Firm Criticizes IRS’s Penalty Approval Rules as ‘Self-Serving’

July 10, 2023

CC:PA:LPD:PR
(REG-121709-19), Room 5203
Internal Revenue Service
PO Box 7604
Ben Franklin Station
Washington, DC 20044

IRS should not be allowed to render a Code provision meaningless by contorting the definition of “initial determination” to deprive a competent court from Congressionally-mandated review of that determination (1) that the penalty has a factual basis and (2) that the penalty was timely approved during the only time period when it could have been used as a bargaining chip.

The proposed regulations' Explanations section asserts that the IRS's violation of the Code provision sometimes results in a Court not determining the penalty can apply “without any indication that the penalty was improper” and when “imposition of the penalty would be proper but for the IRS's failure to obtain written supervisory approval by the deadline”. One can easily see how the IRS could be aggrieved by being penalized for failure to follow the Code. Accordingly, the IRS concedes that the 6751(b) inquiry and these proposed regulations should encompass whether the penalty should apply at all, not just when and whether the appropriate approval is provided.

Bargaining Chip

Congress instructed that in order to ensure the IRS does not threaten penalties as bargaining chips during audit, any penalty must be approved in writing before it is initially determined to apply against a taxpayer. A penalty can only be a bargaining chip between the IRS and the taxpayer. Once a case is in court (deficiency or refund suit) the court determines whether the penalty applies legally. No court can treat any penalty as a bargaining chip for or against any party. By simply issuing regulations declaring the determination of penalties automatically occurs on the notice issued to the party and mandating that every agent's supervisor sign the notice, the IRS is attempting by regulation to circumscribe the scope of Congress' instruction and any Court's inquiry. This does not prevent the assertion of penalties from being a bargaining chip, it simply attempts to prevent the Congressionally mandated inquiry by a court.

Initial Determination

If the initial determination is in the Notice, the only way to fail 6751(b) is for the notice to be unsigned by the agent's supervisor. If that were to happen, IRS would simply seek to dismiss the taxpayer's petition as not predicated by a notice giving access to any court. If the initial determination does not happen until assessment, the Tax Court would have no jurisdiction to even make the inquiry. Under both scenarios the penalties are used as bargaining chips and in both scenarios no court is able to make the required 6751(b) inquiry.

If no court can inquire as to whether the penalties were used as bargaining chips, there is no meaningful oversight and no operation for this Code provision. Further this position incentivizes assertion of every penalty at the outset of any audit, accordingly the IRS is making no individualized determinations of penalty application. These proposed regulations are simply an attempt by IRS to avoid oversight and review, where the Code mandates that review and the Courts of Appeal disagree as to the timing of the inquiry.

The Taxpayer Advocate included in her 2023 Purple Book that the inquiry must be earlier, not later:

At first, it seems a requirement that an “initial determination” be approved by a supervisor would mean the approval must occur before the penalty is proposed. However, the timing of this requirement has been the subject of considerable litigation, with some courts holding that the supervisor's approval might be timely even if provided after a case has gone through the IRS Independent Office of Appeals and is in litigation. Very few taxpayers litigate their tax disputes. Therefore, to effectuate Congress's intent that the IRS not penalize taxpayers in certain circumstances without supervisory approval, the approval must be required earlier in the process . . . [ ]where written supervisory approval is required, it should be required early enough in the process to ensure it is meaningful and is not merely an after-the-fact rubber stamp applied in the cases in which a taxpayer challenges a proposed penalty.¹

The proposed regulations also abandon the plain language meaning of “initial determination”. In Example 4, a revenue agent “concludes” that a taxpayer should be subject to penalties under section 6662(c). However, her immediate supervisor believes more factual development is needed but must close the audit due to the impending statute of limitations. The IRS issues a statutory notice of deficiency without penalties under section 6662(c). After the taxpayer files his petition, IRS counsel proposes to her supervisor that the IRS answer should include a penalty under section 6662(c). The manager approves. The example holds that IRS counsel is the individual “who first proposed the penalty.”

The revenue agent first proposed the penalty in that example, not IRS counsel. The example's holding proposes starting with the penalty and looking backwards to find the last person to propose the penalty — not the first. In the example, the revenue agent concluded the penalty should apply. How can the revenue agent not be the person who first proposed the penalty, even if that proposal was denied? Any other reading would be contrary to a plain language understanding of the words “first” and “proposed.” Such a read would also violate section 6751(b), which requires approval from the immediate supervisor of the person who made the “initial” determination. Not second or third, but initial.

