Paul L. Caron

Monday, November 6, 2023

Lesson From The Tax Court: §6662 Is Sometimes Multiple Penalties For Supervisory Approval Purposes But Sometimes Not

Camp (2021)This week we learn a lesson about the interplay between the supervisory approval requirement in §6751(b) and the §6662 penalty regime.  While §6662(a) seems to impose a single penalty for accuracy-related error, we learn that if the IRS is either careful or lucky, it can cure one defective §6662 approval by later asserting in Tax Court a seemingly different §6662 penalty and getting the proper supervisory approval for that second bite at the penalty apple.

In Stephen R. Kelley and Isabelle Kelley v. Commissioner, T.C. Memo. 2023-126 (Oct. 23, 2023) (Judge Copeland), the NOD asserted a §6662(a) penalty for substantial understatement.  But the IRS employee had not obtained the appropriate supervisory approval before the NOD went out.  So when the case got to Tax Court, the IRS conceded the substantial understatement penalty and the IRS Chief Counsel attorney asserted a §6662(a) penalty for negligence or disregard of rules or regulations.  The taxpayers argued that the penalty imposed by §6662(a) is singular and so the failure to obtain supervisory approval for the NOD precluded any later assertion of penalties under §6662(a).

The Tax Court rejected the taxpayer’s argument and held that the §6662(a) penalty for substantial understatement was different than the §6662(a) penalty for negligence or disregard.

This decision seems in tension with a prior precedential Tax Court opinion, Jesus R. Oropeza v. Commissioner, 155 T.C. 132 (2020), where the Tax Court seemingly held that it would treat §6662 as imposing a single penalty for §6751(b) purposes.  I blogged that in Lesson From The Tax Court: §6662 Penalties Treated As One For Supervisory Approval Requirement, TaxProf Blog (Oct. 19, 2020).

Judge Copeland does not mention Oropeza in her otherwise very comprehensive 19 page opinion, much less seek to distinguish it.  I think the cases are reconcilable but it makes for an awkward lesson: sometimes §6662 imposes a singular penalty and sometimes it imposes multiple penalties for supervisory approval purposes.  This awkwardness seems unavoidable under any interpretation of §6751(b).  It comes from the ambiguity of §6662 and not the nonsensical text of §6751(b).

Details, as always, below the fold.

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.  That has created some difficulties.

On the one hand, §6662 seems like it is a single penalty.  After all, it is titled in the singular: “Imposition of Accuracy-Related Penalty on Underpayments.”  It’s text is also singular.  Section 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.”

On the other hand, §6662(b) says that the penalty “shall apply to the portion of any underpayment which is attributable to 1 or more of the following....”  That subsection then lists eight different types of misconduct that can be penalized.

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, the eight different types of sometimes overlapping behaviors can trigger the subsection (a) penalty.  That’s the ambiguity:  different behavioral triggers result in 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 if you focus on the eight different triggers in §6662(b), it looks like eight different penalties.  Not one.  But if you focus on the singular language in §6662(a) it seems like one penalty.

Second, similarly, §6662 contains various penalty enhancements where the 20% penalty amount gets bumped up to 40% for certain types of additional behavioral triggers.  Examples are if a valuation misstatement is extremely large, §6662(h), or if a noneconomic substance transaction is undisclosed, §6662(i), or if the underpayments is linked to undisclosed foreign financial assets, §6662(j).

One the one hand, these enhancements look the same as the penalty they are enhancing—if you focus just on their substitution of 40% for the 20% in subsection (a).  On the other than, they also looks like multiple penalties because, once again, they enhancements have additional behavioral triggers, generally a failure to disclose.  The 40% does not apply unless there is additional misbehavior over and above the related 20% triggers in §6662(b).

Third, 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.

You can see this ambiguity reflected in this quote from the leading treatise on tax practice and procedure, Saltzman & Book, ¶7B.03 (sorry, no free link):

“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.”  (emphasis added).

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 lesson asks that question for purposes of the supervisory approval requirement in §6751(b).  To help answer that, we should refresh our understanding of both the Tax Court interpretation of §6751(b) and the different interpretation from four different Courts of Appeals.

