Lesson From The Tax Court: Penalty Approval In Conservation Easement Cases

The §6751(b) supervisory approval requirement for penalties has been a thorn in the side of both the IRS and the Tax Court.  Today’s lesson shows us how the IRS penalty approval process in conservation easement audits has forced taxpayers to reach for wilder and less credible attacks in their attempts to avoid penalties by finding IRS procedural foot-faults.

First, in Pickens Decorative Stone LLC v. Commissioner, T.C. Memo. 2022-22 (Mar. 17) (Judge Lauber), the taxpayer argued that when the IRS had publicly committed in a general Notice to seeking penalties against the types of syndicated conservation easement scheme it had engaged in, the IRS was disabled from complying with §6751(b) because the supervisor in the audit had not signed off on that public Notice.  Yeah, pull your eyebrows down; the argument lost.

Second, in Oxbow Bend, LLC v. Commissioner, T.C. Memo. 2022-23 (Mar. 21, 2022) (also Judge Lauber), the taxpayer similarly argued the IRS failed to comply with §6751(b) when the Revenue Agent (RA) had failed to secure supervisory approval before telling the taxpayer during a status conference that penalties were “under consideration” when in fact the RA was completing an internal document recommending penalties that very day.  That was a loser as well.  Details below the fold.

Background: Conservation Easements
The widespread abuse of conservation easements donations is well documented.  Read this informative Senate Finance Committee Report from August 2020.  The abuse not only hurts the federal fisc but also hurts those who genuinely champion environmental preservation, as this Brookings Report explained in 2017.

The abusers are rejoicing, however, from recent events.  The Eleventh Circuit recently invalidated an important Treasury regulation that attempted to prevent the abuse in conservation easements.  Hewitt v. Commissioner, 21 F.4th 1336 (Dec. 29, 2021).  The abusers are also grateful for the recent Supreme Court decision in CIC Services v. IRS, 593 U.S. ___ (2021).  There the Supremes permitted APA challenges against third party reporting requirements to proceed.  Courts are now finding those Notices violate the APA.  See Les Book’s great discussion of this over at Procedurally Taxing.  It’s looking good for the abusers.  They can engage in their conservation easement schemes without fear of being ratted out...or so they think.

Their happiness is misplaced, however, and not just because of a majority of the Sixth Circuit panel in Oakbrook Land Holdings v. Commissioner, ___ F.4th ___ (Mar. 14, 2022) came to a contrary conclusion about the validity of the conservation easement regulation.

Nope.  They should consider Judge Guy’s ironic concurrence in Oakbrook (see my comment after the post for why I call it ironic).  He agreed the regulation was invalid, but upheld the IRS determination of a deficiency based on the statute.  That is, the IRS does not need no stinkin’ regulation to enforce the statutory perpetuity requirement.  They just need to audit.

And audit they do!  The IRS does indeed audit this area robustly as one sees in this list of all conservation easement cases from 2012 through April 2020.  And when it does, you can bet a substantial penalty is coming at you as well.  Heck, the IRS told us that in Notice 2017-10.  And while you can bet your sweet bahooney that promotors of syndicated conservation easements will not voluntarily report their client list to the IRS, the IRS still retains the awesome power of its John Doe summonses “cryptonite.”  See e.g. United States v. Coinbase, Inc., No.17-cv-01431-JSC (N.D. Cal. Nov. 28, 2017).  Audits, like Winter, are coming.  And with them will come penalties.  So today’s lesson on how the IRS complies with §6751(b) should be useful.

Background: The Supervisory Approval Requirement 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 Appeals.  That’s mostly folk history.  The only place you find anything to support that is in the Senate Finance Committee Report where it says 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).

The statute has been the subject of robust litigation over the past five years.

The biggest question presented has been a timing question.  Sure, there must be supervisory approval of an “initial determination” but the statute does not say when that approval must be obtained.  The legislative history is of little help.  The “Explanation of Provision” section of the Senate Finance Committee Report says only that the provision “requires the specific approval of IRS management to assess all non-computer generated penalties unless excepted.”  Id.

So we are left with a statute where Congress supervisory approval of penalty determinations must take place at some point before the penalties were assessed.  And we (think we) know Congress wanted that supervisory check because of a concern that rogue IRS employees were trying to beat up taxpayers by inappropriately proposing penalties.

But the statute is silent on just when the required supervisory approval of the “initial determination” must occur.  What does that silence mean?

