Section 6751 requires the IRS to ensure adequate supervisory approval of tax penalties before those penalties are assessed. But it does not require such approval for any “penalty automatically calculated through electronic means.” §6751(b)(2)(B).
Today we learn a surprisingly nuanced lesson about what constitutes a penalty automatically calculated through electronic means. In Piper Trucking & Leasing v. Commissioner, 161 T.C. No. 3 (Sept. 14, 2023) (Judge Foley), the IRS assessed penalties against the taxpayer, under §6721, for Piper’s alleged failure to file required information returns. The initial letter proposing such penalties was automatically generated, based on information received from the Social Security Administration. But the proposed penalties were the most severe of several alternatives, alternatives that depended on the facts. Yet no IRS employee was supposed to review the penalty unless and until the taxpayer responded to the initial letter in time. In this case, the taxpayer made no timely response. For that reason, the Tax Court held that these penalties fell within the statutory exception and required no human decisionmaker.
This lesson is just another reason why taxpayers need to be sure to respond to all correspondence received from the IRS. Details below the fold.
Law: “Consequential Moment” Rule v. “Horse and Barn” Rule
Section 6751 was a sleepy little statute for the first 20 years after its enactment. But in 2017 the Tax Court followed the lead of the 2nd Circuit to elevate a snippet of a legislative committee report into statutory text, a decision that has caused no end of headaches for taxpayers, the IRS and the courts. I give some of that history in Lesson From The Tax Court: A Practical Interpretation Of The Penalty Approval Statute § 6751, TaxProf Blog (Jan. 30, 2020).
The current law on §6751 is conflicted. The main fight is about when approval must occur. On the one hand, the Tax Court adheres to its interpretation that the statute requires supervisory approval before some ill-defined “consequential moment” that IRS communicates an "initial determination of such assessment" to a taxpayer. See Lesson From The Tax Court: New 'Consequential Moment' Rule For §6751 Supervisory Approval, TaxProf Blog (Mar. 8, 2021); Lesson From The Tax Court: Penalty Approval In Conservation Easement Cases, TaxProf Blog (Apr. 4, 2022).
On the other hand, four Courts of Appeals have pushed back with what I call the “horse and barn” rule. They hold that the IRS obeys the statute whenever supervisory approval comes at a time when the supervisor still had discretion to withhold it. Put another way, once the horse has left the barn, it is too late to give approval for the horse to actually leave the barn. It's left!
The Courts of Appeals’ approach means that the timing depends on the process. For most IRS assessment processes, that means approval must be obtained before an NOD is issued. That’s when the proposed assessment horse typically leaves the Examination Barn. See e.g. Kroner v. Commissioner, 48 F.4th 1272 (11th Cir. 2022) (penalty approval timely when given simultaneously with a 30-day letter but after initial proposal to assert §6662 penalties was communicated to taxpayer). See also Chai v. Commissioner, 851 F.3d 190, 220 (2d Cir. 2017) (“If supervisory approval is to be required at all, it must be the case that the approval is obtained when the supervisor has the discretion to give or withhold it.”). Accord: Minemyer v. Commissioner, No. 21-9006 (10th Cir. 2023) (“We are persuaded by the Second Circuit's reasoning and hold that with respect to civil penalties, the requirements of § 6751(b)(1) are met so long as written supervisory approval of an initial determination of an assessment is obtained on or before the date the IRS issues a notice of deficiency.”).
For other IRS assessment processes, however, where there is no NOD, the timing can be later. See Laidlaw Harley Davidson v. Commissioner, 29 F.4th 1066, 1071 (9th Cir. 2022) (upholding approval of proposed §6707A penalty after taxpayer protested proposed penalty and asked for review by Appeals but before Appeals received the case).
In April 2023 the IRS published these proposed regulations to basically codify the Courts of Appeals’ approach, much to the chagrin of the National Taxpayer Advocate. See NTA Blog: Reconsidering the IRS’s Approach to Supervisory Review (Aug. 30, 2023).
Law: The “Automatedly Calculated” Exception
There has not been a lot of litigation on this part of the statute. Maybe there should be more.
