ABA Tax Section Suggests Changes to Proposed Supervisory Approval Regs

July 7, 2023

Hon. Daniel I. Werfel
Commissioner
Internal Revenue Service
1111 Constitution Avenue, NW
Washington, DC 20224

Re: Comments on Proposed Regulations under Section 6751

Dear Commissioner Werfel:

Enclosed are comments on the Proposed Regulations under section 6751(b) concerning supervisory approval of certain penalties. These comments are submitted on behalf of the Section of Taxation and have not been reviewed or approved by the House of Delegates or the Board of Governors of the American Bar Association. Accordingly, they should not be construed as representing the position of the American Bar Association.

The Section of Taxation would be pleased to discuss these comments with you or your staff.

Sincerely,

C. Wells Hall, III
Chair, Section of Taxation
American Bar Association
Washington, DC

Enclosure

cc:
Hon. Lily Batchelder, Assistant Secretary (Tax Policy), Department of the Treasury
Thomas West, Deputy Assistant Secretary (Tax Policy), Department of the Treasury
Krishna P. Vallabhaneni, Tax Legislative Counsel, Department of the Treasury
William M. Paul, Principal Deputy Chief Counsel and Deputy Chief Counsel (Technical), Internal Revenue Service
Douglas W. O'Donnell, Deputy Commissioner for Services and Enforcement, Internal Revenue Service
Drita Tonuzi, Deputy Chief Counsel (Operations), Internal Revenue Service
Kathryn Zuba, Associate Chief Counsel (Procedure & Administration), Internal Revenue Service
David Bergman Senior Counsel, of the Office of the Associate Chief Counsel (Procedure and Administration), Internal Revenue Service

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AMERICAN BAR ASSOCIATION
SECTION OF TAXATION

Comments on Proposed Regulations under Section 6751

These comments (“Comments”) are submitted on behalf of the American Bar Association Section of Taxation (the “Section”) and have not been reviewed or approved by the House of Delegates or Board of Governors of the American Bar Association. As a result, they should not be construed as representing the position of the American Bar Association.

Principal responsibility for preparing these Comments was exercised by Brian McManus and Benjamin Eisenstat. Substantial contributions were made by Lawrence A. Sannicandro, Daniel Price, Sarah Paul, Fran Obeid, Frank Agostino, Lee S. Meyercord, and Elizabeth Kanyer. Additional comments were made by Susan Morgenstern, Anna Gooch, and Robert Probasco. These Comments have been reviewed by John M. Colvin of the Committee on Government Submissions, and Lisa M. Zarlenga, Vice-Chair for Government Relations for the Tax Section.

Although members of the Section may have clients who might be affected by the federal tax principles addressed by these Comments, no member who has been engaged by a client (or who is a member of a firm or other organization that has been engaged by a client) to make a government submission with respect to, or otherwise to influence the development or outcome of one or more specific issues addressed by, these Comments has participated in the preparation of the portion (or portions) of these Comments addressing those issues. Finally, while the Section's diverse membership includes government officials, no such official was involved in any part of the drafting or review of these Comments.

Contact: Brian C. McManus
brian.mcmanus@lw.com
(617) 948-6016

Date: July 7, 2023

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EXECUTIVE SUMMARY

On April 10, 2023, the Internal Revenue Service (the “Service”) and the U.S. Department of the Treasury (“Treasury”) issued Proposed Regulations under section 6751(b)¹ concerning supervisory approval of certain penalties (the “Proposed Regulations”).² Section 6751(b)(1) generally requires written supervisory approval of certain penalties. In recent years, there has been significant litigation regarding when the Service must obtain supervisory approval as well as who must approve the penalty and the form of that approval. The Proposed Regulations are intended to address the uncertainty that stems from differing interpretations of the requirements of section 6751(b)(1) arising from the various court opinions. For example, the Tax Court has held that supervisory approval is required before the first formal written communication of the penalty; other courts have held that approval is required before the issuance of a notice of deficiency; and other courts only require approval before the entry of an assessment.

The Proposed Regulations provide specific timing rules for supervisory approval of (1) penalties subject to pre-assessment review in the Tax Court, (2) penalties raised for the first time in the Tax Court after a petition is filed, and (3) penalties not subject to pre-assessment review in the Tax Court. The Proposed Regulations further define key terms, including “immediate supervisor” and “higher-level official,” and clarify the exemption to the approval requirement for penalties “automatically calculated through electronic means.”

