Texas State Bar Seeks Clarity in Supervisory Approval Regs

July 10, 2023

Internal Revenue Service

RE: Comments on Proposed Regulations under Section 6751 (REG-121709-19)

Ladies and Gentlemen:

On behalf of the Tax Section of the State Bar of Texas, I am pleased to submit the enclosed response to the request of the Department of the Treasury (the “Treasury”) and Internal Revenue Service (the “IRS” or “Service”) for comments in the Notice of Proposed Rulemaking (REG-121709-19) issued on April 11, 2023 (the “Proposed Regulations”). The Proposed Regulations address the supervisory approval of certain penalties.

THE COMMENTS ENCLOSED WITH THIS LETTER ARE BEING PRESENTED ONLY ON BEHALF OF THE TAX SECTION OF THE STATE BAR OF TEXAS. THE COMMENTS SHOULD NOT BE CONSTRUED AS REPRESENTING THE POSITION OF THE BOARD OF DIRECTORS, THE EXECUTIVE COMMITTEE OR THE GENERAL MEMBERSHIP OF THE STATE BAR OF TEXAS. THE TAX SECTION, WHICH HAS SUBMITTED THESE COMMENTS, IS A VOLUNTARY SECTION OF MEMBERS COMPOSED OF LAWYERS PRACTICING IN A SPECIFIED AREA OF LAW.

THE COMMENTS ARE SUBMITTED AS A RESULT OF THE APPROVAL OF THE COMMITTEE ON GOVERNMENT SUBMISSIONS OF THE TAX SECTION AND PURSUANT TO THE PROCEDURES ADOPTED BY THE COUNCIL OF THE TAX SECTION, WHICH IS THE GOVERNING BODY OF THAT SECTION. NO APPROVAL OR DISAPPROVAL OF THE GENERAL MEMBERSHIP OF THIS SECTION HAS BEEN OBTAINED AND THE COMMENTS REPRESENT THE VIEWS OF THE MEMBERS OF THE TAX SECTION WHO PREPARED THEM.

Respectfully submitted,

Robert C. Morris, Chair
State Bar of Texas, Tax Section

Enclosure

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COMMENTS ON PROPOSED REGULATIONS UNDER SECTION 6751

These comments on the Proposed Regulations (the “Comments”) are submitted on behalf of the Tax Section of the State Bar of Texas. Joshua Smeltzer, Chair, Tax Controversy Committee, primarily drafted these Comments. Robert Probasco, Secretary of the Tax Section, and Lee Meyercord, Chair of the Committee on Government Submissions, reviewed these Comments and provided substantive comments. Robert C. Morris, Chair of the Tax Section, reviewed the Comments.

Although members of the Tax Section who participated in preparing these Comments have clients who would be affected by the principles addressed by these Comments or have advised clients on the application of such principles, no such member (or the firm or organization to which such member belongs) has been engaged by a client to make this government submission.

Contact Persons:

Date: July 10, 2023

I. INTRODUCTION

These Comments are provided in response to the Treasury's and the IRS's request for comments regarding the Proposed Regulations under section 6751(b). Section 6751(b) provides that:

No 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 timing of the approval required by section 6751(b) has been the subject of significant litigation.

The Proposed Regulations provide specific timing rules for supervisory approval of penalties. They require approval of penalties subject to deficiency procedures before the notice of deficiency is issued and require approval of assessable penalties prior to assessment. The Proposed Regulations require approval of penalties raised for the first time in Tax Court at any time before the Commissioner requests that the court determine the penalty. In addition, the Proposed Regulations define “immediate supervisor” and “individual making such determination.” The Proposed Regulations also clarify the exemption from supervisory approval for penalties “automatically calculated through electronic means.”

