Rule in Penalty Approval Regs Won’t Protect Rights, Law School Says

July 7, 2023

Attn: David Bergman, Office of the Associate Chief Counsel
Internal Revenue Service
P.O. Box 7604
Ben Franklin Station
Washington, D.C. 20044

Dear Mr. Bergman:

The following comments were composed by the Director of the University of Minnesota Law School Tax Clinic (Minnesota Tax Clinic), with student contributions from Alex Mueller, Cierra Johnson, and Robin Willis at the University of Minnesota Law School. These comments reflect the opinions of the Minnesota Tax Clinic, but not necessarily of the University of Minnesota Law School.

On April 11, 2023, the Treasury Department and the Internal Revenue Service (IRS) released a Notice of Proposed Rulemaking (proposed regulations) applicable to Internal Revenue Code (IRC) section 6751. As stated in the notice, the proposed regulations were issued primarily to address uncertainty regarding when and how supervisory approval is required for various tax penalties.

We commend the Treasury Department and the IRS for taking steps to formally issue regulations and bring clarity and consistency to the application of this area of law. The Minnesota Tax Clinic has limited its comments and recommendation to one specific issue, which we believe has the greatest impact on low-income taxpayers: changing the proposed definition of what qualifies as “automatically calculated through electronic means.”¹

The Automatically Calculated Exception in the Proposed Regulations

Under the statute, no supervisory approval is required for a penalty that is “automatically calculated through electronic means.”² In Walquist v. Commissioner,³ the Tax Court interpreted this to include IRC §6662(b)(2) “substantial understatement” penalties that resulted from fully automated examinations where the taxpayers never responded to the exam prior to petitioning the Tax Court.

The proposed regulations largely adopt the Walquist decision. As relevant, the proposed regulations provide that a penalty is “automatically calculated through electronic means” if “an IRS computer program automatically generates a notice to the taxpayer that proposes the penalty.”⁴

However, the proposed regulations also provide that the penalty is not considered “automatically calculated through electronic means” if two things occur. First, the taxpayer must respond to the notice “in writing or otherwise,” challenging the proposed penalty or the tax it is attributable to.⁵ Second, an IRS employee must “consider” the response prior to assessment or the issuance of a notice of deficiency that includes the penalty.⁶

Both of these conditions must be met for the taxpayer to receive the procedural protection of supervisory approval of the penalty. Unfortunately, the second condition required in the proposed regulations is highly problematic.

Problems with the Requirement that an IRS Employee “Consider“ the Taxpayer Response

The fundamental problem with the proposed regulation requirement is that it rewards dilatory IRS behavior. Indeed, the proposed regulation actually removes procedural taxpayer protections (i.e. supervisory approval of penalties) in instances where the IRS behaves poorly. A simple example illustrates the problem.

Assume essentially all of the same relevant facts of the proposed regulation “Example 5.”⁷ As provided in that example, a taxpayer receives a “CP2000 Notice” alleging that there was unreported income and proposing a penalty under IRC §6662(d). The taxpayer is given 30 days from the date of the CP2000 Notice to respond to the IRS. The taxpayer responds within those 30 days.

Unlike the proposed regulation example, however, assume that the taxpayer directly disputes the penalty (or underlying tax) in their response to the CP2000 Notice. What happens next?

If the IRS simply ignores the taxpayer response and throws it in the trash (or never processed it to begin with) a notice of deficiency would be sent shortly thereafter. At that point, because no IRS employee “considered” the taxpayer response prior to that notice of deficiency, no supervisory approval would be required for the penalty. A curious result.

But the problem persists even where there is no “bad actor” at the IRS. If the taxpayer sends the response and the IRS is overloaded with work such that no employee sees the response prior to the notice of deficiency, the same outcome occurs: no supervisory approval is required.

These examples highlight the same overarching problem: under the proposed regulation a taxpayer can do everything “right” and still not receive the statutory protection. Instead, the determining factor is whether the IRS takes the correct action, which perversely removes protections for the taxpayer when the IRS does not do so.

Worse, these are not far-fetched hypotheticals. The IRS “Status of Mission-Critical Functions” presently indicates responses to IRS letters or notices are “taking longer than usual due to resource restrictions.”⁸ There is already an extremely tight deadline from the issuance of a CP2000 Notice to the notice of deficiency: generally, 30 days.⁹ It is not at all unlikely that many taxpayer responses (especially those towards the end of the 30 days) are not processed, let alone considered, by an IRS employee until after a notice of deficiency has already been issued.

Indeed, the Minnesota Tax Clinic has seen multiple instances where a notice of deficiency was issued prior to the deadline to respond to an examination letter.¹⁰ Technically, under the proposed regulations, an “early” notice of deficiency would nonetheless remove the supervisory approval requirement for the penalties proposed in exam.

Lastly, we would note that even diligent taxpayers that send a letter and attempt to call the IRS may be out of luck. Automated examinations do not include the contact information for an individual at the IRS that the taxpayer can contact: they must call a general phone line.¹¹ Unfortunately, the problems with the IRS's “level of service” on phone calls are well documented. During the 2022 filing season, the IRS had a level of service of approximately 18%.¹² Again, the taxpayer's access to the statutory protection (i.e. supervisory approval of a penalty) could depend more on the IRS's behavior than on the taxpayer's.