The Proposed Regulations allow supervisors to approve the initial determination to assess a penalty up until the time the Service issues a pre-assessment notice. The preamble to the Proposed Regulations explains that “earlier deadlines created by the Tax Court do not ensure that penalties are only imposed where appropriate,”³ and the “bright-line rule relieves supervisors from having to predict whether approval at a certain point will be too early or too late.”⁴ Penalties raised for the first time in the Tax Court after a petition is filed, such as in an answer or an amended answer, allow supervisory approval to be given at any time before the Commissioner requests that the court determine the penalty. Supervisory approval for penalties not subject to pre-assessment review in the Tax Court may be obtained at any time before the actual assessment.

We look forward to working with Treasury and the Service throughout the implementation process of the Proposed Regulations. To that end, we offer these comments and recommendations:

BACKGROUND

Section 6751 was added to the Code by section 3306 of the Internal Revenue Service Restructuring and Reform Act of 1998 (“1998 Act”).⁷ Section 6751(b) provides procedural requirements for the Secretary of the Treasury or her delegate to assess certain penalties under the Code.⁸ Section 6751(b)(1) provides 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.”

Section 6751(b)(2) provides exceptions to the approval requirement. Section 6751(b)(2), as originally enacted, provides that section 6751(b)(1) “shall not apply to — (A) any addition to tax under §§6651, 6654, or 6655; or (B) any other penalty automatically calculated through electronic means.” Section 6751(b)(2)(A) was subsequently amended to expand the list of penalties excepted from the supervisory approval requirement, adding additions to tax under sections 6662(b)(9) and (10), relating to disallowed deductions for certain charitable contributions.⁹

The 1998 Senate Finance Committee Report accompanying section 6751 stated that the Committee believed that penalties should only be imposed “where appropriate and not as a bargaining chip.”¹⁰ Thus, section 6751(b)(1) “requires the specific approval of IRS management to assess all non-computer generated penalties unless excepted.”¹¹ Treasury and the Service have concluded that “it is in the interest of sound tax administration to have clear and uniform regulatory standards for the penalty approval requirements under §6751(b).”¹²

The Proposed Regulations adopt three significant timing rules for when the Service must obtain supervisory approval under section 6751(b):

The Proposed Regulations define key terms, such as “immediate supervisor,” “higher level official,” “individual who first proposed the penalty,” “personally approved (in writing),” and “automatically calculated through electronic means.” Prop. Treas. Reg. §301.6751(b)-1(a)(3)(iii) defines the term “immediate supervisor” as “any individual with responsibility to approve another individual's proposal of penalties without the proposal being subject to an intermediary's approval.” Prop. Treas. Reg. §301.6751(b)-1(a)(4) designates a higher level official authorized to approve an initial penalty determination for purposes of section 6751(b)(1) as any person directed via the Internal Revenue Manual (“IRM”) or other assigned job duties to approve another individual's proposal of penalties before they are included in a notice prerequisite to Tax Court jurisdiction, an answer (or amended answer) to a Tax Court petition, or are assessed without need for such inclusion.

To identify which supervisor should approve an initial penalty determination, the preamble states that it must be clear which individual made the “initial determination of [a penalty] assessment.”¹³ Prop. Treas. Reg. §301.6751(b)-1(a)(3)(ii) provides that the individual who first proposes a penalty is the individual who section 6751(b)(1) references as the individual making the initial determination of a penalty assessment. Prop. Treas. Reg. §301.6751(b)-1(a)(3)(ii) also provides that the “proposal” of a penalty includes penalty proposals made either to a taxpayer (or the taxpayer's representative), or (in the context of making a request for approval of a proposed penalty assertion) to either the individual's supervisor or a designated higher level official.

Section 6751(b)(1) requires that the immediate supervisor “personally approve[ ] (in writing)” the initial determination to assert a penalty. Prop. Treas. Reg. §301.6751(b)-1(a)(3)(v) provides that “personally approved (in writing)” means any writing, including in electronic form, that is made by the writer to signify the writer's assent and that reflects that it was intended as approval.

Under section 6751(b)(2)(B), supervisory approval is not required for penalties “automatically calculated through electronic means.” Prop. Treas. Reg. §301.6751(b)-1(a)(3)(vi) provides that a penalty is “automatically calculated through electronic means” if it is proposed by a Service computer program without human involvement. A penalty is no longer considered “automatically calculated through electronic means,” however, if a taxpayer responds to a computer-generated notice proposing a penalty and challenges the penalty or the amount of tax to which the penalty is attributable, and an employee of the Service works the case.

