Paul L. Caron

Monday, May 6, 2024

Lesson From The Tax Court: When Is An Excise Tax Really A Penalty?

Lessons From The Tax Court (2024)“The power to tax involves the power to destroy.” Justice John Marshall in McCulloch v. Maryland, 17 U.S. 316, 431 (1819).

“Sometimes a tax is...just a tax.” — Sigmund Freud’s Tax Advisor.

Today’s lesson is about how to tell when an excise tax is really a penalty.  The answer I learn is: “why do you want to know?”  I hope to explain why that answer makes the most sense.

In Clair R. Couturier Jr. v. Commissioner, T.C. Memo. 2024-6 (Jan. 17, 2024) (Judge Lauber), the IRS sent the taxpayer a Notice of Deficiency for over $8 million.  The basis for the proposed deficiency was that Mr. Couturier had made an excess contribution of over $25 million to his IRA, thus triggering the excise tax imposed by §4973 on excess IRA contributions.

In Tax Court, Mr. Courturier—well represented by Taylor, Nelson and Amitrano—argued that the §4973 “tax” was really a “penalty.”  If true, that meant that the IRS needed to have followed the supervisory approval procedures for penalties in §6751(b), which it had not.  The IRS argued that it did not have to follow the §6751(b) supervisory approval procedures before sending out the NOD because the tax was ... just a tax!

Judge Lauber’s opinion explains why the §4973 excise tax was not a penalty for purposes of the §6751(b) supervisory approval requirements.  Keith Fogg has a really good post on this issue here, where he suggests a potential tension between what he describes as the Tax Court’s textual analysis (focusing on the labels) and what he describes as the Supreme Court’s functional analysis about a similar excise tax in U.S. v. Reorganized CF & I Fabricators of Utah, Inc., 518 U.S. 213 (1996), a bankruptcy case.

I see the matter a bit differently than Keith.  Different statutes (e.g., bankruptcy statutes, statutes imposing interest) treat penalties differently than they treat taxes.  The lesson I learn is that looking to see whether an excise tax operates in some abstract sense as a penalty is not the strongest analysis.  Instead, the better analysis is to see whether treating it as a penalty is more appropriate under the relevant statutory scheme than treating it as a tax.  In other words, why do you want to know?

Details, and a fuller explanation, await those intrepid readers who continue below the fold.

Law: Excise Taxes Generally
When we hear the word “tax” we usually think of income taxes.  But as the Beatles remind us, there are other sources of taxation available to government: transactions: “If you try to sit I'll tax your seat / If you get too cold I'll tax the heat / If you take a walk I'll tax your feet.”  (Tax Man).  Those taxes on transactions are called excise taxes.  Don’t ask me why.  Merriam says the etymology of the noun is different than that of the verb.  The noun just comes from an old Dutch word meaning something like “assessment.”

Regardless of the word’s history, governments have, from time immemorial, taxed transactions.  Generally they have taxed transactions that reflect consumption of goods or services.  Think sales taxes.  But governments also tax transactions that are not so obviously related to consumption, such as taxes on licenses or impermissible movements of money into or out of tax-favored accounts. All of those are excise taxes.  And the key to spotting them is that they tax an action, or transaction, if you will.

Today’s lesson concerns one of the excise taxes in Subtitle D (“Miscellaneous Excise Taxes”)Section 4973(a) in Subtitle D imposes a excise tax on excess contributions to a variety of tax-favored savings accounts, such as IRAs.  The tax is 6% of the excess contributions.  But here’s the kicker: it apparently continues to apply each year until such time as the original excess contribution is distributed to the taxpayer and included in income.  At least that is how I read §4973(b)(2).  I invite readers to correct me if I’m wrong on that.

Law: For Bankruptcy Purposes Some Excise Taxes Are Penalties
Just two sections down from today’s excise tax is another excise tax in Subtitle D: §4971 (“Taxes on failure to meet minimum funding standards”).  It’s one of several two-tiered provisions in Subtitle D.  It imposes a tax on employers who have pension plans but fail to fully fund them.  The first tier tax is in §4971(a) which imposes a tax equal to 10% of the funding deficiency.  The second tier comes in §4971(b) which makes that tax equal to 100% of the funding deficiency if the deficiency is not corrected within a certain time period.  Yowsa!

