General Tax Controversy News & Updates

I have recently penned a Law360 article discussing lessons learned from recent tax decisions impacting cannabis businesses.  We will continue to cover this topic on this blog.

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Yesterday, the Tax Court issued its opinion in Alterman v. Commissioner, T.C. Memo 2018-83.  This case involved the operation of a medical marijuana dispensary which was reported on Schedule C.  The opinion includes a long recitation of intricate accounting details that I will address on a summary basis so as to not lose readers other than accountants.  Readers interested in the details should read the opinion linked above.

The important facts are as follows:

  • The taxpayer sold marijuana and non-marijuana products.  The sales of non-marijuana products were 1.4% of gross receipts in 2010 and 3.5% of gross receipts in 2011.
  • On the tax returns, the taxpayer reduced gross receipts by cost of goods sold.  The taxpayer also deducted business expenses.  It does not appear based on the findings of fact that on the original return the taxpayer disallowed any expenses pursuant to Section 280E.
  • It appears the amount of cost of goods sold claimed on the return was, for the most part, amounts paid for purchases of inventory and did not include production costs.  At trial, the taxpayer asserted that it incurred over $100,000 of production costs each year in addition to the amounts paid for purchases of inventory.

The court found:

  • The sales of non-marijuana products were complimentary to the sales of marijuana products and therefore, were not a separate trade or business.  Even if the non-marijuana product sales were a separate trade or business, the record did not give the court any basis for determining the expenses attributable to the secondary business of sales of non-marijuana products.
  • The court applied Section 471 to determine cost of goods sold.  Section 471 allows taxpayers to include direct and indirect production costs in cost of goods sold.
  • The amount of cost of goods sold conceded by the IRS, which does not appear to include production costs, was the allowable amount of cost of goods sold because the taxpayers failed to properly account for beginning and ending inventories.
  • The taxpayer was negligent and subject to the negligence penalty because they did not keep adequate records to compute beginning and ending inventories or adequate books and records.  Further, there was no reasonable cause because the taxpayers did not seek advice regarding inventory accounting or the application of Section 280E.

Lessons and observations:

  • It is important that taxpayers subject to Section 280E use their best efforts to apply Section 280E when filing returns.
  • It is important that taxpayers subject to Section 280E properly classify costs as inventory costs when filing returns and maintain beginning and ending inventories with integrity.
  • It is important that taxpayers retain records needed to substantiate all accounting entries.
  • The substantiation issues are not unique to the marijuana industry.  However, due to high audit rates and the impact of Section 280E, the cost of the failure to substantiate is uniquely burdensome.  That being said, here, it is unclear how the failure to substantiate beginning and ending inventory also creates a restriction on the production costs that should be allowed.  Careful documentation and preparation of returns should overcome some of these burdens.

Attorneys representing cannabis businesses are often faced with questions about what happens when the cannabis business has not paid its taxes and the IRS is proceeding with collection actions.  No one thinks the IRS will seize and sell cannabis to satisfy tax liabilities, because in doing so the IRS would engage in criminal violations of the Controlled Substances Act.  However, recently, IRS Chief Counsel issued advice addressing questions posed by the field about whether an IRS sale of equipment used in a cannabis business would result in a violation of criminal laws.

In CCA 2018042616201420, Chief Counsel determined that Gas Chromatographer Mass Spectrometers (GCMS) and Liquid Chromatographer Mass Spectrometers (LCMS) used by taxpayers involved in the marijuana industry to measure the amount of cannabinoids in marijuana were not drug paraphernalia under the Drug Paraphernalia Statute, 21 U.S.C. § 863.  The conclusion was that because the equipment, which is used to measure organize material, can be used for purposes other than measuring cannabinoids, such as in fire investigations, explosive investigations, and even the identification of foreign material collected from outer space, the equipment was not drug paraphernalia.

The CCA also concluded that the existence of marijuana residue on the equipment did not prohibit the sale because, pursuant to 21 U.S.C. § 841(a), the existence of a residual amount of a controlled substance did not create the intent to distribute a controlled substance.

The CCA advised that the equipment should be subject to a “deep cleaning” prior to sale not only to avoid any possibility of a criminal violation but also to maximize the value of the equipment at auction.    The cost of this cleaning should be considered by Collections when determining collection potential of the property.

In Wendell Falls Development, LLC v. Commissioner, T.C. Memo. 2018-45, the Tax Court denied a charitable contribution deduction for a taxpayer’s contribution of a conservation easement because the taxpayer expected to receive a substantial benefit from the donation.