DISCUSSION

Penalties should be used only to “encourage voluntary compliance” by taxpayers and not as a “bargaining point” in exchange for resolving a tax adjustment.¹⁴ To that end, the Service issued its Penalty Policy Statement to promote fairness in administrating penalties and standardize the behavior expected by its employees.¹⁵ In that policy statement, the Service observed that for penalties to be effective, they must “relate to the standards of behavior they encourage” and apply only when the specific facts fully support the application of a penalty.¹⁶ This leads to similarly situated taxpayers being treated alike and promotes fairness.¹⁷ When penalties are imposed in an evenhanded and judicious manner, tax offenders are penalized while compliant taxpayers are encouraged by unbiased and fair tax administration.¹⁸

Although penalties are not supposed to be used as a “bargaining point,” both taxpayers and Service personnel often view them as such. It has been observed that “[t]axpayers and their representatives frequently offer to agree to all, or a larger portion, of a deficiency in exchange for a government concession of the penalties,”¹⁹ while “the IRS will often say if you don't settle, we are going to assert the penalties. If you do settle, we may not assert the penalties.”²⁰ When penalties are used — or are perceived to be used — as bargaining chips, they no longer serve their intended purpose — they skew the system, underpenalizing tax offenders and overpenalizing compliant taxpayers.

I. Penalty approval

Congress enacted section 6751(b) to “prevent IRS agents from threatening unjustified penalties to encourage taxpayers to settle.”²¹ Section 6751(b) provides that no penalty can be assessed by the Service, unless the “initial determination” of such assessment is personally approved (in writing) by the immediate supervisor of the individual making the determination to impose the penalty.

A. Penalties subject to pre-assessment Tax Court review

1. Summary of case law

The Second Circuit in Chai v. Commissioner observed that while section 6751(b)(1) clearly explains what requires written approval: the “initial determination of . . . assessment,” it fails to clearly explain when the approval must take place.²² Thus, the Court in Chai found the statute was ambiguous as to when the initial determination must be approved.²³ The Court explained that to understand why section 6751(b)(1) is ambiguous requires familiarity with the deficiency process.²⁴ That process, as highlighted by the Court, is as follows:

• Assessment: An assessment is the last of a number of steps required before the Service can collect a “deficiency.”

• Deficiency: A tax liability, determined by the Service, that is greater than what the taxpayer reported on the return.

• Notice of deficiency: The Service's announcement to the taxpayer that it intends to assess that deficiency.

• Effect of a petition to the Tax Court: If the taxpayer does not file a timely petition with the Tax Court for a redetermination of the deficiency, the deficiency must be assessed. If the taxpayer does file a petition, the Service is restricted from assessing the deficiency until the decision of the Tax Court has become final. The entire amount redetermined as the deficiency by the decision of the Tax Court which has become final must be assessed.²⁵

Given the meaning of “assessment,” the Second Circuit found the statute ambiguous — “If 'assessment' is the formal recording of a taxpayer's tax liability, then section 6751(b) is unworkable: one can determine a deficiency, and whether to make an assessment, but one cannot determine an assessment.”²⁶

Because of the inherent ambiguity in the statute, the Second Circuit found that it must consult legislative history and other tools of statutory construction to discern Congress's meaning. The Court observed that the Senate Finance Committee Report on section 6751(b) “clearly” stated that the purpose of the provision is that penalties should “only be imposed where appropriate and not as a bargaining chip. . . . The statute was meant to prevent IRS agents from threatening unjustified penalties to encourage taxpayers to settle.”²⁷ The Second Circuit explained that allowing an unapproved initial determination of the penalty to proceed through administrative proceedings, settlement negotiations, and potential Tax Court proceedings, only to be approved before assessment would not stem the abuses section 6751(b)(1) was meant to prevent.²⁸

The Second Circuit in Chai concluded that, for a supervisor's discretion to be given force, the supervisor's penalty approval must be issued before the Tax Court proceeding is even initiated. Indeed, section 6751 requires supervisory approval of “the initial determination of such assessment.”²⁹ The Second Circuit held that section 6751(b)(1) requires approval of the initial determination of the penalty determination “no later than the date the IRS issues the notice of deficiency . . . asserting such penalty.”³⁰

