A recent opinion from the 5th Circuit Court of Appeals, PBBM-Rose Hill,[1] disallowed in full a conservation easement deduction and imposed a 40% valuation penalty on the taxpayer. The opinion is significant because of the Court's rejection of the “improvements clause” found in many easement deeds and for the court's findings on conservation purpose. We posted a blog on the improvements issue recently (here), and will cover the conservation purpose findings soon. However, the 5th Circuit's opinion also involves an issue broader than deductibility. The 5th Circuit made a significant interpretation of the IRS obligation under Code section 6751(b)(1) to obtain supervisory approval prior to asserting penalties against a taxpayer.

There are statutory requirements that the IRS must follow before it can assert penalties against a taxpayer. One is found in Code section 6751(b), which states 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 IRS is barred from asserting penalties if this section is not complied with.

The specific abuse Congress sought to curb with section 6751(b)(1) was IRS agents improperly wielding penalties as a club to beat taxpayers into settlement: “The [Senate Finance] Committee believes that penalties should only be imposed where appropriate and not as a bargaining chip.”[2] Congress felt strongly about this abuse, so it imparted, as a statutory pre-requisite to penalty assertion, an obligation that IRS agents obtain their immediate supervisor's signature prior to bringing penalties “into the conversation.”[3]

Prior to PBBM-Rose Hill, the 2nd Circuit, in Chai, addressed “at what point the IRS's obligation to comply with the written-approval requirement [in section 6571(b)(1)] kicks in.”[4] The Tax Court had previously determined that the IRS could obtain supervisory approval at any time prior to assessment of a penalty.[5] The 2nd Circuit, however, found that the legislative history of Code section 6751(b)(1) “strongly rebuts … that written approval may be accomplished at any time prior to, even if just before, assessment.”[6] Assessment of a penalty normally occurs at the very end of a tax deficiency proceeding. The court reasoned that permitting “an unapproved initial determination of the penalty to proceed through administrative proceedings, settlement negotiations, and potential Tax Court proceedings, only to be approved sometime prior to assessment would do nothing to stem the abuses § 6751(b)(1) was meant to prevent.”[7] Indeed, “the supervisor's Johnny-come-lately approval of the “initial determination” would add nothing to the process.”[8]

In Graev v. Commissioner, 149 T.C. No. 23, at *5 (December, 20, 2017) (“Graev III”) the Tax Court reversed, in part, its prior determination [9] and adopted the 2nd Circuit's reasoning in Chai. Importantly, the Tax Court adopted the 2nd Circuit's reasoning as its own rather than deciding the case “under the Golsen rule and liv[ing] to fight another day in another circuit.”[10] Accordingly, it remains unclear what precedential weight the Tax Court will give to the contradictory opinion of the 5th Circuit in PBBM-Rose Hill.

In Graev III, Judge Lauber explained (in a concurring opinion) that section 6751(b)(1) requires supervisory approval the first time an IRS agent introduces penalties “into the conversation” as a means of protecting taxpayers against the “improper wielding” of penalties as a bargaining chip in settlement negotiations

The Court adopts a more sensible approach. It treats the “initial determination of such assessment” as referring to the action of the IRS official who first proposes that a penalty be asserted. This is a reasonable construction of the statute, giving primacy to the word “initial” (a term that appears in the statute) rather than to the penalty-asserter's scope of authority (a term that does not appear). And by requiring supervisory approval the first time an IRS official introduces the penalty into the conversation, the Court's interpretation is faithful to Congress' purpose by affording maximum protection to taxpayers against the improper wielding of penalties as bargaining chips.[11]

In spite of Chai and Graev III, the 5th Circuit found the IRS complied with section 6751(b)(1), even though, the only evidence set forth on the issue was a “cover letter” to a “summary report” that was signed by a “manager.” The 5th Circuit reasoned that the summary report reflected the IRS examiner's prior determination to assert the gross valuation and that the manager approved the assertion.

The 5th Circuit's opinion in PBBM-Rose Hill appears to contradict to Congress' intent that section 6751(b)(1) prevent IRS agents from using penalty assertion as a bargaining chip in negotiations during an audit.In nearly every audit, the “manager” assigned to supervise the IRS agent will review the formal “summary report” and issue it under a similar cover letter. A summary report is issued, in most examinations, after the IRS agent completes the examination, not when the agent makes its “initial determination.” Penalties would be “brought into the conversation” much earlier if they were being improperly wielded as a club. Thus, the 5th Circuit's opinion renders the protections Congress sought to provide taxpayers in section 6751(b)(1) illusory.[12]

Permitting the IRS agent to threaten the imposition of penalties during the examination prior to an immediate supervisor's approval “would do nothing to stem the abuses § 6751(b)(1) was meant to prevent.”[13] The harm Congress sought to prevent was IRS agents using penalties as a bargaining chip in negotiations with taxpayers. The 5th Circuit's opinion appears to render the protection of Code section 6751(b)(1) a nullity. As the 2nd Circuit aptly reasoned, section 6751(b)(1) “would make little sense if it permitted written approval of the ‘initial determination' up until and even contemporaneously with the IRS's final determination.” [14]