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 an appropriate point in 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, TaxProf Blog (Jan. 23, 2020).

Courts do not agree on when the appropriate point in the pre-assessment process occurs.

Consequential Moment Rule.  The Tax Court reads §6751(b) as requiring supervisory approval at the first “consequential moment” in the pre-assessment process where the IRS function proposing a penalty formally tells a taxpayer that the IRS is proposing a penalty. Beland v. Commissioner, 156 T.C. 80 (2021) (for §6663 fraud penalty); Belair Woods v Commissioner, 154 T.C. 1 (2020) (for §6662(a) and treating §6662(a) as separate penalties).

Horse and Barn Rule.  Four Circuit Courts of Appeals have uniformly agreed that supervisory approval is timely so long as it “is obtained when the supervisor has the discretion to give or withhold it.” Chai v. Commissioner, 851 F.3d 190, 220 (2d Cir. 2017).  I call that the horse-and-barn rule: once the horse leaves the barn it is now too late to approve what the horse is carrying.  Accord: Minemyer v. Commissioner, No. 21-9006 (10th Cir. 2023); Kroner v. Commissioner, 48 F.4th 1272 (11th Cir. 2022); Laidlaw Harley Davidson v. Commissioner, 29 F.4th 1066, 1071 (9th Cir. 2022).  All the cited cases involved horses that were in the form of a pre-assessment notice giving the taxpayer the right to petition the Tax Court, such as a Notice of Deficiency.  They all say that the supervisor needed to approve the penalty before the IRS sent the taxpayer whatever pre-assessment notice triggered the right to judicial review.  That's when the horse left the barn.

Law: Interplay of §6751(b) with §6662(a)
The Tax Court seems to generally treat each §6662 trigger as a separate penalty for §6751(b) supervisory approval purposes.  That has been true whether the trigger is one of the listed §6662(b) misbehaviors or one of the enhancements in later subsections.  For example, in Palmolive Building Investors v. Commissioner, 152 T.C. 75 (2019), 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 added, in the alternative, a §6662(a) 20% penalty triggered by §6662(b)(1) (negligence).

Attached to Exam’s 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.  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.

The Tax Court analyzed these facts to say the IRS was seeking to impose four separate penalties. It looked separately at the 30-day letter, the 60-day letter, and the FPAA separately and concluded they had each complied with the supervisory approval requirement.  The Court thus treated the 20% subsection (b)(3) penalty as distinct from the 40% subsection (h) enhancement.  You see this most starkly in its 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).

Similarly, in Oropeza v. Commissioner, T.C. Memo. 2020-111 (“Oropeza I”), the Revenue Agent failed to obtain supervisory approval before sending the taxpayer a Revenue Agent Report (RAR) proposing a 40% penalty under either of subsections (h) or (i) or (j).  The eventual NOD also proposed one of 40% penalties, but only under subsection (i) (nondisclosed noneconomic substance transaction).  The NOD also proposed, for the first time, a 20% penalty for the misconduct described in §6662(b)(1) (negligence) and (b)(2) (substantial understatement).  The IRS could show proper supervisory approval of the NOD.

Under those facts, the Court treated the 20% penalties in the NOD as separate from the penalties proposed in the RAR.  Thus, while the penalties proposed in the RAR were invalid because of the failure to secure supervisory approval before the “consequential moment” of sending the RAR, that failure did not taint the later NOD because the NOD was asserting a different penalty.  I blogged this case in Lesson From Tax Court: §6662 Contains Multiple Penalties For §6751 Supervisory Approval, TaxProf Blog (Aug. 17, 2020).

But the Tax Court also sometimes reads §6662 as imposing a singular penalty.  An example is Oropeza v. Commissioner, 155 T.C. 132 (2020) (Oropeza II), a case dealing with the same taxpayer but different tax period.  There the Court decided that the failure to properly approve one set of penalties proposed in an RAR did taint the later (properly approved) NOD, even though the NOD seemed to proposed different penalties.  I blogged about that in Lesson From The Tax Court: §6662 Penalties Treated As One For Supervisory Approval Requirement, TaxProf Blog (Oct. 19, 2020).