Following Chai, the Tax Court applied precepts from the legislative history to determine at what point in the administrative process leading to a deficiency should supervisory approval be required. In Clay v. Commissioner, the Tax Court observed that the determinations made in a notice of deficiency are typically based on the adjustment proposed in a Revenue Agent Report. The Revenue Agent Report is included with the 30-day letter allowing a taxpayer to protest those adjustments at Appeals.³¹ The Clay Court thus interpreted section 6751(b)(1) to require that supervisory approval be secured no later than (1) the date on which the Service issues the notice of deficiency or (2) the date, if earlier, on which the Service formally communicates to the taxpayer the Examination Division's determination to assert a penalty and notifies the taxpayer of his right to appeal that determination.³² Later, in Belair Woods v. Commissioner, the Tax Court gave meaning to the word “determination” and held that supervisory approval must be obtained before the Service sends a notice that “formally communicates to the taxpayer, the Examination Division's unequivocal decision to assert a penalty.”³³

Several circuit courts have taken differing views of section 6751(b)(1).³⁴ Most recently, the Eleventh Circuit interpreted section 6751(b)(1) to mean that the term “initial” describes “what must be approved, not when.” ³⁵ It held, consistent with the Ninth Circuit, that the Service satisfies section 6751(b) “so long as a supervisor approves an initial determination of a penalty assessment before it assesses those penalties.” The Eleventh Circuit believed its decision was in line with the plain meaning of the phrase, “initial determination of such assessment,” the lack of a timing requirement in the statute, and the legislative history.³⁶ In the wake of the Eleventh Circuit's decision, however, the Tax Court has found no basis to vacate its bright-line rule.³⁷

2. Recommendation

We recommend that Treasury and the Service follow the Second Circuit's opinion in Chai and its logical extension by the Tax Court. As noted in Chai, once a taxpayer receives a formal notice of deficiency, a taxpayer will feel pressured to settle or bargain to avoid assessment of a penalty. Thus, we recommend that the final Regulations require supervisory approval before the issuance of the 30-day letter, or substantive equivalent, that proposes a penalty covered by section 6751. This recommendation includes those penalties that would have been subject to Tax Court review and included in the notice of deficiency but were not because the taxpayer agreed to their immediate assessment.

In finding the statute merely requires approval before assessment, the Eleventh Circuit failed to appreciate and give effect to the deficiency process as described in Chai: “[O]ne can determine a deficiency, and whether to make an assessment, but one cannot determine an assessment.”³⁸ Thus, even if what must be approved is the “initial determination of such assessment,” when the supervisor must approve the term “initial determination of such assessment” remains ambiguous. As a result, the statute must be interpreted based on its legislative history and other tools of statutory construction to discern Congress's meaning. As the Second Circuit explained in Chai, the legislative history provides “clear[ ]” guidance that the purpose of the provision is that penalties should “only be imposed where appropriate and not as a bargaining chip.”³⁹ The Eleventh Circuit's interpretation overlooks the legislative intent underlying section 6751(b)(1). “The statute would make little sense if it permitted written approval of the 'initial determination' up until and even contemporaneously with the IRS's final determination.”⁴⁰

The consequential moment for when the penalty should be approved is before issuance of the 30-day letter, or substantive equivalent, as explained in Clay. Without the statutory check of section 6751(b), the Service's revenue agents are incentivized to be over-inclusive when determining which penalties to propose in a 30-day letter, or substantive equivalent, as it will represent their opening bid in settlement. It is exactly this concern that penalties would be used as a bargaining chip that led Congress to enact section 6751(b). The involvement and approval of a supervisor should be required before issuance of the 30-day letter to ensure that the revenue agent assigned to the case is not acting alone in deciding that penalties are officially on the table.

In the preamble to the Proposed Regulations, Treasury and the Service assert that prior to assessment, it is unclear what constitutes an unequivocal decision to assert a penalty other than a notice that gives the taxpayer the right to petition to the Tax Court.⁴¹ But a Revenue Agent Report that proposes a penalty, accompanied by a 30-day letter giving the taxpayer the right to appeal the penalty, is as much of an unequivocal decision to assert a penalty as a notice of deficiency. In each scenario, the Service has decided to assert a penalty and has formally communicated that decision to the taxpayer in writing. We believe that requiring approval before formal communication of the penalties to the taxpayer provides an important check on over-zealous examiners who may propose penalties where they are not appropriate. Once approval is obtained and the penalty is formally communicated to the taxpayer, the Service and the taxpayer can debate the reasonableness of the proposed penalty and negotiate a resolution of the matter with the Independent Office of Appeals, or litigate the issue. The taxpayer's ability to present further arguments to the Examination Division on the applicability of the penalty goes not to whether the Service has made an unequivocal decision to assert a penalty, but rather, to whether the Service's unequivocal decision is an “initial determination” or a “final determination.” The language of the statute, importantly, requires supervisory approval of the “initial determination.”