In U.S. v. Reorganized CF & I Fabricators of Utah, Inc., 518 U.S. 213 (1996), the Supreme Court was asked to opine on whether the §4791(a) 10% hit was a tax or a penalty for purposes of determining the proper place in the priority payout line the government’s claim for payment should go.  The Court said it was a penalty despite the label of “tax.”

But to properly understand the Court’s holding that §4971 was a penalty and not a tax, one must understand the relevant statutory scheme.  That is, I read the analysis in CF&I on whether §4971 imposed a penalty or a tax as exploring the reason for wanting to know whether it was a penalty and not a tax.  That involves understanding bankruptcy law and policy.

So let’s talk bankruptcy!  The reason the issue arose was because a major purpose of a bankruptcy proceeding is to sort out creditors’ claims into a payout order.  The basic statute where Congress sets out the priority of payouts is 11 U.S.C. §507.  Government claims for certain unsecured taxes are listed as 8th priority in §507(a)(8).  Included there are claims for excise taxes on transactions that either should have been reported on a return within 3 years before the date of bankruptcy or that occurred within the three year lookback period.  §507(a)(8)(E).

Government claims for unsecured taxes that are described in §507(a)(8) not only get a higher position in the payout priority line, they are also non-dischargeable, so the government can keep pursing the debtor even after bankruptcy.  11 U.S.C. §523(a).

In contrast, government claims for unsecured taxes that are not described in §507(a)(8) are put at the very bottom of the payout line and, additionally, may be dischargeable by the bankruptcy.  Similarly, government claims for what are called pecuniary loss penalties also get a place in the priority payout line. §507(a)(8)(G).  However, all other claims for penalties are relegated to last in the payout line alone with all the other general unsecured creditors and get discharged.

The bankruptcy purpose at issue was a key part of the Supreme Court’s analysis in CF&I.  The Court started its analysis by pointing out that “Here and there in the Bankruptcy Code Congress has included specific directions that establish the significance for bankruptcy law of a term used elsewhere in the federal statutes.” 518 U.S. at 219 (emphasis supplied).  Put another way: “No one denies that Congress could have included a provision in the Bankruptcy Code calling a §4971 exaction an excise tax (thereby affording it the priority claimed by the Government); the only question is whether the exaction ought to be treated as a tax (and, if so, an excise) without some such dispositive direction.”  Id. (emphasis supplied).

The Court gave multiple examples of where Congress had cross-referenced definitions of bankruptcy terms in non-bankruptcy statutes, include the Internal Revenue Code.  It found it significant that Congress did not cross-reference the Tax Code. Again, without an explicit tether, the question was whether §4971 created a tax or a penalty for bankruptcy purposes.  Here’s how the Court explained it:

“This absence of any explicit connector between §§ 507(a)(7)(E) and 4971 is all the more revealing in light of the following history of interpretive practice in determining whether a “tax” so called in the statute creating it is also a “tax” (as distinct from a debt or penalty) for the purpose of setting the priority of a claim under the bankruptcy laws.”  Id. at 220.

The Court then reviewed the “history of interpretive practice” for bankruptcy purposes and concluded that the Court always “looked behind the label placed on the exaction and rested its answer directly on the operation of the provision using the term in question.”

Applying that approach, and looking at the legislative history, the Court had no problem concluding that §4971 should be treated as a penalty for bankruptcy purposes.

Law: What Is a Penalty For Some Purposes Is a Tax For Others
You can see the “why do you want to know” analysis even more clearly in how Courts interpret two other statutes: §72(t) and §4975.

1. Section 72(t)

Section 72(t) imposes what it calls an “additional tax” when a taxpayer makes certain early withdrawals from their IRA.  The amount of this “additional tax” is 10% of the unpermitted early withdrawal. 

a. It’s a Penalty!

Bankruptcy courts have held that this “additional tax” imposed by §72(t) is a penalty for bankruptcy purposes.  You can find a great example of why in the case of In Re Bradford, 534 B.R. 839 (M.D. Ga. 2015).  There, Judge Carter follows the “why do you want to know” approach of CF&I and of other bankruptcy courts.  He explains that viewing the §72(t) as a tax and not a penalty undermines the purpose of the priority payout scheme because “giving preference to punitive exactions puts the “sting” of the deterrent on the creditors, such that the deterrent’s impact is lost.  These policies flow from the Bankruptcy Code’s overall objective in providing equal and fair distribution among creditors.”  534 F.R. at 857.

b. No, It’s a Tax!

