Last week, the Tax Court issued an important opinion on the §6751(b)(1) supervisory review requirements. In Jesus R. Oropeza v. Commissioner, 155 T.C. No. 9 (Oct. 13, 2020) (Judge Lauber), held that the 20% penalty under §6662(b)(6) is the same as the 40% penalty under §6662(i) and therefore the failure to secure proper approval for assertion of the former in an RAR precludes assertion of the latter in a later NOD. The latter subsection simply “enhances” the amount of §6662(b)(6) penalty and does not impose a separate penalty.
The path of the law is not linear. Doctrinal development sometimes involves two steps forward, one step backwards, and maybe even a step or two sideways. In Oropeza the Tax Court took what some may view as a step sideways, and what the government will likely view as a step backwards. The decision seems in tension with prior Tax Court opinions that treat §6662 as containing multiple penalties for supervisory approval purposes, including an opinion by the same judge about the same taxpayer! The upshot of today’s opinion is that practitioners need to read NODs very carefully. Details below the fold.
Law: The Supervisory Approval Requirement of §7651
Section 6751(b)(1) creates a supervisory approval requirement for penalties. The idea behind the provision is that the IRS should not assess a penalty against a taxpayer unless the penalty was properly approved by a supervisor during the pre-assessment process.
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 whichever IRS office is proposing a penalty first formally tells a taxpayer that the office---and not just an individual IRS employee---will seek to impose a §6662 penalty. Belair Woods v Commissioner, 154 T.C. No. 1 (Jan. 6, 2020). That case was a giant step forward in clarifying and regularizing application of §6751. 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.”
Law: The §6662 Accuracy-Related Penalty Regime
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. The Saltzman & Book treatise explains: “In place of...five penalties, a single accuracy-related penalty for five different types of misconduct was enacted.” Saltzman & Book, IRS Practice and Procedure, ¶7B.03 (no free link, sorry). Accordingly, §6662(a) 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.” Section 6662(b) then lists different reasons for imposing the penalty.
Section 6662(b) started off describing five different types of misconduct that could result in the 20% penalty imposed by §6662(a). Congress has since added three additional types of misconduct. For one of those it has made the 20% penalty 40%. §6662(j) (providing that the penalty amount for the misconduct described in §6662(b)(7) is 40%).
In addition, Congress has also added two provisions, §6662(i) and §6662(j), to provide that for certain additional misconduct, “subsection (a) shall be applied with respect to such portion by substituting “40 percent” for “20 percent.”
In sum: 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.
Some aspects of the statute suggest it is a single penalty. First, §6662(a) uses the singular. Second, the IRS cannot stack the penalties by applying multiple 20% penalties to the same part of the single return for different reasons.
Other aspects of the statute suggest it authorizes multiple penalties. First, at least eight different types of sometimes overlapping behaviors can trigger the subsection (a) penalty. Second, the IRS can apply different parts of §6662 to different parts of a return’s understatement, again making it seem like separate penalties.
This excerpt from the Saltzman & Book treatise reflects this ambiguity by describing §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. (emphasis added).
Adding to the confusion are §§6662(h) and (i). On the one hand, they look like penalty enhancements because they bump up the 20% penalty amount to 40% under certain conditions. On the other hand, those certain conditions happen when the taxpayer has engaged in additional or more egregious behavior. For example a taxpayer gets hit with the 20% penalty per §6662(b)(6) for engaging in a non-economic substance transaction. But if the taxpayer further misbehaves by not disclosing the non-economic substance transaction, then the taxpayer gets hit with a 40% penalty under §6662(i) instead of the 20%. It looks like two penalties because of the additional behavioral trigger. But then comes §6664(c)(2) which says a taxpayer cannot raise a reasonable cause defense to a (b)(6) penalty but makes no mention of the (i) which, again, makes (i) look simply like an enhanced amount based on the same (b)(6) conduct.
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 ten different penalties, one for each of eight different types of misconduct listed in §6662(b) and two for the bump-ups in subsections (h) and (i)? Or does it impose eight different penalties and two “enhancements”?
Until last week it appeared that the Tax Court would treat each subsection (b) misbehavior as a separate penalty, and would treat the (h) and (i) 40% provisions as separate penalties as well.
First, Palmolive Building Investors v. Commissioner, 152 T.C. 75 (2019), involved the interplay of subsection (h) and (b)(2). There, the IRS had audited a claimed charitable deduction for a conservation easement donation. The 30-day letter proposed the §6662(h) 40% penalty for gross valuation misstatement. It did not propose any other penalty. After a conference, Exam issued a 60-day letter. The 60-day letter also proposed to apply the 40% penalty to “the full amount of the adjustment to charitable contributions.” However, attached to the 60-day letter were two penalty forms, one justifying the 40% penalty described in the letter, and the other justifying a §6662(b)(1) negligence penalty. Finally, after the taxpayer protested to Appeals, the Appeals Officer threw in two other penalties: §6662(b)(2) and (b)(3). The final FPAA proposed all four penalties: the original 40% proposed in the 30-day letter, the one added in the 60-day letter, and the two added by Appeals.