This recommendation applies equally to those penalties that would have been subject to Tax Court review and included in the notice of deficiency but were not because the taxpayer agreed to their immediate assessment, which the preamble explains the Proposed Regulations currently only require approval before assessment.⁴² Although the Proposed Regulations would treat these types of penalties the same as assessable penalties, they should not be treated differently than penalties subject to pre-assessment reviews. Had these penalties not been agreed, they could have been included in a pre-assessment notice, which would have provided the basis for Tax Court jurisdiction upon timely petition. As a result, these penalties should be subject to the same timing rule as penalties subject to pre-assessment review. To be sure, the same concern that the penalties would be used as a bargaining chip apply equally to these penalties in which the taxpayer agrees to their immediate assessment.

Low-income taxpayers disproportionally are subjected to penalties without ever receiving a 30-day letter. Most audits of low-income taxpayers result from the Automated Underreporter (“AUR”) or Automated Correspondence Exam (“ACE”) processes, which typically result in notices of deficiency rather than 30-day letters if the matter is not resolved. Those notices of deficiency, if the adjustment amount is over $5,000, generally include substantial understatement penalties without supervisory approval. However, our recommendation below regarding “automatically calculated through electronic means” would require supervisory approval for these penalties.

B. Penalties not subject to pre-assessment Tax Court review

Like penalties subject to pre-assessment review by the Tax Court, we recommend that the final Regulations require assessable penalties not subject to deficiency procedures be approved before the issuance of the 30-day letter, or substantive equivalent, that proposes the penalty. The preamble posits that these penalties cannot be used as a bargaining chip because they are not in addition to a tax liability.⁴³ However, assessable penalties are often one aspect of a larger audit and may be used as a bargaining chip in other respects and not just regarding a related tax liability (e.g., a section 6700 penalty for promoting abusive tax shelters). Further, treating assessable penalties the same as those subject to deficiency procedures provides one clear bright-line rule that promotes certainty and is easy to administer.

II. “Personally approved (in writing)” by the “immediate supervisor” or “higher-level official”

Section 6751(b)(1) requires the initial determination to assess certain penalties be personally approved in writing by “the immediate supervisor” of the individual making the initial determination or such “higher level official” as the Secretary may designate. As the preamble to the Proposed Regulations explains, “[t]o be able to identify which supervisor should approve the initial penalty determined, it must be clear which individual made the 'initial determination of [a penalty] assessment.'”⁴⁴ We agree with Prop. Treas. Reg. §301.6751(b)-1(b)(3)(ii), which identifies that person as the “individual who first proposed the penalty.” Prop. Treas. Reg. §301.6751(b)-1(a)(3) proposes definitions for the terms “immediate supervisor” and “higher-level official.” The statute does not define either term, and we commend Treasury and the Service for proposing definitions for these terms. However, as discussed below, to provide certainty for taxpayers and to promote administrability within the Service, we recommend that Treasury and the Service revise the definitions as proposed in these Comments. And we recommend that, if made electronically, the supervisor demonstrate his or her approval, if made electronically, through a digital, time-stamped signature.

A. Immediate Supervisor

Prop. Treas. Reg. §301.6751(b)-1(a)(3)(iii) defines “immediate supervisor” to mean “any individual with responsibility to approve another individual's proposal of penalties, as defined in paragraph (a)(3)(i), without the proposal being subject to an intermediary's approval.” In proposing the definition, Treasury and the Service explained that the proposed rule does not limit the term immediate supervisor to a single individual because that would restrict section 6751(b) in a way that does not reflect how the Service operates. Rather, according to Treasury and the Service, this term is understood to refer to any person who, as part of their job, directly approves a penalty proposed by another, including acting supervisors operating under a proper delegation of authority.⁴⁵

As written, this definition could allow non-managerial, non-supervisory personnel to approve penalties, as long as that person has the “responsibility” to approve the penalties. This definition provides no guidance on when a supervisor has “responsibility” to approve another individual's proposed penalties as part of their job. As the Tax Court observed in Sand Inv. Co. v. Commissioner,⁴⁶ the Service does not employ the term “immediate supervisor” uniformly in its personnel practices.⁴⁷ Accordingly, it is not clear, based on the Service's internal policies, which person should be considered to have the “responsibility” for approving penalties “as part of their job.”

