TAXLITIGATOR – Tax Controversy (Civil & Criminal) Report

The IRS often proposes penalties in notices of deficiency. Under IRC section 7491(c), in a proceeding in court, the IRS has the burden of producing evidence to show that the taxpayer is liable for the penalty.  Under IRC section 6751(b)(1), the IRS cannot assess a penalty “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.”  There are exceptions to the need for a supervisor’s written approval, including late filing and payment penalties and penalties that are computed by electronic means.

In Chai v. Commissioner, Docket Nos. 15-1653 (2^nd Cir. Mar. 20, 2017), the Second Circuit held that the IRS has the burden of proving compliance with section 6751(b). Chai also involves an interesting issue on the relationship between TEFRA partnership adjustments and deficiency proceedings and on whether a taxpayer is engaged in a trade or business, but a discussion of those issues will have to wait for a future blog.

The taxpayer in Chai received a 1099 for $2 million from his employer.  He claimed that the $2 million was a return of capital.  The IRS treated the payment as compensation.  Due to the fact that Chai was “over sheltered,” i.e., his losses from tax shelters exceeded all of his reported income plus the $2 million, he could not have an income tax deficiency unless the partnership losses were disallowed in TEFRA partnership proceedings.  So the IRS issued a notice of deficiency asserting self-employment tax on the $2 million plus a 20% accuracy-related penalty under IRC section 6662.

While Chai’s Tax Court case was pending, the TEFRA partnership proceedings ended with the losses being disallowed. The IRS amended its answer to assert that he owed an income tax deficiency on the $2 million.  The Tax Court ruled that it did not have jurisdiction to decide whether there was an income tax deficiency as a result of disallowance of the partnership losses.  It did, however, hold that the $2 million was compensation and that Chai owed self-employment tax.  It also held that he was liable for the 20% penalty. The Tax Court further held that Chai’s argument that the IRS failed to prove that the supervisor signed off on the penalty was not raised until post-trial briefing and, thus, was too late.  The Second Circuit reversed.

While the appeal was pending in Chai, the Tax Court issued its opinion in Graev v. Commissioner, 147 T.C. No. 16 (2016).  In Graev, the Court held that section 6751(b) only requires written approval before assessment. Since that wouldn’t occur until after the Tax Court’s decision, it was premature to raise the issue in a Tax Court deficiency case.

The IRS had argued in Tax Court that Chai raised the issue of supervisor approval too late. Before the Second Circuit it changed it tune.  It argued that Chair’s claim was premature, relying on Graev.

The Second Circuit sided with the taxpayer and rejected the Graev Court’s interpretation of section 6451(b).  Based on the historical meaning of “assessment” the Second Circuit found the phrase “initial determination of such assessment” ambiguous.  It therefore looked to the legislative history.  Congress enacted section 6571(b) out of concern that the IRS was using penalties as bargaining chips to get taxpayers to agree to larger deficiencies in exchange for not being assessed a penalty.  This would indicate that approval was to be given before a notice of deficiency was issued, since if a taxpayer went to Tax Court and lost, any approval by a supervisor would be meaningless.  The Second Circuit also noted that the IRS’s administrative practice was to require that the supervisor’s written approval be given before the notice of deficiency was issued.  The Second Circuit also emphasized the fact that approval was required before the “initial determination,” which would be no later than when a notice of deficiency is issued.

The Second Circuit next held that proving supervisory approval was part of the IRS’s burden of proof under section 7491(c). The final issue was whether the Tax Court abused its discretion in determining that Chai had raised the issue too late.  It had.  The IRS failed to produce evidence that supervisory approval was given and all Chai was doing was arguing that there was insufficient evidence to permit a finding in favor of the IRS on the penalty issue.

The moral: where the IRS has the burden of proof, hold its feet to the fire. While he won on the penalty issue, it didn’t turn out all that well for Chai.  The Second Circuit reversed the Tax Court’s decision that it did not have jurisdiction to determine whether Chai was taxable on the $2 million.  But that is a story for another day.

ROBERT S. HORWITZ – For more information please contact Robert S. Horwitz – horwitz@taxlitigator.com or 310.281.3200   Mr. Horwitz is a principal at Hochman, Salkin, Rettig, Toscher & Perez, P.C., a former Assistant United States Attorney of the Tax Division of the Office of the U.S. Attorney (C.D. Cal) and represents clients throughout the United States and elsewhere involving federal and state, administrative civil tax disputes and tax litigation as well as defending criminal tax investigations and prosecutions. Additional information is available at http://www.taxlitigator.com