers to return to TaxProfBlog each Monday for a new Lesson From The Tax Court.