In Graev III, issued late last year, the Tax Court held that the Commissioner must comply with section 6751(b)(1) as part of his burden of production for tax penalties. Section 6751(b)(1) requires that an initial penalty determination be approved in writing by the immediate supervisor of the individual making the determination. As a result of Graev III, the Commissioner faces significant issues in penalty cases, as shown most recently by Becker v. Commissioner, a Judge Holmes decision released last week.
In Becker, a key issue was the fraud penalty under section 6663. Section 6663 imposes a penalty on any underpayment of tax due to fraud equal to 75% of the underpayment. The Commissioner determined that the taxpayer, Mr. Becker, was liable for the fraud penalty because he filed his tax returns with the intent to evade tax. For the fraud penalty, the Commissioner must show by clear and convincing evidence that the taxpayer underpaid and that the underpayment was attributable to fraud. A number of things can show fraudulent intent, including understating income, keeping inadequate records, failing to file tax returns, implausibly explaining behavior, and concealing assets.
Judge Holmes found that Mr. Becker almost certainly had fraudulent intent. He consistently understated his income, took large deductions to zero out his returns, and failed to keep sufficient records. Mr. Becker also provided implausible and inconsistent explanations for his behavior. At trial, he said that his Schedules C were completely fabricated, but he told the IRS that his accountant told him to report what he reported. Mr. Becker gave varying explanations for his lack of records as well. Once he told the IRS that he would give it the documents it requested; later he said that the documents were destroyed by a hurricane.
The Tax Court would normally sustain the Commissioner’s fraud penalty determination on these facts. But Graev III held that the Commissioner must comply with the section 6751(b)(1) written supervisory approval requirement as part of his burden of production for penalties. In Becker, the Commissioner never raised section 6751 before or at trial – even though Mr. Becker put the penalties at issue.
As a result, Judge Holmes considered the consequences of failing to comply with Graev III. Section 6751 is not a new Code section, and Graev III did not create new law. It simply interpreted section 6751(b)(1). The Tax Court treats Graev III’s construction of section 6751(b)(1) as the correct construction, even before Graev III was decided. Thus, Judge Holmes held that Mr. Becker was not liable for the fraud penalty because the Commissioner failed to meet the section 6751(b)(1) supervisor approval requirement – even though Mr. Becker’s fraud was evident.