Immediate Supervisor

The IRS routinely asserts penalties after several levels of mandatory review, accordingly, the title of the person first determining a penalty is not dispositive as anyone involved in that process may initially determine a penalty which will meet the requirements of section 6751(b), so long as that person's immediate supervisor approves such penalty in writing. Accordingly, penalties may be initially determined by:

If the person has the authority to correct the revenue agent's initial determination and/or instruct the revenue agent to assert any other penalty, that person is initially determining the additional penalty and that person's immediate supervisor must provide timely written approval of such penalty under section 6751(b). If the IRS wishes to confine the section 6751(b) inquiry to only the revenue agent and the agent's supervisor, then the IRS must mandate that no other employee may instruct that agent to alter their initial determination. This is the core purpose of section 6751(b) — Congress does not mandate who makes the initial determination, it only instructs that we must look to that person's immediate supervisor for the written approval of such determination. By mandating multiple levels of review of penalties by IRS employees, each of which are permitted to instruct the revenue agent as to penalties, the IRS widens the scope of section 6571(b), not taxpayers.

The Penalty Form has evolved to prevent individual inquiries

Congress passed this statute to “clamp down” on the prior IRS practice of asserting penalties without appropriate deliberation. See Roth v. Comm'r, 922 F.3d 1126, 1132 (10th Cir. 2019). The Second Circuit has reinforced this notion, adding “[t]he statute was meant to prevent IRS agents from threatening unjustified penalties to encourage taxpayers to settle.” Chai v. Comm'r, 851 F.3d 190, 219 (2d Cir. 2017) (emphasis added). Underpinning this caselaw is an understanding that the government must have some factual basis for the penalty before asserting it.

Black's Law Dictionary defines justification as “1. A lawful or sufficient reason for one's acts or omissions; any fact that prevents an act from being wrongful. 2. A showing, in court, of a sufficient reason why a defendant acted in a way that, in the absence of the reason, would constitute the offense with which the defendant is charged.” Justification, Black's Law Dictionary (11th ed. 2019). Section 6751(b), as it has been interpreted, requires that Respondent have a justification before threatening a taxpayer with a penalty. Further, Congress's purpose in enacting Section 6751(b) was to afford “maximum protection to taxpayers against the improper wielding of penalties as bargaining chips.” Graev v. Comm'r, 149 T.C. 485, 501 (2017) (Lauber, J., concurring) (emphasis added). Reliance on a civil penalty form, without some factual basis for the calculation which would show a penalty could apply, only affords maximum protection to the IRS.

To make matters worse, practitioners who submit Freedom of Information Act (“FOIA”) requests for their clients' file have seen just how little deliberation often goes into the “initial determination.” Indeed, emails between the revenue agent and his or her supervisor regularly show the “initial determination” amounts to a thoughtless three-step process:

In effect, the supervisor in this example is both initially determining the additional penalty AND purporting to provide supervisory approval for this same penalty.

Further, every practitioner has seen the penalty forms evolve to include pre-printed language and an expansive list of penalties, such that revenue agents need only put an X in a box and forward the form to their supervisor for sign off. There is more often no discussion explaining why any penalty applies to any taxpayer, and yet in the Explanations section IRS bemoans that without the signature on the form an otherwise appropriate penalty fails. Congress did not implicitly or explicitly require the IRS to create and utilize a superfluous form, nor provide a rubber stamp by a supervisor — Congress instructed that any person who initially determines that a penalty applies to a taxpayer on the merits and not as a bargaining chip, and then that person's immediate supervisor must review application of the penalty and then approve the initial determination of the penalty.

The proposed regulations seek to prevent the operation of the Code

The Internal Revenue Code mandates that the Court's inquiry include a determination of the penalty, not just a form recording the penalty. Congress determined that taxpayers' ability to prove entitlement to deductions and credits (and therefore inapplicability of penalties) was not sufficiently protected by the Code and therefore enacted Section 6751(b). The provision references “penalt[ies] under this title,” and therefore under the canon “in pari materia” the approval requirement must be read together with the remaining portions of the statute. The second half of the sentence does not stand independently of the first half. Each portion of Section 6751 must be given meaning. The Supreme Court explained as much in TRW Inc. v. Andrews:

It is “a cardinal principle of statutory construction” that “a statute ought, upon the whole, to be so construed that, if it can be prevented, no clause, sentence, or word shall be superfluous, void, or insignificant.” Duncan v. Walker, 533 U.S. 167, 174 (2001) (internal quotation marks omitted); see United States v. Menasche, 348 U.S. 528, 538-539 (1955) (“It is our duty 'to give effect, if possible, to every clause and word of a statute.'” (quoting Montclair v. Ramsdell, 107 U. S. 147, 152 (1883))). . . . We are “reluctant to treat statutory terms as surplusage in any setting,” ibid. (internal alteration and quotation marks omitted), and we decline to do so here.

534 U.S. 19, 31 (2001); see also United States v. Home Concrete & Supply LLC, 566 U.S. 478, 484-85 (2012) (similar). Section 6751(b) is not limited to the question of whether supervisory approval existed; it also requires an inquiry into the “penalt[ies] under this title.” To read the statute otherwise would render the language “under this title” superfluous. This failure often occurs when the IRS does not attempt to show that the penalty applies according to the statutory terms — such as a calculation mathematically showing a certain percentage or a failure to utilize its own resources to make an alternative valuation.