In contrast to the bankruptcy courts finding that §72(t) is a penalty, the Tax Court has found that it is indeed a tax for supervisory approval purposes.  The leading case is  Grajales v. Commissioner, 156 T.C. 55 (2021).  There the taxpayer had received an early distribution of $900 and the IRS proposed to hit her with a $90 “additional tax” as authorized by §72(t).  It did not follow the supervisory approval procedures required by §6751(b).

Represented by the indefatigable Frank Agostino, the taxpayer argued that the IRS’s failure to obtain proper supervisory approval was fatal because §72(t) functioned as a penalty or at least as an “additional amount” within the scope of §6751(b).  Frank relied in part on the various bankruptcy cases like Bradford that had held §72(t) to be a penalty.

Judge Thornton rejects the applicability of the bankruptcy cases by noting that “an exaction may be a ‘tax’ for one purpose and a ‘penalty’ for another purpose, depending on the context.”  Id. at 61.

Reviewing the Tax Court case law, Judge Thornton does a great job explaining how §72(t) is properly viewed as a tax for various other contexts in the Tax Code.  For example, §7491(c) provides that the IRS “shall have the burden of production in any court proceeding with respect to the liability of any individual for any penalty, addition to tax, or additional amount imposed by this title.” Judge Thornton explains how the Tax Court has repeatedly held that §72(t) is not a “penalty, addition to tax, or additional amount” for purposes of shifting the burden of production.  Similarly, he cites Tax Court cases that hold §71(t) to be a tax for purposes of imposing joint and several liability under §6013.

2. Section 4975

Moving back to Subtitle D’s excise taxes, we find another excise tax just two sections up from today’s excise tax.  Section 4975 (“Tax on prohibited transactions”).  This is another two-tiered excise tax like the one in §4971.  It hits a “disqualified person” with a 15% excise tax on the value of any “prohibited transaction” between the person and certain tax-favored savings plans like a qualified annuity plan under §403(a).

a. It’s a Penalty!

Again, bankruptcy courts have found §4975 to be a penalty for bankruptcy purposes and for similar reasons found in CF&I.  For example, in In Re Unified Control Systems, 586 F.2d 1036, 1038 (5th Cir. 1978) the court followed the reasoning in Matter of Kline, 403 F.Supp. 974 (D.Md. 1975) and explained that the purpose of bankruptcy priority payouts would not be fulfilled where the government claim has a penal purpose, regardless of the label given, because giving that claim priority would punish the other creditors in the payout line rather than punish the debtor.

The Supreme Court of Iowa followed this reasoning in explaining why it also interpreted §4975 as a penalty for purposes of applying an insurance policy. See Hofco, Inc. v. National Union Fire Insurance Co., 482 N.W. 2d 397 (1992).

b. No, It’s A Tax!

Again, in contrast to the bankruptcy case law finding that §4975 is a penalty, federal courts have decided that the provision is really a tax after all, for Tax Code purposes.  In Latterman v. United States, 872 F.2d 564 (3rd Cir. 1989), the debate was how the interest rules in §6601 should apply to a §4975 liability.

The general rule of §6601(a) is that interest accrues on “any amount of tax” starting on “the last date prescribed for payment.”  But for interest on “any assessable penalty, additional amount, or addition to the tax” starts only after the taxpayer fails to pay “within 10 days from the date of notice and demand therefore.”  §6601(e)(2).

In Latterman the taxpayer engaged in a prohibited transactions in 1975 and 1978.  The IRS eventually caught him out and in 1983 sent him a notice and demand for payment of the excise tax amount of over $22,000 and accrued interest of almost $17,000.  Letterman claimed the IRS had assessed too much interest because the IRS had calculated interest from the due date of his returns in 1975 and 1978.  He argued that the IRS should have calculated interest starting 10 days after it had sent him notice and demand in 1983.

