Code Section 6751(b)(1) requires personal, written approval “by the immediate supervisor” of the “initial determination” of a penalty assessment. A string of recent cases have put into question what an “initial determination” means, at what point in time the approval is needed, and who is the appropriate “immediate supervisor” to approve the determination. The most recent in this line of cases is Graev v. Commissioner, 149 T.C. 23 (2017) (“Graev III”). Dynamo Holdings v. Commissioner, 150 T.C. 10 (2018), considered the impact of Graev III in the context of partnership proceedings. The IRS has published litigating guidelines in light of these and other cases.
In Graev III, the Tax Court partially adopted the holding of the Second Circuit in Chai v. Commissioner, 851 F.3d 190 (2d Cir. 2017). In a prior split opinion in Graev II, the Tax Court sustained a penalty against individual taxpayers. The majority opinion held that approval under section 6751(b)(1) could be obtained at any time before the penalty was assessed and that the taxpayers’ challenge of the penalty in a deficiency case was premature. The dissenting opinion, joined by four other judges, would have held that approval must be obtained prior to initiating Tax Court proceedings. See Graev v. Commissioner, 147 T.C. 16 (2016), and Tax News and Developments article, The IRS Skips Statutory Procedures—The Tax Court Rules in its Favor (Vol. XVII, Issue 2, March 2017).
Subsequently, the Second Circuit in Chai reversed a Tax Court order that had upheld a penalty assessed against an individual taxpayer. The Second Circuit declined to follow the majority opinion in Graev II. Instead, the court concluded that approval must be obtained no later than the date that the IRS issued the notice of deficiency (or filed an answer or amended answer) asserting the penalty. Reading sections 7491(c) and 6751(b)(1) together, Chai further held that compliance with section 6751(b) was part of the IRS’s burden of production and proof in deficiency cases. Under section 7491(c), “the Secretary shall have the burden of production in any court proceeding with respect to the liability of any individual for any penalty ….” See Tax News and Developments article, The Second Circuit Agrees with Dissenting Tax Court Judges to Hold the Commissioner Accountable (Vol. XVII, Issue 4, May 2017).
Because Graev II was appealable to the Second Circuit—the same Court of Appeals as Chai—the Tax Court vacated Graev II. Subsequently, in Graev III, the Tax Court overruled in part Graev II which rejected taxpayers’ argument as premature. Graev III held that the written supervisory approval must occur no later than the date the IRS mailed the notice of deficiency (or filed an answer or amended answer) asserting the penalties. Graev III also held that part of the IRS’s burden of production for penalties under section 7491(c) included producing evidence of compliance with section 6751(b). The Tax Court ruled that the IRS had shown compliance with section 6751(b) and that the taxpayers were liable for the penalty. The dissent—joined by five other judges—partially dissented because the penalties in the Graev cases were not approved by a supervisor who had authority to do so. See prior analysis on Graev II for factual background.
In Dynamo Holdings, the Tax Court held that, section 7491(c), which applied to “any court proceeding” with respect to the “liability of any individual,” was inapplicable to partnership-level proceedings or corporate-level proceedings. The IRS did not bear the burden of production in these proceedings, but that lack of compliance with section 6751(b) may be raised as a defense by the taxpayer. The court focused its analysis on partnership-level proceedings.
First, under a plain reading of the statutes governing partnership-level proceedings, such proceedings were not with respect to the liabilities of individuals. The tax treatment of partnership items and the applicability of any penalty, addition to tax, or additional amount relating to an adjustment to a partnership item, were determined at the partnership level. Once a partnershiplevel proceeding was final, the liability of the partners may be determined in a partner-level proceeding, where partners may raise defenses to penalties.
Moreover, the very nature of partnership-level proceedings was inconsistent with section 7491(c), which focused on liability. A partnership-level proceeding did not determine the liability of any partner for either tax or penalties. In addition, partnership-level proceedings were not proceedings with respect to “individuals”—partnerships were not individuals. Lastly, other Code sections and other subsections of section 7491 showed that Congress did not intend section 7491(c) to apply to partnership-level proceedings. The Tax Court noted “practical concerns” in partnership-level proceedings that made the Tax Court’s approach the “only reasonable approach.”
Chief Counsel Notice CC 2018-006
In light of Graev III, the IRS has released guidance to Chief Counsel attorneys on how to address compliance with section 6751(b) in litigation. IRS, Office of Chief Counsel, Notice CC-2018-006, “Section 6751(b) Compliance Issues for Penalties in Litigation” (Jun. 6, 2018) (“CC-2018-006”). CC-2018-006 provides litigating guidelines on, among others, the following: (1) burden of production and burden of proof; (2) compliance with section 6751(b)(1) in deficiency cases and Tax Equity and Fiscal Responsibility Act of 1982 (“TEFRA”) cases; (3) how to show evidence of compliance; and (4) what to do when there is no such evidence.
CC-2018-006 largely echoes the holdings of the recent decisions and recommends that Chief Counsel attorneys be vigilant on documenting compliance with section 6751(b)(1). For instance, CC-2018-006 instructs attorneys to submit evidence of compliance during litigation, regardless of whether the petitioners have raised the issue, “at the earliest opportunity, and no later than filing the pretrial memorandum.” When Chief Counsel attorneys review a notice of deficiency and recommend a penalty, they should obtain approval from their immediate supervisor and prepare a memorandum to memorialize the recommendation and approval. When Chief Counsel attorneys raise penalties in litigation, they should obtain their supervisor’s signatures. These instructions are in direct response to the fact pattern in the Graev cases. Chief Counsel attorneys also must concede the penalty if they cannot find evidence to establish compliance with section 6751(b)(1). Chief Counsel attorneys must concede “at the earliest opportunity, which will typically be in the answer, and in all events at the very latest in the pretrial memorandum.”
CC-2018-006 also hammers home IRS-friendly takeaways. For instance, CC2018-006 states repeatedly that compliance with section 6751(b)(1) is not necessarily a part of the IRS’s burden of proof. CC-2018-006 points out that both the majority and concurring opinions in Graev III questioned Chai’s holding that producing evidence of compliance with section 6751(b)(1) was part of the IRS’s burden of proof in deficiency cases. CC-2018-006 also reminds the Chief Counsel attorneys that the IRS can assert penalties later on in answers or amended answers, even if they were not included in the notice of deficiency.