An attempt to bolster a litigation position and avoid any judicial inquiry

The IRS has routinely taken the position that the reviewers of the revenue agent's work cannot initially determine a penalty, even when faced with an email or memorandum to the agent identifying a new penalty that provides explicit or implicit instructions to the revenue agent to create a new penalty form and ask that their immediate supervisor sign the form. When the reviewing IRS attorney tells the revenue agent to include an additional penalty, the IRS attorney's immediate supervisor is often neither contacted about the case nor informed about the additional penalty and instead IRS attempts to use the revenue agent to shield the IRS attorney's initial determination of the penalty and the IRS attorney's obligation to obtain his or her immediate supervisor's approval. Further still, these proposed regulations seek to prevent any inquiry into that fact that the reviewing attorney is the first employee to decide another penalty applies.

In the absence of a timely signed civil penalty approval form, the IRS instead takes the position that the agent determined a penalty in the notice (because it is drafted by the agent) and signed by their supervisor. This routinely happens when an Answer is filed, and then that reviewing attorney has their immediate supervisor sign the Answer, but the IRS wants the Courts to believe that the prior instruction by an attorney to an agent has no effect. In that instance the reviewing attorney must be initially determining that a penalty applies — if that action was outside of the reviewing attorney's authority, the agent would not be mandated to send the notice to the reviewing attorney or follow the reviewing attorney's instruction.

We have seen many administrative records created and provided by the IRS where the attorney instructs the agent to determine another penalty, simultaneously we have seen many administrative files with several penalty forms, each of which are signed by the agent's immediate supervisor, often within minutes and without any explanation why a penalty should apply even when the penalty Code section requires a calculation before it can apply. The administrative files created by the IRS only provide evidence that the revenue agent's immediate supervisor acts as a rubber stamp and there are many people who can instruct the agent to “determine” a penalty.

The evolution of the civil penalty approval form shows that the IRS is further limiting the revenue agent's role by creating a form pre-populated with every penalty under the Code and simply requires an X and a line for the supervisor signature. Earlier versions had some perfunctory explanation sections, but the newer forms are completely pre-printed. The IRS seeks to fulfill its 6751(b) obligations through the presentation of a form and asks that the Courts ignore any evidence to the contrary. This is especially concerning now that there is evidence that the signatures and dates on the forms can be manipulated and that even senior IRS attorneys are unconcerned with this violation of the Code. Lakepoint Land II, LLC v. Comm'r, No. 13925-17 (T.C. June 9, 2023), and its companion case pending in federal district court, Lakepoint Land Grp., LLC v. U.S. IRS, No. 1:23-cv-01553 (D.D.C. June 7, 2023). If these regulations are implemented in final form, they would only attempt to prevent review of the fraud on the Court in Lakepoint and potentially other cases.

The IRS cannot by regulation, seek to prevent the review Congress instructed. Congress left up to the IRS how it wished to determine penalties, but the reality created by the IRS inserts several levels of mandatory review, each of which can instruct the revenue agent to change their position on any penalty. By self-limiting who can draft a notice or fill in a form and who can sign that notice or form, the IRS wants the Courts to ignore any of its other contemporaneous records to the contrary. The IRS is in control of every aspect of the initial determination and cannot simultaneously expand the list of individuals who have the authority to instruct the agent while limiting review to only one of them.

Conclusion

These proposed regulations do not protect taxpayers against the ills Congress intended to correct and instead are only self-serving. The only “clarity” these proposed regulations would provide is certainty that IRS can prevent any inquiry into its failures to follow 6751(b). These proposed regulations seek to protect the IRS's litigation position and limit or eliminate any review of the agency's actions regarding penalties.

Recommendations

If the IRS wants any Court to limit its inquiry to a revenue agent and their immediate supervisor only, it must not allow any instruction as to penalties from any person other than the agent's immediate supervisor. If that limitation is not sufficient for IRS's purposes, then the IRS must admit that when a person other than the revenue agent raises an additional or alternate penalty, that person is “initially determining” that the new penalty applies and that person's immediate supervisor must approve the new penalty in writing. To act or instruct otherwise violates the Code and should be removed from the proposed regulation.

If the IRS proceeds with a regulation on this issue, it must (1) identify the role of any individual eligible to “initially determine” a penalty and (2) both limit and identify the role of any other individual who can instruct that individual initially determining the penalty. Without this limitation, the term initial determination has no meaning.

By taking the position that the penalties are not “determined” until the issuance of the notice, the IRS seeks to eliminate the word “initial” from the Code. By the time a penalty appears in the notice, it has been determined to apply by anywhere from 2 to 10 people, often for the first time by someone other than the revenue agent. The IRS is not confused by the term “initial”; it just finds the results of the word inconvenient and seeks to alter its plain meaning through these regulations. The IRS should excise any limitation of the term “initial determination” to only the revenue agent.

Respectfully submitted,

Elizabeth K. Blickley
Nicholas Lyskin
Adam R. Young
Fox Rothschild LLP
Washington, DC