We appreciate the opportunity to comment on the Proposed Regulations. We believe that the statute would be better served if the regulations were to require supervisory approval of penalties prior to the issuance of the 30-day letter or its equivalent, as outlined by Tax Court decisions. We also believe that defining “immediate supervisor” as the person who “directly” supervises the “substantive work” of the person who first proposed the penalty provides a more workable rule that is consistent with the plain language of the term “immediate supervisor” in the statute. In addition, requiring approval to be done using a digital signature with a software-generated timestamp, indicating precisely who signed the document and when, would provide clarity regarding approval of the penalties. Finally, we believe that “automatically calculated through electronic means” should not include any penalty subject to defenses that must be determined on a case-by-case basis unless expressly stated in section 6751(b).

III. TIMING OF APPROVAL REQUIRED BY SECTION 6751(b)

Penalties should be used only to “encourage voluntary compliance” by taxpayers¹ and not as a bargaining chip in exchange for resolving a tax adjustment.² To that end, the IRS issued its Penalty Policy Statement to promote fairness in administrating penalties and standardizing the behavior expected by its employees.³ In that policy statement, the IRS 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.⁴ The Second Circuit in Chai v. Commissioner concluded that Congress enacted section 6751(b) to “prevent IRS agents from threatening unjustified penalties to encourage taxpayers to settle.”⁵

If supervisory approval is to meet the goal of not being used as an unfair “bargaining chip,” it must be required before such unwanted behavior can occur. The Proposed Regulations adopt timing rules for penalty approval and require approval of penalties subject to deficiency procedures before the issuance of the notice of deficiency and of assessable penalties prior to assessment. These timing rules vary from the rulings of the Tax Court and do not effectuate Congress's intent.

The Tax Court, following the emphasis by the Second Circuit in Chai on the word “initial,”⁶ found that when there is a formal communication to the taxpayer advising of proposed penalties and providing appeal rights, “the issue of penalties is officially on the table.”⁷ This is frequently accomplished via a 30-day letter with an accompanying Revenue Agent Report (“RAR”) indicating the ability to protest adjustments with IRS Appeals.⁸ The Tax Court held that supervisory approval under section 6751(b)(1) was required no later than the earlier of the notice of deficiency or the date when the IRS first formally communicates its determination to assert a penalty and notifies the taxpayer of his right to appeal that determination.⁹ The Tax Court then clarified the term “determination,” in Belair Woods, as being the formal communication to the taxpayer of the IRS's “unequivocal decision to assert a penalty.”¹⁰

While other Circuit Courts have entered decisions with differing views on the timing of section 6751(b) approvals,¹¹ we believe that the Tax Court, as opposed to other federal courts, has a greater appreciation for the deficiency procedures involved. Further, penalties become a “bargaining chip” once they are formally proposed to the taxpayer. The IRS Revenue Agent has a clear incentive to be overinclusive of penalties in the 30-day letter to encourage a taxpayer to settle the tax adjustment in return for eliminating the penalties. The Independent Office of Appeals performs a “quasi-judicial” review, distinctly different in nature from the determination by Examination. Examination is where the potential for inappropriate assertion of penalties is highest. Examination's discretion effectively ends on issuance of the 30-day letter.

Requiring a supervisor's approval prior to this time provides the check Congress intended by enacting section 6751(b)(1). Therefore, we believe that following the Tax Court's well-reasoned decisions and requiring supervisory approval before the issuance of the 30-day letter or its equivalent would best serve Congress's intent and provide a bright-line rule that would be easy to administer by IRS employees and be clear to taxpayers. This bright-line rule should apply to penalties subject to Tax Court review and those penalties that would have been subject to Tax Court review but were not only because the taxpayer agreed to their immediate assessment.

The preamble contends that this would not prevent penalties from being used as a bargaining chip in all circumstances because it would not require approval before an oral communication of the penalties. However, that it may not prevent the use of penalties as a bargaining chip in some extreme circumstances that even the preamble acknowledges would violate IRS policy statements and instructions, hardly warrants abandoning it for a rule that would allow the use of penalties as a bargaining chip in far more circumstances. In addition, the preamble contends that the Tax Court's rule has led to penalties being disallowed where the penalties were otherwise “appropriate.” But it is the statute that bars assessment of penalties when the IRS fails to obtain supervisory approval regardless of whether the penalty is otherwise appropriate, not the Tax Court.