Not all penalties require the §6751(b)(1) supervisory approval. Specifically, those “automatically calculated through electronic means” may be assessed with no supervisory approval. §6751(b)(2)(B). Apparently the reason for that is because there is no human discretion involved as to the individual taxpayer. No there can be no abuse. For my critique of that idea, see Lesson From The Tax Court: The Incoherence Of §6751(b), TaxProf Blog (Apr. 12, 2021).
The tricky part of this exception is that while some assessment processes start out with “automatically calculated” penalties, those may or may not turn into “human calculated” penalties. It depends on whether the IRS receives a timely taxpayer response. If the taxpayer responds, then the exception no longer applies because now human discretion is involved. More importantly, that means that the initial penalties proposed are default penalties: they are just the penalties that the IRS has programmed its computers to apply. So they are “automatic” in the sense they are pre-programmed, but not “automatic” in the sense that the IRS has no discretion.
We can see that by comparing two automated processes.
First, consider the Automated Correspondence Exam (ACE) process. When the IRS computer systems detect a significant enough mismatch between a taxpayer return and information in certain other IRS databases, the system automatically sends a notice to the taxpayer proposing both a deficiency and a §6662 penalty if it calculates a statutory substantial understatement of income. As described in IRM 220.127.116.11 (01-01-2021): “Using ACE, Correspondence Exam can process specified cases with minimal to no tax examiner (TE) involvement until a taxpayer reply is received. Because the ACE system will automatically process the case through creation, statutory notice and closing, TE involvement is eliminated entirely on no-reply cases.” (Emphasis supplied).
If the taxpayer does not respond, then the proposed deficiency and penalties are assessed. The Tax Court has held that does not violate the §6751 supervisory approval requirements. Walquist v. Commissioner, 152 T.C. 61, 67 (2019). However, if the taxpayer submits a response to the automatic letter, then the supervisory approval requirements kick in. See IRM 18.104.22.168.2(5).
The Section 6721 Penalty Proces
Second, consider the §6721 penalty process. We see what may be an important difference between it and the ACE process.
Section 6721 imposes various penalties for failure to file required information returns. That is, employers are supposed to file Forms W-2 and W-3 with the Social Security Administration (SSA) so that employee taxpayers get proper credit. Section 6721(a) imposes a default penalty of $250 for each information return that was not filed on time, capped at a total penalty for any calendar year of $3 million.
Here's what's important: the §6721 penalty can drop or increase from the default in subsection (a). It drops to $100 per return ($1.5 million total cap) if the taxpayer files by August 1st of the year the return is due. It drops to $50 per return ($500,000 total cap) if the taxpayer files no more than 30 days late. §6721(b). §6721(b).
But the default penalty can increase as well. Section 6721(e) provides that if the failure to file is “due to intentional disregard of the filing requirement (or the correct information reporting requirement)” then the penalty is $500 per return, with no total cap at all! Yowsa!
The reason that §6721(e) is important is because, like the ACE process, the §6721 penalty process starts with IRS computers issuing a letter proposing the penalty based on a document matching program. The program is called the Combined Annual Wage Reporting (CAWR). Judge Foley describes how the system works:
“The SSA sends two warning letters to employers that fail to file these forms. The first letter informs the employer to either respond or file the missing forms. The second letter warns the employer that the matter will be referred to the Internal Revenue Service (IRS) to determine whether penalties are applicable. If an employer fails to respond to both letters, their name is added to a database. Every year the SSA transfers this database to the IRS. Following the transfer of the database, the CAWR computer program automatically sends the employers in the database a Letter 98C asserting a section 6721(e) penalty.”
Alert readers will spot the problem: the LTR 98C imposes the highest possible penalty, the penalty in subsection (e), and not the default penalty in subsection (a). It is programmed to simply presume the failure resulted from “intentional disregard.” Again, per IRM 22.214.171.124.1, the “initial Letter 98C automatically calculates (through electronic means) the IRC 6721(e) penalty for failure to file an information return due to intentional disregard.” That would be like the ACE process simply presuming that the error was due to fraud instead of just calculating under the §6662(a)(2) formula. I welcome comments on whether my understanding of how ACE incorporates the §6662(a)(2) penalty is erroneous. But I don't think the ACE process attempts to impose the maximum possible penalty automatically. The §6721 process does.