To provide certainty for taxpayers as to which person has the “responsibility” to approve penalties as part of their “job,” we recommend that Prop. Treas. Reg. §301.6751(b)-1(a)(3)(iii) be amended to focus on the person who “directly” supervises the “substantive work” of the person who first proposed the penalty. As a result, we recommend Treasury revise the definition of immediate supervisor as follows:

(iii) Immediate supervisor. The term immediate supervisor means any individual who directly supervises, including through a valid delegation of authority, the substantive work of the individual who first proposed the penalty.

This revised definition, like the proposed definition, takes into account that more than a single individual may directly supervise the substantive work of an individual. As a result, it would not invite unwarranted disputes where multiple individuals could be considered the immediate supervisor about which specific individual was more appropriate. And this revised definition would also address the Treasury and the Service's observation that the immediate supervisor is understood to refer to “any person who, as part of their job, directly approves a penalty proposed by another,”⁴⁸ while also addressing the Treasury and the Service's concern that the definition include acting supervisors operating under a proper delegation of authority.⁴⁹

Importantly, this proposed definition gives effect to the plain meaning of the terms “immediate” and “supervisor.”⁵⁰ The term “immediate” means “with no intermediary.”⁵¹ And the term “supervisor” means “a person who supervises,” i.e., a person who “oversee[s], direct[s], or manage[s] work, workers, a project, etc.”⁵² Taken together, immediate supervisor means any individual who directly oversees or manages the work, or a project. In the context of section 6751(b)(1), the Tax Court found that these terms are most logically viewed as the person who supervises the agent's substantive work on an examination.⁵³

And this proposed definition is consistent with the legislative history of section 6751(b), which states that approval should come from “IRS management.” The 1998 Senate Finance Committee Report explained that section 6751(b) “requires the specific approval of IRS management to assess all non-computer generated penalties unless excepted.”⁵⁴ In other words, Congress was concerned with a penalty being imposed without “IRS management's” approval. “Management” is defined as “the act or art of managing: the conducting or supervising of something (such as a business).”⁵⁵ As the Tax Court observed,

Given this legislative purpose, an agent's 'immediate supervisor' is most logically viewed as the person who supervises the agent's substantive work on an examination. That person (after the agent) presumably has the greatest familiarity with the facts and legal issues presented by the case. That person is thus in the best position to supply the approval that Congress believed desirable.⁵⁶

In short, we recommend that Treasury revise the definition of “immediate supervisor” to focus on the person who “directly” supervises the “substantive work” of the person who first proposed the penalty, since it is consistent with the plain meaning of the statute, legislative history, and case law. We believe that our recommended definition is consistent with Service practice and should address the concern that acting supervisors and others operating under a proper delegation of authority are covered.

B. Higher-Level Official

Prop. Treas. Reg. §301.6751(b)-1(a)(4) defines the term “higher level official” as “[a]ny person who has been directed by the Internal Revenue Manual or other assigned job duties to approve another individual's proposal of penalties before they are included in a pre-assessment notice prerequisite to the United States Tax Court (Tax Court) jurisdiction, an answer, amended answer, or amendment to the answer to a Tax Court petition, or are assessed without need for such inclusion, is designed as a higher level official authorized to approve the penalty for purposes of §6751(b)(1).”

As proposed, the definition of “higher level official” includes a person who has “other assigned job duties” to approve another individual's proposal of penalties. This could be read as allowing an oral or implicit assignment of job duties. Such an informal assignment would lead to confusion within the Service about who is assigned the duty as well as evidentiary issues as to whether the person was in fact assigned the duty of penalty approval.

We, therefore, recommend that the proposed definition in Prop. Treas. Reg. §301.6751(b)-1(a)(4) be revised to include a written component for “other assigned job duties” as follows:

(iv) Higher level official. Any person who has been directed by the Internal Revenue Manual or has been assigned, in their written job duties, to approve another individual's proposal of penalties before they are included in a 30-day letter or its substantive equivalent or, an answer, amended answer, or amendment to the answer to a Tax Court petition, is designated as a higher level official authorized to approve the penalty for purposes of section 6751(b)(1).

This revised definition would provide certainty for both the Service and taxpayers as to whether the Service has in fact assigned the person to approve penalties.

We also suggest that such assignments of penalty approval authority to higher level officials should be made judiciously and rarely, and their approval of proposed penalties should still be subject to the documentation requirements discussed below.