Writing for the Court, Judge Gustafson’s opinion analyzes each of these as separate penalties. He looked at each of the 30-day letter, the 60-day letter, and the FPAA separately and concluded they had all complied with the supervisory approval requirement. Judge Gustafson thus treated the 20% subsection (b)(3) penalty as distinct from the 40% subsection (h) enhancement. You see this most starkly in his conclusion: “Thus, the undisputed facts show that each of the four penalties at issue in this case was initially determined by an individual who obtained his supervisors written approval before the penalty determination was communicated to [the taxpayer].” 152 T.C. at 84 (emphasis supplied).
Second, in Oropeza v. Commissioner, T.C. Memo. 2020-111 (“Oropeza I”) which I blogged here, the IRS failed to obey §6751(b)(1) before sending the taxpayer an RAR containing what the Court decided was its initial determination of a 40% penalty under either of subsections (h) or (i) or (j). The eventual NOD also proposed that same 40% penalty and, for the first, time proposed as an alternative, a 20% penalty for the misconduct described in §6662(b)(1) and (2). In that case, Judge Lauber analyzed the 20% penalties separately from the 40% penalties. Thus, while the NOD’s assertion of the 40% penalty was invalid because of the failure to secure supervisory approval of the RAR, that failure did not render the IRS unable to later assert a 20% §6662(b)(2) valuation misstatement penalty in the NOD, which was properly approved. The invalid RAR did not taint the later NOD.
Last week’s case takes us in a different direction. Let’s look.
This case concerns the same taxpayer as in Oropeza I that I blogged about here. In both cases the taxpayers argued that they should not be subject to penalties because the IRS had not obeyed §6751(b)(1). Oropeza I, concerns this taxpayer's 2012 tax year and a joint return. There, Judge Lauber rejected the argument that an invalid RAR tainted a later NOD. However, in last week’s opinion, which concerns the 2011 tax year, Judge Lauber accepted the same argument, because “the proper analysis requires a closer inspection of the statutory text and the RAR.” Op. at 12.
Let's compare and contrast because, as I constantly try to teach my first year students, facts matter!
Both years involved the same substantive tax problem: a micro-captive insurance tax shelter. Both years also involved the same timing problem: the revenue agent issued an RAR very close to the end of the assessment limitation period. In both cases the RAR proposed penalties without, it turns out, the proper §6751 supervisory approval. In both cases the taxpayers refused to extend the assessment limitations period. And in both cases the IRS issued an NOD that proposed the same penalties as contained in the defective RAR as well as additional penalties not contained in the RAR.
The distinction between the two cases was in the mix of penalties contained in the RAR as compared to the penalties contained in the eventual NOD. That distinction makes all the difference in outcome.
In Oropeza I, the revenue agent threw all three of the 40% penalty triggers into the RAR, 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 eventual NOD asserted a 40% penalty based just on subsection (i) and then, as an alternative, proposed a 20% penalty, justified either under §6662(b)(1) misconduct (negligence) or §6662(b)(2) misconduct (substantial understatement). Judge Lauber held that the invalid RAR did not taint the NOD’s proposed 20% penalties. Notice that neither of the 20% penalties asserted in the NOD related to any of the 40% penalties proposed in the RAR.
The fact pattern at issue in last week’s opinion, however, had a different order of penalties. For the 2011 audit, the revenue agent threw in a bunch of 20% penalty triggers, hoping perhaps one would stick. The RAR did not mention any potential penalty of 40%. Specifically, the RAR asserted a 20% penalty attributable to “one or more of the following”: negligence per (b)(1), substantial understatement per (b)(2), substantial valuation misstatement per (b)(3), or noneconomic substance per (b)(6). The eventual NOD proposed to assess what labeled as “a 40% section 6662(b)(6) penalty.” The NOD’s explanation, however, shows this was a penalty per §6662(i) and not (b)(6) because it states that the IRS “determined that all of the underpayment of tax is attributable to one or more nondisclosed noneconomic substance transactions. Consequently, there is added to the tax an amount equal to 40% of such underpayment.” That is the §6662(i) trigger. The NOD also proposed the RAR’s 20% penalty as an alternative to the 40%.
Lesson: 6662(b)(6) and 6662(i) are but one penalty for supervisory approval purposes.
The IRS argued that the assertion of the 40% subsection (i) penalty in the NOD was properly approved. The taxpayers argued that it had to be thrown out because it was no different that the 20% penalty that the RAR said might be because of (b)(6) misconduct. That directly raised the question of the relationship of (b)(6) to subsection (i).
Judge Lauber agreed with the taxpayers. He concludes that since one of the grounds listed in the RAR was the (b)(6) noneconomic substance transaction, it necessarily includes a potential penalty under subsection (i). Judge Lauber finds that subsection (i) “simply increases the rate of the penalty imposed by section 6662(a) and (b)(6) for engaging in a transaction lacking economic substance.”
