Tax Court holds section 6662(i) is not a separate penalty


Authored by RSM US LLP

The U.S. Tax Court issued another division opinion regarding written supervisory approval of penalties. In Jesus R. Oropeza v. Commissioner, 155 T.C. No. 9 (Oct. 13, 2020), the Court held that the IRS failed to obtain section 6751(b)(1) written supervisory approval prior to initially notifying the taxpayer of the proposed section 6662(a) accuracy-related penalties. More significant, the Court held that the section 6662(i) 40% increase for section 6662(b)(6) (nondisclosed noneconomic substance transactions) does not constitute a distinct penalty. Therefore, if the underlying sections 6662(a) and 6662(b)(6) penalty lacks timely supervisory approval, then there is no applicable penalty for which the rate could be increased under section 6662(i). 

The taxpayer in Jesus R. Oropeza, was under exam for tax year 2011. The assessment limitation statute was approaching, so on Jan. 14, 2015, the revenue agent issued a Letter 5153 and Form 4549-A (revenue agent report), which included the assertion of the 20% penalty under sections 6662(a) attributable to one or more of the grounds under section 6662(b)(1), (2), (3) and (6). The letter gave the taxpayer three choices: (1) agree, (2) consent to extend the assessment statute and appeal or (3) decline the first two options and receive a notice of deficiency.  The revenue agent obtained supervisory approval a few weeks later, on Jan. 29, 2015. The taxpayer declined the first two options, and the IRS issued a deficiency notice on May 6, 2020. The notice asserted the 20% penalty on alternative grounds of negligence and substantial understatement. It also asserted for the first time the 40% increase under section 6662(i). The 40% increase had been approved on May 1, 2015. 

Section 6751(b)(1) 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 IRS characterized its May 6, 2015 deficiency notice as the initial determination, and argued it obtained timely supervisory approval on Jan. 29, 2015.    But the Court disagreed and found that the Jan. 14, 2015 Letter 5153 and revenue agent report constituted the initial determination and therefore the 20% penalty was not timely approved. Please see our Jan. 10, 2020 and Jan. 30, 2020 alerts for a discussion of the recent Tax Court opinions defining initial determination under section 6751(b).

The Court’s analysis of the 40% penalty increase under section 6662(i) is the significant aspect of this opinion. The parties agreed that the deficiency notice was the first notification to the taxpayer of possible liability for the increase.  The IRS again argued it obtained timely supervisory approval because the approval was dated May 1, 2015, before the deficiency notice was mailed to the taxpayer. The Court distinguished between section 6662(a) and section 6662(i) noting that the former is the ‘imposition of a penalty’, and the latter is an ‘increase in penalty’ in the case of a nondisclosed noneconomic substance transaction. Therefore, the Court first wanted to determine whether the Jan. 14, 2015 letter and revenue agent report asserted the section 6662(b)(6) penalty. If it did, and timely approval was not obtained, the Court wanted to determine if the IRS could nonetheless satisfy the written approval requirement by later asserting a timely approved section 6662(i) increase.  

The Court held that the Jan. 14, 2015 letter and revenue agent report (initial determination) ‘did’ assert the section 6662(b)(6) penalty (transaction lacking economic substance). The Court noted the IRS practice of asserting a penalty and including a list of potential grounds, and concluded any taxpayer reading such a list would believe that the IRS reserved the right to establish the penalty on ‘any’ of the listed grounds. Thus, because the Jan. 15, 2015 initial determination included section 6662(b)(6) as a potential ground, and the initial determination lacked timely written supervisory approval, the section 6662(b)(6) penalty was not valid.  Consistent with its statutory observation, the Court held that section 6662(i) was an increase to an existing penalty and not its own penalty. Therefore, if section 6662(b)(6) was not valid, then section 6662(i) cannot be applied.  

This case is good news for taxpayers. It illustrates some of the policy concerns behind the supervisory approval requirement. The IRS does not get a second bite at the apple. If the IRS fails to secure proper approval of an underlying penalty by later gaining timely approval of an enhancement provision, it cannot retroactively cure its initial error. The decision also holds the IRS accountable for asserting a penalty and listing multiple grounds upon which the penalty could be asserted. If the IRS is going to communicate all possible grounds early in the process, it will need approval of each ground. The decision is consistent with the underlying policy of curbing an individual agent from using threat of penalty to force the taxpayer into a concession. The facts of this case appear to be the textbook example of an agent pressed for time, and who communicated a list of penalty grounds to the taxpayer hoping for a concession or consent to extend the assessment statute. The Court even notes that to allow the 40% increase as a distinct penalty, would enable to the IRS to force a taxpayer into a choice between conceding or facing a doubled penalty in the event of an IRS approval mistake.