Historically, the Tax Court and IRS took what I call a hyper-textual approach: silence means silence.  So long as the penalty approval comes before the assessment, it did not matter whether the approval is before or after the IRS told the taxpayer it was going to assert a penalty.  The first Circuit Court to deal with this question rejected the hyper-textual interpretation of the statute in favor a practical interpretation and the Tax Court has since followed suit.  For details, see Lesson From The Tax Court: A Practical Interpretation Of The Penalty Approval Statute § 6751, TaxProf Blog (Jan. 13, 2020).

The Tax Court now grounds its approach on a practical interpretation of the phrase “initial determination.”  At some point in the back-and-forth between taxpayers and IRS employees, there comes what the Court calls a “consequential moment” where the IRS function (usually the Exam function) tells the taxpayer “yup, we’re going to hit you with a penalty.”  That is, the consequential moment is “the first formal communication to the taxpayer of the initial determination to assess penalties.” Beland v. Commissioner, 156 T.C. 80, 86 (2021).  That’s the line.  Gotta get approval before that “first formal communication.”  While I disagree sometimes with where the Tax Court draws that line—see Lesson From The Tax Court: New 'Consequential Moment' Rule For §6751 Supervisory Approval, TaxProf Blog (Mar. 8, 2021)—that just reflects a disagreement about where the line is, and not to the approach.

Alert readers will note here, however, that the Ninth Circuit has now re-opened the timing question!  Yessiree Bob.  In Laidlaw v. Commissioner,  No. 20-73420 (9th Cir., Mar. 25, 2022), a divided panel upheld the traditional hyper-textual interpretation long favored by the Tax Court.  It will be interesting to see what impact the Laidlaw opinion has on the Tax Court.  My guess is that it will not alter the Tax Court’s interpretation, which the Court has spent countless hours refining over the past five years.

Today’s lesson is part of that refinement.  Both of today’s cases involve conservation easement litigation.  Those are areas where there are some very large potential penalties and taxpayers are thus rather willing to throw out (up?) any possible argument to invalidate the penalties.  But desperate arguments sometimes make for good lessons.

Today we learn more about what does not constitute the kind of “consequential moment” that signals the latest point in time by which an IRS employee must secure supervisory approval.

Lesson 1: A General Public Notice to Impose Penalties is Not A Consequential Moment
In Pickens, the taxpayer in this case engaged in a syndicated conservation easement scheme.  For details on how those work, see IRS Notice 2017-10.  Here, the taxpayer (a partnership) basically took a piece of property that had been purchased for some $490k, donated a conservation easement to Foothills Land Conservancy, and then took at $24.7 million §170 deduction that it passed through to its partners.  Don’t ask me how they justified the valuation.  It’s Appraisal Magic.  But you can see why these taxpayers would prefer not to get hit with penalties if it turns out their donation was not a qualified one!

The IRS audited in 2019.  After concluding the donation was not a qualified donation, the Revenue Agent (RA) not only proposed to disallow the deduction but also recommended penalties under §6662 and §6662A.  The RA’s supervisor signed off on the recommended penalties in April 2020.  In July 2020 the RA sent the taxpayer Form 4605-A and Form 886-A.  Those are both documents that formally explain the results of the audit, including the decision to assert penalties.  In August 2020 the RA sent out the Final Partnership Administrative Adjustment (FPAA), which serves as a partnership’s ticket to the Tax Court much like a Notice of Deficiency does for individual taxpayers.

The taxpayer petitioned the Tax Court and the government moved for summary judgment both on the merits and on the ever-present issue of whether the penalties were properly approved.  Judge Lauber denied summary judgment on the merits, noting that “on the basis of the record that currently exists, petitioner seems to have the stronger argument...”

But Judge Lauber had no problem granting the government summary judgment on the penalties.

The taxpayer had a very . . . creative...argument on why the IRS had violated §6751(b).  Normally, in partnership cases, the issuance of Form 4605-A and Form 886-A (if issued) would be the consequential moment, the point by which the RA should have obtained supervisory approval.  And the RA did that here.  But the taxpayer said that for syndicated easement transactions the IRS had made a public commitment to assert penalties in all such cases, via Notice 2017-10.  That was the consequential moment; that was the "initial determination" and it was for all taxpayers.  Therefore, said the taxpayers, the supervisory approval here came too late because it came after the Notice.