Alert readers will note that subsection (i) does not penalize the same misconduct described in (b)(6)---engaging in a noneconomic substance transaction. It requires the further misconduct of failing to disclose the noneconomic substance transaction. That makes it seem like a separate penalty.
Judge Lauber deals with this; it is the reason this is a precedential Tax Court decision!
First, Judge Lauber points out that the IRS treats subsection (i) as the same as (b)(6). He points to language in the RAR and the NOD (quoted above).
Second, Judge Lauber notes that both provisions were enacted in the same legislation and the relevant Committee Report refers to both as a single penalty. Here’s a short excerpt:
“The provision imposes a new, stronger penalty under section 6662 for an understatement attributable to any disallowance of claimed tax benefits by reason of a transaction lacking economic substance.... The penalty rate is 20 percent (increased to 40 percent if the taxpayer does not adequately disclose the relevant facts affecting the tax treatment in the return or a statement attached to the return).” H.R. Report. No. 111-443 (1) at 304.
While strong, the point is not irrefutable. Elsewhere the Committee Report seems to refer to two penalties: “The new 20-percent penalty (and 40-percent penalty for nondisclosed transactions) is also added to the penalties to which section 6662A will not also apply.” Id. But a fair reading of the Report supports the idea that the writers thought they were just creating a single new penalty with a sliding scale of amount depending on the egregiousness of the behavior.
Third, Judge Lauber says the result is good policy because otherwise the IRS would be able to bully taxpayers into Appeals by proposing a 20% penalty while holding the 40% enhancement in reserve, thus forcing taxpayers to “confront the dilemma of having to make concessions or risk that the penalty would be doubled” by a later assertion of the 40% penalty.
Bottom Line: We should all start referring to the subsection (b)(6) and (i) provisions as a single penalty. If the IRS messes up on supervisory approval of either one, that will preclude later assertion of the other.
Comment 1: Compliance with §6751 Supervisory Approval Just Got More Complicated
Today’s case has an important logical ramification. If the 40% penalty authorized by subsection (i) is just a rate enhancement of the penalty for subsection (b)(6) misconduct, then the same logic applies to say that the 40% penalty authorized by subsection (h) is just a rate enhancement of the penalty for subsection (b)(3) misconduct. That result walks away from the result in Palmolive where the Court treated a later assertion of a 20% penalty for (b)(3) misconduct as not related to an earlier assertion of a 40% penalty for (h) misconduct.
So one must really pay attention to what kinds of penalties the IRS is asserting and in what documents. In light of today’s case, I would see the §6662 penalty regime as imposing eight different penalties, all listed in §6662(b). The enhancements in subsections (h) and (i) are just the same as the enhancement in (j); one does not need to evaluate the additional misconduct seemingly required until one first evaluates the misconduct listed in subsections (b)(3) and (b)(6), respectively.
To see how gnarly this subject is, go review Oropeza I and see if you think today's opinion conflicts with it. I do not think the outcomes are in conflict. They are different because the fact patterns are different. Facts matter.
Comment: It May Be Good Law, But Is It Good Policy?
Judge Lauber believes his reading of the law is consistent with good policy. I am not so sure. It is counter-intuitive, at least for me, to think that proposing a smaller penalty than might otherwise be imposed puts the taxpayer in what Judge Lauber calls “a dilemma.” Congress was concerned about revenue agents putting random penalties in the RAR to force taxpayers “bargain away” the penalties in Appeals. So it is not so much the amount of the penalty as it is the reasons given for asserting it. The reality is that penalty determination is a function of what information the IRS has at what time. That is why, in these cases, the IRS just threw a bunch of penalties in the RAR: they were working on intuition and only later were they able to figure out which were the proper penalties. I would think the concern would be with forcing taxpayers into Appeals with larger rather than smaller penalty proposals.
Indeed, to follow Judge Lauber's logic, an RAR that does not contain any proposed penalty is even more abusive! If a 20% penalty creates the danger of a later larger 40% penalty then, heck, a zero penalty proposal in the RAR would really increase the supposed “risk” taxpayers would face in Appeals! Worse (from the taxpayer's point of view) is that if the RAR contained no proposed penalties, then it could not taint a later NOD since no penalties would ever even be proposed until the NOD. Gotta think that one through. ...
I think most folks would agree that if they received an RAR with zero penalties and an opportunity to go to Appeals, they would love to lock in that zero penalty in Appeals! But these are just the musings of an academic. I would be interested to know how readers might feel about receiving an RAR with zero penalties. Does Judge Lauber's logic say that would put your taxpayer in a "dilemma"? Would that be the kind of “abuse” that you think Congress was trying to end by enacting §6751(b)(1)? Again, I think the feared abuse was in putting an unjustified penalty simply to make taxpayers go to Appeals to get rid of it. Size does not matter.
Bryan Camp is the George H. Mahon Professor of Law at Texas Tech University School of Law. He invites readers to return each Monday for a new Lesson From The Tax Court.