That is, the IRS system for imposing §6721 penalties is programmed to start by going full monty...automatically. Still, just as with ACE, the process by which the IRS assesses those penalties is not fully automatic. The automatic part is just the initial LTR 98C. It proposes maximum penalties and gives the taxpayer a deadline to respond. If the IRS gets no response by the deadline, the assessment is made. But if the taxpayer does respond, an IRS employee must then determine whether to impose the default penalty instead, or one of the lesser penalties, or no penalty at all. At that point, even the IRS concedes that supervisory approval is required. IRM 126.96.36.199.1. (“Once the taxpayer responds to the Letter 98C, the tax examiner’s evaluation of the response, regardless of whether or not the taxpayer specifically addresses the penalty, means that the “automatically calculated through electronic means” exception no longer applies and written supervisory approval is needed.”).
Today we learn that the Tax Court fully agrees with the IRM: when the IRS computer systems are programmed to automatically apply the maximum of a range of permissible penalties, there is no requirement for supervisory approval if the taxpayer makes no response.
Facts and Lesson: Taxpayer Response is Needed To Trigger Supervisory Approval
The facts are simple. The CAWR determined that the taxpayer here, Piper Trucking and Leasing (Piper) failed to filed required Forms W-2 information returns for 2015. The CAWR issued a LTR 98C on May 29, 2018, proposing the maximum of the permissible range of penalties. Piper made no response. The IRS then assessed the penalty on March 4, 2019, sending out a §6320 CDP notice that September. Piper timely asked for and received a CDP hearing.
Then COVID hit and the process got strung out. The IRS Office of Appeals was eventually able to issue its Notice of Determination in June 2021 and Piper timely petitioned the Tax Court for review, proceeding through its principal officer, Mr. Steven Piper. So this is a pro se taxpayer.
After reviewing the facts and the law, Judge Foley quickly concludes, based on analogy to the ACE process and the holding in Walquist, supra, that “[b]ecause petitioner failed to respond to the Letter 98C, the underlying section 6721(e) penalty...was “‘automatically calculated through electronic means.’”
Bottom line: What an IRS employee may not do individually, the IRS may do institutionally: proposed a maximum penalty with no review.
Comment: I confess a concern, although not with the automated nature of the penalty: the IRS absolutely needs bulk-processing systems like ACE and CAWR to deal with the vast numbers of taxpayers. My concern is with the bulk-processing decision to change the Congressional statutory command through a programming decision. The statute says the default penalty is $250 per unfiled return. The CAWR programming changes that to a default penalty of $500 per return. My concern echoes long-standing concern about how the IRS administers penalties through bulk-processing algorithms. See e.g. National Taxpayer Advocate 2013 Report To Congress Vol 1: Most Serious Problems #17: Accuracy Related Penalties
One creative response to this concern would be judicial: interpret the phrase “penalty automatically calculated through electronic means” in §6751 to mean the default penalty imposed by a statute for which no additional information is needed. Such as the §6662(a)(2) penalty. Or the default penalty in §6721(a). That would pressure the IRS to change its underlying bulk-processing rules.
Another creative response would be administrative: have IRS justify the bulk-processing rules as part of the computer program and design process. Here, for example, perhaps it is indeed reasonable to presume that Piper intentionally disregarded its duties because the SSA is supposed to have sent at least two warning letters about those duties. This second idea would be the same as the supervisory approval idea in §6751, only now it would apply at the stage where bulk-processing decisions are made.
Finally, if you want to be even more creative---or disruptive---assert that the computer algorithm qualifies as a “rule” under the Administrative Procedure Act! That would mean decisions about programming choices qualify as rulemaking and require the IRS to go through notice and comment for every programming change!
Regardless, in this era of big data and large-scale automated processing, it may make sense to change our idea of what constitutes adequate supervision of an IRS decision to impose penalties.
Bryan Camp is the George H. Mahon Professor of Law at Texas Tech University School of Law. He invites readers to return each Monday (or Tuesday if Monday is a federal holiday) to TaxProf Blog for another Lesson From The Tax Court.
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