The Tax Court ruled in Graev v. Commissioner, 147 T.C. No. 16, that a taxpayer was liable for the 20% accuracy-related penalty for a substantial understatement of income tax under Section 6662(a).  The case is notable as a lengthy full Tax Court opinion with a concurrence and a dissent that disagree regarding the proper procedures needed for a penalty determination to be valid.

Background

The original case involved a charitable contribution deduction for a donation of a façade easement to the National Architectural Trust.  The Tax Court denied the deduction for tax years 2004 and 2005.  The taxpayers then petitioned the Tax Court to contest their liability for the 20% accuracy-related penalty on the grounds that the IRS failed to comply with Section 6751(a) because the computation of the 20% penalty was not included in the original notice of deficiency. The taxpayers also argued that the IRS failed to comply with Section 6751(b) because the revenue agent did not obtain supervisory approval of the initial determination of the penalty.

Tax Court opinion

The taxpayers contended that they were not liable for the 20% accuracy-related penalty, because the notice of deficiency did not include the penalty, as required by Section 6751(a).  The revenue agent's initial notice provided only for a 40% gross valuation misstatement penalty under Section 6662(h).   The Chief Counsel's office then reviewed the notice and added a new sentence following the assessment of the Section 6662(h) penalty that said, "Alternatively, you are liable for the 20% accuracy-related penalty imposed under Section 6662(a) for 2004 and 2005."  The revenue agent revised the initial notice and provided calculations of the penalty for both years. The calculations showed a net zero amount attributable to the 20% Section 6662(a) penalty because it was reduced by the 40% Section 6662(h) penalty to avoid stacking.  The Chief Counsel attorney conceded the 40% penalty at trial, but still sought the 20% substantial understatement penalty.

The majority of the court (nine judges) found that the substantial understatement penalty was properly included in the notice of deficiency issued to the taxpayers.  The notice of deficiency clearly informed petitioners of the determination of the 20% penalty (as an alternative) and clearly set out the computation (albeit reduced to zero, as it had to be then, to account for the greater 40% penalty). Thus, the calculation showing a $0 penalty did not violate Section 6751(a). The court also found Section 6751(a) does not provide for a "consequence of noncompliance" if the IRS fails to include the penalty computation in the notice.

The majority of the court also disagreed with the taxpayers that the IRS violated Section 6751(b), which provides that an initial determination of a penalty must be approved by a supervisor before an assessment is made.  The majority found that, because the IRS had not yet assessed a 20% penalty, it was premature to consider whether the IRS had satisfied Section 6751(b).  A concurring opinion (three judges) declined to join in the reasoning of the majority opinion, but concurred in the result because it would have found that the actions of the IRS did not prejudice the petitioners, even though the IRS did not strictly comply with Section 6751(b). Finally, a dissenting opinion (5 judges) disagreed with the holding of the majority and concurrence, and would have concluded that Section 6751(b) was violated due to not obtaining supervisory approval of the 20% penalty at the time of the initial determination.

Implications

This case is a useful reminder of the procedures governing the assertion of the accuracy-related penalty under Section 6662 in the examination context.  The Internal Revenue Manual  (IRM) (Section 4.10.6.4) requires that an IRS revenue agent discuss the assertion of penalties, including alternative positions, with the taxpayer or representative before issuing an examination report. It also suggests that taxpayers should request an in-person meeting if there is a potential for a penalty being raised in an examination.  While the Tax Court's opinion did not elaborate on whether the exam team adhered to the IRM in this case, taxpayers should be aware of the current IRM procedures regarding the assertion of penalties during an examination.

Although the IRM (Section 20.1.1.2.3.1) provides that a tax examination change report (e.g., Form 4549, Income Tax Examination Changes) does not have to be reviewed by a manager before discussions with the taxpayer regarding the penalties, the manager must perform a meaningful review of the employee's penalty determination before assessment.  This review includes determinations as to whether the penalties were fairly and accurately computed, whether the employee did not improperly assert the penalties in the first instance as a bargaining chip, and whether the employee's conclusions regarding "reasonable cause" (or the lack thereof) were proper.  Taxpayers also should consider whether it is beneficial to invite the revenue agent's manager to a meeting regarding penalties with the IRS revenue agent.

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