Judge Lauber teaches the Lesson: the relevant consequential moment comes when the IRS proposes to act against a particular taxpayer as the result of a particularized audit.  Writes Judge Lauber: “Our inquiry thus turns on the timing of the IRS communication to the taxpayer against whom the penalties are being asserted. *** An IRS announcement directed to the public at large cannot constitute the first formal communication to the taxpayer of penalties.” (emphasis in original)

Lesson 2: Oral Communication To Taxpayer Is Not Consequential Moment
Oxbow:  In 2014 the taxpayer here (another partnership) acquired land and made two donations to The National Wild Turney Federal Research Foundation.  First, the taxpayer donated a conservation easement, taking a $12.3 million §170 deduction.  Second, the taxpayer then (three weeks later) donated its fee simple interest in the land to a wholly owned passthrough entity of the Foundation, taking an additional $4.1 million deduction.  I would love to hear from anyone who can explain the purpose for that structure, apart from generating additional lawyer fees.

In 2017 the IRS opened an examination of Oxbow’s 2014 return.

In October 2018 the RA started drafting her Revenue Agent Report, including drafting penalties under §6662 and §6662A.  That’s the report that would normally be sent to the taxpayer along with Form 886-A.

In November 2018, she and her supervisor had a telephone “status conference” with the taxpayer’s representative.  In that call, the RA explained that “penalties were currently under consideration” and that she did not plan to give this taxpayer a pre-FPAA opportunity to go to Appeals, such as would be given by issuing a Form 886-A.  Instead, she planned to simply issue an FPAA.  The telephone call was just that, a telephone call.  The RA did not give the taxpayer’s representative any documents.  No drafts, no waivers, nothing.  But on that the same day the RA completed an internal “penalty lead sheet” documenting the RA’s recommendation to assert penalties.

In February 2019, the RA’s immediate supervisor signed the proper forms approving the penalties the RA recommended.  In April 2019, the IRS sent Oxbow the FPAA disallowing the deductions and proposing penalties.  Because the supervisor’s approval was secured before the FPAA issued, it would seem as thought the IRS complied with §6751(b).

Not so, argued the taxpayer.  The formal scheduling and designation of the November 2018 telephone call as a “status conference,” coupled with the fact that the RA completed the penalty lead sheet that very same day, was enough to make that telephone call the initial determination for §6751(b) purposes.  It was the consequential moment.  The RA needed to have obtained supervisory approval before the telephone call.

The taxpayer relied on Beland v. Commissioner, supra, for the proposition that a meeting can be a consequential moment.  In Beland, the RA and the RA’s supervisor had a face-to-face “status conference” with the taxpayers at which they personally delivered the pre-FPAA formal documents proposing a penalty, without the supervisor having signed a prior written approval.  I disagree with Beland, for the reasons I have in my New Consequentialist Moment blog post, supra.  But, hey, it’s a T.C. opinion so we gotta deal with it. 

And Judge Lauber easily does so by distinguishing the facts.  In Beland, the IRS employees did not just talk the talk; they walked the walk by delivering the formal documents for the taxpayer to consider signing and agreeing to the penalties.  In this case, the RA and her supervisor just jawed with the taxpayer’s representative.  Writes Judge Lauber: “RA Stafford did not provide Oxbow’s representative—before, during, or immediately after the phone call—with an RAR or other document determining any penalties.  In terms of formality, the telephone conference was at the opposite end of the spectrum from the meeting in Beland, to which the taxpayers were formally summonsed under threat of legal sanctions.”  Op. at 7.

Concludes Judge Lauber: “We have never found a telephone call of the sort involved here to embody an “initial determination” within the meaning of the statutory text, which denotes a communication with a high degree of concreteness and formality.”  Op. at 8.

Comment: I said Judge Guy’s concurrence in Oakbrook was “ironic.”  Here's why.  Judge Guy' thought the regulation was what is called a "legislative" regulation and was not an "interpretive" regulation.  While Treasury had followed the proper APA process for issuing an interpretive regulation, that process was not proper for issuing a legislative regulation.  So Judge Guy said the regulation was inoperative because it had not been validly issued.  Ok so far.  But then Judge Guy ends up construing (oh! dare I say "interpreting") the statutory language at issue.  The irony here is that Judge Guy totally agrees with the regulation on how the term “perpetuity” in the statute should be interpreted.  So the taxpayer loses.  But I doubt Judge Guy would say he was “legislating” from the bench!  Nah!  He was just “interpreting.”  Cuz that's what a court does, doncha know. Thus the irony: when Treasury does the same thing as a Court does in a regulation suddenly it’s a legislative act and not an interpretive act.  But when the Court does it, it’s just...well...interpretation.  Go figure.  

Bryan Camp is the George H. Mahon Professor of Law at Texas Tech University School of Law.  He invites readers to return each week to TaxProf Blog for yet another Lesson From The Tax Court.