As I read those cases, the critical difference between Oropeza I and Oropeza II was the relationship between the penalties in the RAR and the penalties in the NOD.  In Oropeza I neither of the 20% penalties asserted and approved in the NOD related to any of the 40% penalties proposed in the RAR but not properly approved.  In contrast, in Oropeza II one of the invalidly proposed penalties in the RAR was the 20% penalty triggered by §6662(b)(6) for transactions lacking economic substance.  And the 40% penalty approved in the NOD was the enhanced penalty triggered by §6662(i), a penalty for nondisclosed transactions lacking economic substance.  The Tax Court apparently thought the enhanced penalty in subsection (i) was the same as the penalty listed in (b)(6).  Here’s what Judge Lauber wrote:

“If we permitted the IRS to impose a 40% penalty in the circumstances here, the IRS could penalize a taxpayer more severely despite its own mistake. If the IRS recognized the failure to comply with section 6751(b)(1) for a 20% penalty [under §6662(b)(6)], it could later assert (and get approval for) the same penalty at a 40% rate under section 6662(i).” 155 T.C. at ___.  (emphasis added).

My guess is that the Court saw the subsection (i) penalty as the same as the (b)(6) penalty because (i)(2) references the (b)(6) trigger.  Apparently the IRS thought so too because the NOD explicitly labeled the (i) penalty as a 40% section 6662(b)(6) penalty”!  As I commented in my blog post, however, the Tax Court ignores the additional behavioral trigger of nondisclosure that permits the 40% penalty.  I have a hard time reconciling that with the Court’s approach in Palmolive.  Obviously, I’m missing something!

Today we once again see the Tax Court treating the various triggers as imposing separate penalties.  Let’s take a look.

Facts of The Case
Mr. and Ms. Kelley are deeply committed hobbyists.  Both are highly educated geologists who consulted extensively with Lawyer Google to conclude that none of the approximately $325,000 in wages they received from their employers in 2017 constituted gross income.  So they reported zero income on their timely filed return.  Oh, and they also claimed a refund of the over $96,000 in tax withholdings.

Following its policy of “refund first, audit later,” for taxpayers who don’t claim the EITC, the IRS actually sent the Kelleys their claimed refund and only then, over a year later, sent an NOD when the AUR computer matching system caught the discrepancy between the W-2s and the return.  That’s one aspect of tax administration that most folks overlook: the IRS is unable to perform a contemporaneous match when taxpayers file their returns.  It’s something that IRS Commissioners have tried to educate Congress about for at least the last 20 years, but to no avail.

Without the ability to do contemporaneous matching, the IRS must instead rely on taxpayers making honest efforts to comply with the law.  And penalties are there to encourage taxpayers to file properly.  Here, the NOD proposed a §6662(a) penalty triggered by §6662(b)(2) (substantial understatement).

The Kelleys petitioned Tax Court.  In response to their Petition, the IRS Chief Counsel attorney filed an Answer.  The Answer conceded that the Kelleys could not be assessed a 20% penalty for substantial understatement because that penalty in the NOD had not been properly approved.  However, the Answer also asserted that the Kelleys could and should instead be assessed a §6662(a) 20% penalty triggered by §6662(b)(1) (negligence or disregard).  The Answer had received the proper supervisory approval.

Lesson: §6662(a) Is Multiple Penalties—Sometimes
In Tax Court the Kelleys urged the Court to read §6662(a) as imposing a single penalty.  They apparently protested that reading the statute as imposing multiple penalties would allow the IRS to abuse taxpayers by getting multiple bites at the same accuracy-related penalty.