The Third Circuit decided that the §4975 excise tax was a tax for interest accumulation purposes.  It explained that the purpose of §6601 was to allow the government to collect an assessment in real dollars.  That meant that “interest must begin to accrue when the tax should have been reported.  Thus, in self-assessing situations §6601(a) governs, while in non-self-assessing situations, §6601(e)(2) governs.” Id. at 567.

The court then explained that the §4975 was a self-assessing situation because the IRS provided taxpayers with a specific form on which to self-report the 15% excise tax. In fact, Form 5330 is still used today and encompasses many of the Subtitle D excise taxes.

Law: The Purpose of the Supervisory Approval Requirements in §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.”

The Tax Court has spent a great deal of time and effort trying to make sense of the nonsensical text in §6751(b).  It has generally take a functional approach to evaluating how to judge the IRS’s compliance with the statute.  See Bryan Camp, Lesson From The Tax Court: A Practical Interpretation Of The Penalty Approval Statute § 6751, TaxProf Blog (Jan. 13, 2020).

The Tax Court bases its approach on a sliver of legislative history that suggests the purpose of the statute was to prevent misuse of penalties.  The perceived misuse was that IRS employees were stuffing penalties into proposed deficiencies simply to create a bargaining chip for when taxpayer went to the Office of Appeals.  See Senate Finance Committee Report, S. Rep. No. 105-174, at 65 (1998) ("The Committee believes that penalties should only be imposed where appropriate and not as a bargaining chip.").

The Tax Court’s approach to §6751(b) has created somewhat of a mess.  That is because it believes that the IRS must demonstrate the required supervisory approval before some ill-defined “consequential moment” where the IRS has made a sufficiently formal communication to the taxpayer of a sufficiently initial determination.  For more, 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).

The Tax Court's approach has been rejected by every Circuit Court to consider the matter, as I explain in Lesson From The Tax Court: The Rules For Penalty Approval Depend On Geography, TaxProf Blog (Oct. 30, 2023).  The Circuit courts read §6751(b) as creating what I call a horse-and-barn rule:  the supervisory approval does not need to come before an initial determination is communicated to the taxpayer.  It just has to come while the supervisor has the discretion to let the penalty horse out of the barn or keep it in the barn.  Once the penalty horse has left the barn (such as moving from Exam to Appeals), then it is too late to approve the penalty.

With this background, let’s take a look at today’s Lesson.

Facts and Lesson
The facts of this case important for today’s lesson are pretty straightforward.  Basically, Mr. Couturier received a $26 million buyout as part of a corporate reorganization and that money all ended up in his IRA.  Mr. Courturier reported the $26 million as a nontaxable rollover.  So he did not self-report a §4973 excise tax on his return for either the year he received the buyout or later years.  On audit, the IRS disagreed and thought that about $25 million was an excess contribution.  That triggered the §4973 excise tax which added up to some $8.5 million. The IRS sent him an NOD but without following its supervisory approval procedures for penalties.

This case has raised a number of really interesting procedural lessons that Keith Fogg and others have been blogging about on Procedurally Taxing.  Today’s lesson is just about one aspect of the case and arises because the IRS moved for summary judgment on whether it was required to have followed the §6751(b) supervisory approval procedures before sending Mr. Courturier the NOD for the excise tax.

Judge Lauber’s opinion spends two paragraphs discussing why, as a textual matter, the word “tax” in §4973 means “tax.”  He then says that while “this textual analysis suffices to resolve the issue” he will nonetheless explore “numerous other factors [that] all point in the same direction.” Op. at 5.  Uh huh.

Judge Lauber then spends fifteen more paragraphs (the rest of the opinion) conducing that exploration. LOL.  It’s in these 15 additional paragraphs that I see the lesson: the answer to the issue is really why do we want to know whether the excise tax is a penalty?  What is the Tax Code context for answering the question of whether §4973 is a tax or penalty?  Basically, Judge Lauber explains how §4973 is interpreted as a tax for many tax law purposes.  For example, the Tax Court has held that a taxpayer who fails to report their excise tax liabilities will be subject to the various “additions to tax” in §6651.  If §4973 were a penalty then it there could be no such “additions to tax.”