C. Personally approved (in writing)

Section 6751(b)(1) requires that the immediate supervisor or higher level official “personally approve (in writing)” the initial determination to assert a penalty. Prop. Treas. Reg. §301.6751(b)-1(a)(3)(v) provides that “personally approved (in writing)” means any writing, including in electronic form, that is made by the writer to signify the writer's assent and that reflects that it was intended as approval.” We agree with the Proposed Regulations' inclusion of electronic approvals. Although courts have noted that section 6751(b) does not expressly require any particular form of written supervisory approval,⁵⁷ we recommend that this definition be modified to require that, if the approval is made electronically, the approval be made through a digital signature that includes a software-generated timestamp indicating precisely when and who signed the document.

Typed signatures and dates lead to confusion as to when the supervisory approval occurred. This confusion can lead to inaccurate discovery responses and incorrect factual representations to the Court. Resolving this confusion wastes resources for the taxpayer, the Service, and the Court. As a result, we recommend that the proposed definition of “personally approved (in writing)” be modified to require the approval, if electronic, be shown through a digital signature that includes a software-generated timestamp indicating precisely who signed the document and when.

III. Automatically Calculated Through Electronic Means

Section 6751(b)(2) exempts from the penalty approval requirements penalties under sections 6651, 6654, 6655, 6662(b)(9), and 6662(b)(10) or “any other penalty automatically calculated through electronic means.” The Proposed Regulations provide that a penalty is “automatically calculated through electronic means” if a Service computer program automatically generates a notice to the taxpayer that proposes the penalty.⁵⁸ As indicated in the preamble to the Proposed Regulations, Treasury and the Service intend that the proposed rule align with the Tax Court's holding in Walquist.⁵⁹

The Proposed Regulations define “electronic means” but not the word “calculated.” This could lead to the conclusion that all penalties generated by computers without supervisory approval fall under this exception. And the Service would have unnecessarily broad discretion in determining what constitutes “calculated.” To avoid this outcome, we recommend that the final Regulations explicitly adopt the factors in Walquist to determine whether a penalty asserted by computer without supervisory approval fits within the exception of §6751(b)(2)(B). In Walquist, the Tax Court noted that computer-determined penalties were similar in nature to the “addition to tax under sections 6651, 6654, or 6655.”⁶⁰ And the Tax Court noted that these additions to tax share certain common characteristics. They were all (1) mandatory, (2) determined mathematically according to a formula derived from the statutory text, and (3) generally calculated automatically by computer.⁶¹ We believe that the final Regulations should be more explicit and specifically incorporate the factors in Walquist to determine whether a penalty meets the exception under section 6751(b)(2)(B).

Relatedly, we recommend that the Service intermittently (or through an annual revenue procedure) publish a list of penalties that are determined according to the Walquist factors to give taxpayers notice and eliminate potential uncertainty. As computers and artificial intelligence tools become more sophisticated, the Service may determine more and more penalties by computers, which could, without the safeguard of the Walquist factors, be used as a bargaining chip inconsistent with Congressional intent. Moreover, as the Service increasingly imposes penalties based on computer-generated computations and notices, more taxpayers will be subject to penalties that are not reviewed or approved by any Service employee, let alone a manager or supervisor. As a result, we recommend that the Service intermittently publish a list of penalties that may be determined in this way to give taxpayers notice and eliminate potential uncertainty. For example, the Service could designate which penalties other than those specified in section 6751(b)(2)(A) would fall under section 6751(b)(2)(B).

Finally, we recommend that the final Regulations clarify that penalties subject to defenses that must be determined on a case-by-case basis cannot be treated as “automatically calculated through electronic means” except where section 6751(b) expressly provides otherwise (e.g., sections 6651, 6654, and 6662(b)(9) and (10)). For example, that there is a reasonable cause defense to a certain penalty suggests that there are facts and circumstances that should be considered in determining whether a penalty is being properly asserted. The validity of a reasonable cause defense is determined case-by-case, considering all the facts. That cannot be accomplished by a computer. Nor can the existence of a reasonable cause defense be determined by whether or not the taxpayer responds to a computer-generated notice. Therefore, Prop. Treas. Reg. §6751(b)-1(a)(3)(vi) does not alleviate the problem.⁶²

Even for an apparent objective penalty such as the substantial understatement penalty, the penalty does not apply when there is substantial authority or, if adequately disclosed, reasonable basis. In Osteen v. Commissioner, the Eleventh Circuit noted that a “substantial authority” standard for the substantial understatement penalty can apply both to legal issues and factual issues.⁶³ The Service thus cannot adequately evaluate whether a taxpayer had substantial authority on a factual issue without engaging with the taxpayer. And, if substantial authority exists, it does so regardless of whether the taxpayer responds to a computer-generated notice. The concern is likewise not adequately addressed by Prop. Treas. Reg. §6751(b)-1(a)(3)(vi).