Recommendation and Reasons for Change

We recognize the difficulties the IRS faces in administering the underlying code section. Nonetheless, and put simply, the proposed regulation's definition of “automatically calculated through electronic means” does not protect taxpayer rights.¹³ Additionally, it does not advance the IRS's own penalty policies.¹⁴

In considering our recommendations, we think it is relevant to first consider exactly which taxpayers are most likely to be affected by the proposed regulation language at issue. We think it is undeniable that the “automatically calculated through electronic means” exception will apply predominantly and disproportionately to taxpayers with low or moderate incomes. The reason is simple: these are the taxpayers that are most likely to be subject to a fully automated exam in the first place.

The most salient example of this involves the Earned Income Tax Credit (EITC), which is means-tested and generally only available to taxpayers with very modest earned income.¹⁵ Taxpayers claiming the EITC tend to be audited at a higher rate than other similarly situated taxpayers.¹⁶ Notably and importantly, these audits are almost entirely automated and by correspondence. In the most recent fiscal year, 99.36% of the closed EITC exams were done by automated correspondence.¹⁷ Thus, essentially 100% of the exams on low-income taxpayers claiming the EITC are likely to implicate the “automatically calculated through electronic means” issue when an accuracy penalty is proposed in the initial exam letter.

Wealthy taxpayers, by contrast, are relatively unlikely to be subject to automated exams. In the most recent fiscal year, of examinations closed on taxpayers with positive income over $1 million approximately 54% were from field (i.e. non-automated) exams.¹⁸ Accordingly, wealthy taxpayers are more likely to be afforded a statutory protection (the requirement for supervisory approval on penalties) than low-income taxpayers are.¹⁹ This seems fundamentally unfair, and not in accordance with the IRS's own penalty policies.

A stated purpose of tax penalties is to “enhance voluntary compliance.”²⁰ The IRS policy states that voluntary compliance is enhanced when penalties (1) demonstrate the fairness of the tax system to compliant taxpayers, and (2) increase the cost of noncompliance.²¹

Studies and the IRS's own guidance reflect that the taxpayer's perception of the tax system being fair drives voluntary compliance.²² The relevant literature suggests that there are “three main components of fairness: horizontal equity, proportionality, and procedural fairness.”²³ At a minimum, the proposed regulation language fails to promote the perception of a fair system on horizontal equity and procedural fairness grounds.

It does not demonstrate procedural fairness, as the proposed regulation language would create a system that (1) functionally provides more protections for high-income earners than low-income earners, and (2) strips away protections from diligent taxpayers when the IRS acts poorly (or fails to act at all). It also does not demonstrate horizontal equity, since two taxpayers situated exactly the same and taking exactly the same actions (i.e. sending a response to an IRS examination) can get different legal protections depending on whether an individual IRS employee acts or fails to act.

By failing these two components of fairness there is little reason to believe that the proposed regulation language will “demonstrate the fairness” of the tax system thereby failing to meet the goal of increasing voluntary compliance. Further, there is little reason to believe that the cost alone of the substantial understatement penalty does much to increase compliance.²⁴ The proposed regulation language at issue, therefore, is unlikely to enhance voluntary compliance, and in fact could undermine it by creating a perception that the IRS acts arbitrarily or that the system favors the wealthy.

Recommendation and Recommended Language

We recommend that the proposed regulations fully remove the requirement that an IRS employee consider a taxpayer's response for the penalty to no longer be “automatically calculated through electronic means.” In addition to the problems we have already outlined, it is entirely possible that in the future many responses (especially to low-income taxpayers) by the IRS may be performed by chatbots or with the use of other generative artificial intelligence. Arguably, increased IRS reliance on automation would only further impede taxpayers from the protection of supervisory approval.

To avoid these issues, we recommend that the “automatically calculated through electronic means” exception look solely at the behavior of the taxpayer. That is, did the taxpayer actually and timely respond to the IRS proposal of the penalty? If so, the penalty should no longer be considered “automatically calculated through electronic means.”

Our recommended language is as follows:

§301.6751(b)-1(a)(3)(vi)

Automatically calculated through electronic means. A penalty, as defined in paragraph (a)(3)(i) of this section, is automatically calculated through electronic means if an IRS computer program automatically generates a notice to the taxpayer that proposes the penalty. If a taxpayer responds in writing or otherwise to the automatically-generated notice and challenges the proposed penalty, or the amount of tax to which the proposed penalty is attributable prior to assessment or the issuance of a notice of deficiency that includes the penalty (or prior to the deadline to respond specified in the notice, if such deadline is later than either assessment or the issuance of the notice of deficiency), then the penalty is no longer considered “automatically calculated through electronic means.”

We appreciate your attention to our comments, and hope that you will take seriously our concerns about the proposed regulation language. We believe our recommendation is both administratively workable and better in-line with the purpose and policy of tax penalties.

Caleb Smith
Clinical Professor of Law
Director, University of Minnesota Law School Ronald M. Mankoff Tax Clinic
190 Walter Mondale Hall
229 19^th Ave S
Minneapolis, MN 55455