To me, the most interesting part of Judge Lauber’s 15-paragraph exploration is when he relates the §4973 provision to the purpose of the supervisory approval requirements.  Because that is really why we want to know whether this is a penalty or not.  Writes Judge Lauber:

“Congress enacted section 6751(b), requiring supervisory approval of penalties, to help ensure that penalties are asserted only “where appropriate” and “not as a bargaining chip” during settlement negotiations. In enacting this provision, Congress was responding to concerns that revenue agents might gin up penalties artificially at the end of an examination, then offer to remove them if the taxpayer agreed to accept the examination’s results.” Op. at 8.

Judge Lauber then notes that “section 4973 exactions cannot be used as “bargaining chips” in this way.”  In other words, the excise tax is not a penalty because reading it as a penalty does not fit into the purpose of the supervisory approval requirement.

This is my take-away lesson from today’s case.  An excise tax may be a penalty in some circumstances and a tax in others.  The basic approach to deciding the question is to ask “why do you want to know.”

Coda: Section 4401 imposes what is called an "excise tax" on wagers that are collected by any person "engaged in the business of accepting wagers."  That's a fancy way of saying "bookie."  It imposes the tax on the bookie.  As presently written the amount of the tax is 0.25 percent of the amount of each wager.  So that looks like a tax.  But as originally enacted, it was a penalty.  That is, the amount of the excise tax was set at 10%, not 0.25%.  See Cabot and Miller, Sports Wagering in America: Policies, Economics, and Regulation (2018). 

I was grateful to have a chat about this with Prof. Anthony Cabot, who has a long and distinguished career at UNLV in the subject area of gambling.  As I understand it (subject to correction from Mr. Cabot!) the 10% hit was intended to be a penalty, to knock out the bookies.  Indeed it did: it operated as a penalty because bookies generally run high-volume, low margin operations, far below the 10% tax.  Accordingly "the 10% wagering excise in 1951 devastated the sportsbook industry in Nevada." Id. at 30. ... Except for a few hardy bookies who kept double books.  After Congress reduced the tax to 2% in the 1970's and then to its current 0.25%, however, the industry and thus the 10% tax would have See generally their operations as it really would have shut down all

Bryan Camp is the George H. Mahon Professor of Law at Texas Tech University School of Law.  He invites readers to return on the first Monday of each month (or Tuesday if Monday is a federal holiday) to TaxProf Blog for another Lesson From The Tax Court.

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I believe you have a transposition in the second paragraph discussing Fabricators where you currently reflect 4791(a) instead of 4971(a).

Posted by: Rick G | May 6, 2024 1:12:55 PM


Your postings are always good and contribute to my CLE.

I want to engage on one point you make. You cite Latterman v. United States, 872 F.2d 564 (3rd Cir. 1989) for the proposition that “the purpose of §6601 was to allow the government to collect an assessment in real dollars.” (The Tax Court in Couturier also cites Latterman but not for that proposition.) Latterman says that (p. 567):

The clear, overarching purpose of § 6601 is to allow the government to recover amounts due in "real" (inflation-adjusted) dollars. That section therefore ties its interest rate to the prime rate. § 6621. When a taxpayer owes the government money and delays payment after the date on which payment was due, the government should not have to suffer a depletion in real dollars because of that delay and, conversely, the taxpayer should not reap the benefit of delaying payment, thereby in effect diminishing the amount owed.

However, I was curious about this explanation of tax interest in § 6601 (which I suppose could be used to explain other interest provisions in the Code). I have most commonly seen (or at least noted) interest as compensation for the use of money–like rent. To be sure, in the real world, a lender factors in both the “rent” for the money and the risk of inflation in reduced-value dollars. See e.g., Bank of NY Mellon Corp. v. Commissioner, 140 TC 15, 41 (2013) (IRS expert testified that commercial loans are priced depending on “on the time value of money and the risks presented to the lender through the particular loan transaction;” of course, a risk presented is payment of the principal in deflated dollars). Economically, the benchmark for benchmark for calculating interest (federal short term rate) will have an inflation risk factor. But I don’t think that inflation risk is the principal component or is usually stated as the reason for § 6601 or was in Congress’ mind for § 6601 and related interest provisions in the IRC.

Posted by: Jack Townsend | May 6, 2024 12:33:34 PM

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