It was a wild-card weekend in the National Football League, and when the dust settled, many fans were left wondering: When is a penalty a penalty? The Tax Court tackled that same argument in a recent case that, like the bid for the playoffs, resulted in a significant divide.
The Internal Revenue Service has made no secret that it has its eye on charitable easements. Overstating the value of an easement is precisely what attracted attention to Belair Woods, LLC (Belair). But the issue that landed the taxpayers in Tax Court (for a second time) was just as controversial: assessment of penalties.
In 2009, Belair claimed a charitable deduction of $4,778,000 for the donation of a conservation easement. The IRS believed that Belair had overvalued the easement and in 2012, issued a notice of adjustment disallowing the deduction because Belair had not properly substantiated the value. The matter went to Tax Court, which found that “[t]his was not a case of inadvertent omission, but of a conscious election not to supply the required information.” (Belair Woods, LLC v. Commissioner, T.C. Memo. 2018-159)
The IRS also assessed penalties to the taxpayer. The timeline is important. In October of 2012, the IRS informed Belair: “We’re beginning our audit of your partnership’s federal tax return.” The next month, the revenue agent assigned to the case concluded that Belair had substantially overvalued the easement. Over the next few weeks, the agent discussed the application of penalties with her supervisor.
In December of 2012, the agent sent a letter inviting Belair to a meeting to discuss the matter. In the letter, the agent explained that she intended to deny the charitable contribution deduction and impose a “gross valuation misstatement” penalty under Section 6662(a) and (h). She also outlined proposed penalties for negligence and substantial understatement of income tax and explained the available defenses.
The agent met with the taxpayer in February 2013 and made some progress. The IRS and taxpayers held a second meeting in May 2014, but that meeting was not as productive: They didn’t reach an agreement. Eventually, the agent finalized the Civil Penalty Approval Form, which she had initiated when the audit began, and forwarded it to her supervisor. On Sept. 2, 2014, the supervisor signed off on the three penalties listed on that form.
On March 9, 2015, the IRS issued a 60-day letter formally advising the taxpayer of the adjustments and three penalties. The letter explained that the taxpayers could accept the changes, or appeal. The taxpayer chose to appeal.
On June 19, 2017, the Appeals Office informed the taxpayer that it was disallowing the charitable deduction and was applying a gross valuation misstatement penalty. The IRS also advised that it was considering penalties for negligence, substantial understatement of income tax, and substantial valuation misstatement under Section 6662(e). This was the first time the IRS had suggested to the taxpayer that it was considering a Section 6662(e) penalty.
The matter eventually landed in Tax Court, where the taxpayer asked for summary judgment, meaning that they wanted the judge to decide the case without a full trial. The question at issue was whether the IRS complied with Section 6751(b)(1). That section 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.”
In its decision, the Tax Court threw back to Clay v. Commissioner, 152 TC 223, 249 (2019). In Clay, the Tax Court interpreted Section 6751(b)(1) to require supervisory approval before the date of the notice of deficiency or the date when the IRS formally communicates the assertion of a penalty and the right to appeal (whichever is earlier).
Relying on Clay, the Tax Court found that sending the letter and inviting the taxpayer to a meeting didn’t constitute “the initial determination” of a penalty. The intent of the letter, according to the Tax Court, was to put Belair on notice that penalties were under consideration and present the opportunity to argue its side of the story.
If that ruling sounds to you a little bit like Monday-morning quarterbacking, you’re not imagining it. There is no instant replay in tax law. The Tax Court can only review what happened and make a ruling.
The Tax Court suggested that if an initial review of the Belair case were equivalent to a determination, “a strategically minded taxpayer” could raise penalties as an early defense. If the agent hadn’t already obtained supervisory approval at the start, the taxpayer could argue that no penalties could be assessed. That isn’t, the Tax Court explained, what Congress intended.
Furthermore, the Tax Court found that the “initial determination” was spelled out in the 60-day letter issued in 2015. Since the supervisor had signed off on that letter, that means that the IRS complied with the requirements of Section 6751(b)(1) for the first three penalties.
However, the Tax Court didn’t agree that the IRS satisfied the requirements of Section 6751(b)(1) for the fourth penalty. That’s because it wasn’t clear that the penalty was even a consideration until the matter was appealed—thus, no timely supervisor approvals.
The opinion wasn’t unanimous. A split court issued a concurrence and two dissents. In his dissent, Judge Gustafson argued that the result “misconstrues the statute in a manner that frustrates and even contradicts its purpose.” The purpose of the statute, he wrote, is to “undo the determinations of individual agents who make unapproved assertions of penalty liability.” The majority, however, he says, suggests that they may not need supervisory approval, which he argued was not the right result.
But isn’t a win a win? Why do these dissents matter?
Consistency matters to taxpayers when determining the timing and applicability of penalties. The importance of applying the rules uniformly means that those impacted know what to expect. Like the arguments over penalties in sports, so long as there’s ambiguity, you can count on future controversies.
This is a weekly column from Kelly Phillips Erb, the TaxGirl. Erb offers commentary on the latest in tax news, tax law, and tax policy. Look for Erb’s column every week from Bloomberg Tax and follow her on Twitter at @taxgirl.