We believe the same rule should apply to assessable penalties (e.g., the section 6707A penalty). The preamble suggests that these penalties cannot be used as a bargaining chip because they are not in addition to a tax liability. But this ignores that the 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. 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, consistent with the preamble's stated objectives.

III. DEFINITION OF IMMEDIATE SUPERVISOR

Ensuring the proper individual provides the required supervisory approval is just as important as making sure such approval occurs at the right time. 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. Proposed Regulation §301.6751(b)-1(a)(3) proposes definitions for the terms “immediate supervisor” and “higher-level official.” The statute does not define either term. Proposed Regulation §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.” This definition, as written, does not prevent non-managerial, non-supervisory personnel from being included in those permitted to provide supervisory approval under section 6751(b)(1) merely because they may have “responsibility” to approve penalties. This could allow the IRS to centralize penalty approval to an extent that is inconsistent with a careful and thoughtful review of whether the penalty is appropriate under the specific facts and circumstances. Also, the definition of the term “immediate supervisor” in the Proposed Regulations is vague and lacks a clear easy-to-apply standard, so it will be difficult for the IRS and taxpayers to determine whether the “immediate supervisor” approved the proposals.¹²

On the other hand, defining “immediate supervisor” as the person who “directly” supervises the “substantive work” of the person who first proposed the penalty provides an objective standard that taxpayers and the IRS can easily apply. This definition best serves the objectives of the statute because the person who directly supervises the substantive work of the individual is the best person to evaluate whether, consistent with the IRS policy statement, the specific facts fully support application of a penalty. This is also consistent with the plain meaning of “immediate supervisor,” which suggests that there can only be one and Congress's intent that penalties only be imposed when appropriate. For example, in Example 3 in Proposed Regulation §301.6751(b)-1(e)(3), the issue manager (B) would be the “immediate supervisor” under this definition as that is the person who supervises the substantive work of the revenue agent (A) that concluded the negligence penalty applied. While the case manager may be responsible for approving the examination report, the case manager may not have the necessary information or expertise to determine whether a penalty is appropriate, and therefore should not be treated as the “immediate supervisor” within the meaning of the statute.

IV. DIGITAL SIGNATURES

Finally, section 6751(b)(1) requires that the immediate supervisor or higher-level official “personally approve (in writing)” the initial determination to assert a penalty. Proposed Regulation §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 must “reflect that it was intended as approval.” The courts have consistently noted that section 6751(b) does not expressly require any particular form of written supervisory approval;¹³ rather, the important factor is that such form clearly shows the date, time, and authority of the individual approving the penalty. Digital signatures, properly used, can avoid confusion caused by typed signatures and dates on forms. Therefore, we believe that the IRS and Treasury should consider adopting regulations that define “personally approved (in writing)” as requiring approval through a digital signature with a software-generated timestamp indicating precisely who signed the document and when, because such a rule will minimize disputes.

V. AUTOMATICALLY CALCULATED USING ELECTRONIC MEANS

Section 6751(b)(2) exempts from the penalty approval requirements any “penalty automatically calculated through electronic means.” Proposed Regulation §301.6751(b)-1(a)(3)(vi) provides 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. A common example is a CP2000 notice issued pursuant to the Automated Underreporter (AUR) program that proposes a penalty, as described in Proposed Regulation §301.6751-1(b)(1)(e)(5).

We do not believe that any penalty subject to defenses that must be determined on a case-by-case basis (e.g., reasonable basis, substantial authority, and reasonable cause and good faith) should be treated as “automatically calculated through electronic means” unless expressly stated in section 6751(b). To treat these penalties as automatically calculated would treat similarly situated taxpayers differently, as the taxpayer who responds to the notice with a reasonable basis defense would not be penalized, while a taxpayer who fails to respond would be penalized despite the same reasonable basis. We further believe that the CP2000 notice itself should be considered equivalent to a 30-day letter in triggering the supervisory approval requirement. We are not addressing this at length in our comments but concur with comments being submitted by the ABA Section of Taxation on this point.