Judge Copeland does a masterful job of what I like to call “legal judo.”  That is, she totally flips the taxpayers’ argument on its head and explains that the feared abuse would actually come from reading the statute as imposing a single penalty.  Here’s how she explains it:

“The Kelleys’ interpretation would give carte blanche to IRS officials to assert additional causes under section 6662(b) after a supervisor approved a penalty under one or more other causes. For instance, an IRS revenue agent might get approval to penalize a taxpayer by reason of section 6662(b)(1) (negligence or disregard of rules or regulations) but, upon receiving convincing rebuttal from the taxpayer, assert a penalty by reason of section 6662(b)(3) (substantial valuation misstatement)—perhaps even enhanced to a 40% penalty for gross valuation misstatements under section 6662(h). If the Kelleys are correct, then the revenue agent would not need further supervisory approval for the second penalty assertion, because the second penalty would be the “same” as the first (approved) penalty.”  Op. at 9.

Invoking the Tax Court’s main rationale for its interpretation of §6751(b), Judge Copeland then goes on to explain that treating §6662(a) as a single penalty would lead to more opportunities for nefarious low level IRS employees to threaten the various triggers in subsection (b) as “bargaining chips” against hapless taxpayers.

She therefore concludes: “We therefore hold that each of the eight causes of an underpayment listed in section 6662(b) yields a distinct penalty for purposes of the supervisory approval requirement under section 6751(b)(1).” Op. at 10.

Comment 1:  This opinion is in tension with the Tax Court’s precedential opinion in Oropeza II.  Notice that in Oropeza II, the Tax Court basically took the position the Kelleys were asserting in this case about how to characterize the interplay of §6751(b) with §6662.  Again, consider Judge Lauber’s reasoning for reading §6662(a) as imposing a single penalty (with enhancements):

“If we permitted the IRS to impose a 40% penalty in the circumstances here, the IRS could penalize a taxpayer more severely despite its own mistake. If the IRS recognized the failure to comply with section 6751(b)(1) for a 20% penalty, it could later assert (and get approval for) the same penalty at a 40% rate under section 6662(i).”

Now contrast that with Judge Copeland’s reasoning for interpreting §6662(a) as imposing multiple penalties and reading enhancements as separate penalties requiring separate approvals:

“an IRS revenue agent might get approval to penalize a taxpayer by reason of section 6662(b)(1) ...but, upon receiving convincing rebuttal from the taxpayer, assert an [alternative] penalty...perhaps even enhanced to a 40% penalty for gross valuation misstatements under section 6662(h).

The quick way to reconcile these cases is to note that Judge Copeland’s language is dicta.  The only issue for her to decide was whether a 20% §6662(a) penalty based on the (b)(2) trigger was different than a 20% penalty based on the (b)(1) trigger.  Her opinion can thus be limited to a holding that each of the eight §6662(b) triggers are separate penalties.  In contrast, Judge Lauber was considering whether a 40% penalty under subsection (i) was sufficiently related to the 20% penalty under subsection (b)(1) so as to make them the same penalty for supervisory approval purposes.  He thought they were.

But quick is not easy.  Judge Copeland is (properly in my opinion) reading each part of §6662(b) as imposing separate penalties.  That makes sense to me because the behavioral triggers are different.  Different penalties for different conduct.  So you need separate supervisory approval for each.  In contrast, I think Judge Lauber overlooked that the subsection (i) enhancement is not for the same conduct as the (b)(3); it requires additional conduct of non-disclosure.

Comment 2: It does not matter whether one uses the Tax Court’s consequential moment interpretation of §6751(b) or the Circuit Courts’ horse-and-barn rule.  Either way, if a penalty asserted in an NOD did not receive supervisory approval, the IRS will not be able to assess that penalty.  So if §6662 imposes only one penalty, an invalid NOD will taint an further assertion of §6662.  But if §6662 imposes multiple penalties, then an invalid NOD will not preclude the IRS from asserting a §6662 penalty based on a different behavioral trigger in Tax Court.  And remember, the IRS will then bear the burden of proof as to that new matter asserted.  Tax Court Rule 142.

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.

[Editor's Note:  If you would like to receive a daily email with links to each Lesson From The Tax Court and other tax posts on TaxProf Blog, email here.]

Bryan Camp, New Cases, Scholarship, Tax, Tax Practice And Procedure, Tax Scholarship | Permalink


Post a comment