We note that this recommendation is inconsistent with the Tax Court's holding in Walquist while the Proposed Regulations indicate the intent of Treasury and the Service to align with that holding. While we believe that the Walquist factors are generally appropriate for determining whether a penalty is “automatically calculated through electronic means,” the Walquist determination regarding the substantial understatement penalty has been called into question by a later amendment to section 6751(b)(2)(A), which added “6662 (but only with respect to an addition to tax by reason of paragraph (9) or (10) of subsection (b) thereof).” Further, treating the substantial understatement penalty as automatically calculated through electronic means would disproportionally affect low-income taxpayers subject to the AUR and ACE processes, which typically do not employ a 30-day letter, but rather move very quickly to the issuance of a Notice of Deficiency.

IV. Manner of Review

We recommend the Service develop an open-ended form to guide employees through the proposed penalty assertion determination. We also recommend the Service develop a separate form to enable the approving official to determine the propriety of the proposed penalty assertion. Regarding the initial determination, we propose querying:

Requiring the penalty-proposing employee to complete such a form would force an understanding of the appropriateness of the proposed penalty assertion, and it would also compel the proposing employees to consider all relevant factors.

In the same vein, requiring the reviewing official to complete a form would force the reviewing official to develop: (1) a statement supporting agreement or disagreement with each of points discussed on the proposing employee's form, and (2) an independent conclusion.

We take our guidance in this regard from the Service's experience in asserting refundable credit bans against taxpayers who have improperly claimed refundable credits such as the earned income tax credit (e.g. sections 24(g), 25A(b)(4), and 32(k)). The Service procedures for imposing such bans require certain steps be taken, both by the employee proposing the ban and as to the supervisor approving the ban. In particular we note that the IRM⁶⁴ outlines the steps the employee must take vis-a-vis the taxpayer, as well as the required case file documentation. These steps include reviewing taxpayer documentation, account research, understanding applicable tax law, and clear workpaper documentation, all prior to submitting the proposed penalty of a two-year refundable credit ban for supervisory approval. Given the magnitude of many of the non-computer-generated penalties under the Code, we believe the same care should be taken in the proposal and approval of penalties.

We also recommend the Service develop annual, updated training on the penalty determination process to ensure full adherence to penalty assertion regulations.

V. Other Recommendations

We also recommend that the Service develop policies that require its employees to provide taxpayers with evidence of supervisory approval without the need for a FOIA or discovery request. If the Service's procedures require supervisory approval of the 30-day letter or its substantive equivalent and the approval is documented on that letter, the taxpayer will receive the documentation reflecting timely supervisory approval with the 30-day letter, so there is no additional burden on the Service. These policies should protect taxpayers' right to be informed,⁶⁵ the right to pay no more than the correct amount of tax,⁶⁶ and the right to challenge the position of the Service and be heard.⁶⁷ In addition, the Service should develop ongoing training and monitor the efficacy of the supervisory review process and ensure procedures are being followed and, if not, confirm that there is no effort to conceal untimely approval.

We also recommend that Treasury and Counsel seek to educate the Service employees handling FOIA requests, and Appeals personnel considering FOIA appeals, of the connection between section 6751(b)(1) and records revealing the supervisory or managerial status of penalty approving employees. In our experience with FOIA requests, the Service routinely refuses to provide records on the managerial or supervisory status of penalty approving personnel. Even when FOIA requests explain the connection between section 6751(b)(1) and the requested records, Service employees handling FOIA requests simply cite FOIA exemption (b)(6)⁶⁸ and generally refuse to provide records to establish the status as a supervisor of the Service employees who approved penalties. Furthermore, the Independent Office of Appeals has refused to consider the need for records of supervisory status in considering FOIA appeal cases. Thus, it is important that the Service develop practices to train its employees on the requirements of section 6751(b)(1).

CONCLUSION

For all these reasons, the Section urges the Service to accommodate the foregoing comments and recommendations to ensure that penalties are not used as bargaining-chips in the process of an exam.

Thank you for considering our views on these important issues.