The taxpayer purchased 27 contiguous parcels of unimproved land, comprising 1,280 acres. The taxpayer planned to subdivide the 1,280 acres into a master-planned community with residential areas, commercial spaces, an elementary school, and a park. The taxpayer would then sell the lots to builders.

The taxpayer identified 125 acres of the 1,280 acres as land upon which a park would be placed. The taxpayer and the County discussed the County acquiring the 125 acres for use as a county park. The taxpayer sought to ensure that the 125 acres would be restricted to park use and proposed placing a conservation easement on the 125 acres. Ultimately, the taxpayer and the County entered into a purchase agreement for the 125 acres, and placing a conservation easement on the land was a precondition to the sale. The taxpayer granted a conservation easement on the 125 acres in favor of a land trust and transferred ownership of the 125 acres to the County. The taxpayer claimed a charitable deduction for its contribution of the conservation easement on its tax return.

The issue here is the “substantial benefits” test. No deduction for a charitable contribution is allowed if the taxpayer expects a substantial benefit from the contribution. The taxpayer owned and intended to sell the 1,280 acres of land adjoining the 125 acres that was designated as park land. The taxpayer’s master-planned community was designed so that all residential areas would have access to the 125-acre park.  According to the Court, the taxpayer expected a substantial benefit from the donation because it sought to ensure that the 125 acres was restricted to park use, and as the prospective seller of the lots the taxpayer “would benefit from the increased value to the lots from the park as an amenity.” Because the taxpayer expected a substantial benefit from the donation, the Court disallowed the charitable deduction. (Note: alternatively, the Court determined that the value of the easement was zero because the park land did not diminish the value of the 125 acres).

Recently, the written supervisory approval requirement of Section 6751(b) has been one of the primary issues in Tax Court litigation concerning penalties that the IRS has asserted against taxpayers. The focus of this litigation is the effect of Section 6751(b) and its interplay with the Commissioner’s burden of production as to penalties in court proceedings under Section 7491(c). In Dynamo Holdings v. Commissioner, 150 T.C. No. 10 (May 7, 2018), the Tax Court addressed these issues in a partnership-level proceeding.

Section 6751(b)(1) 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…” (note that Section 6751(b)(2) provides certain exceptions to this general rule).

Section 7491(c) provides that the IRS “shall have the burden of production in any court proceeding with respect to the liability of any individual for any penalty, addition to tax, or additional amount imposed by this title.”

Until the Chai and Graev III opinions, there had been little litigation over the effect of Section 6751(b).

In Chai v. Commissioner, 851 F.3d 190 (2nd Cir. 2017), the taxpayer argued in his post-trial brief that compliance with the written-approval requirement in Section 6751(b)(1) is an element of the Commissioner’s claim for penalties and is therefore part of the Commissioner’s burden of production under Section 7491(c). The Second Circuit Court of Appeals agreed, holding that Section 6751(b)(1) requires written approval of the initial penalty determination no later than the date the IRS issues the notice of deficiency (or files an answer or amended answer) asserting such penalty. Chai held that Section 6751(b) is part of the Commissioner’s burden or production in a deficiency case in which a penalty is asserted.

In Graev v. Commissioner (Graev III), 149 T.C. No. 23 (Dec. 20, 2017), the Tax Court held that the Commissioner’s burden of production under Section 7491(c) includes establishing compliance with the written supervisory approval requirement of Section 6751(b). Thus, in a deficiency case in which a penalty is asserted, it is the IRS’s burden to introduce sufficient evidence establishing compliance with the supervisor approval requirement.

In Dynamo Holdings, the Tax Court addressed the interplay between the supervisor approval requirement and the IRS’s burden of production in a partnership-level proceeding. The Court held that the IRS does not bear the burden of production with respect to penalties under Section 7491(c) in a partnership-level proceeding. The Court reasoned that Section 7491(c) provides that the IRS has the burden of production “with respect to the liability of any individual for any penalty…” Because partnership-level proceedings do not determine liabilities and are not with respect to individuals, the IRS does not bear the burden of production as to penalties. In a similar vein, the IRS does not bear the burden of production with respect to penalties asserted against corporations.

The Court further held that where the IRS does not bear the burden of production as to penalties, the lack of supervisory approval of penalties may be raised as a defense to those penalties. However, taxpayers should note that they must affirmatively argue that the IRS failed to comply with the supervisory approval requirements of Section 6751. Failure to make such an argument can be costly, as the taxpayer will be deemed to have waived the defense.

United States v. Gerard, a recent case from the Northern District of Indiana, demonstrates how a tax lien, once attached, can stay with property even after the property is conveyed to someone other than the taxpayer.  In 1990, a husband and wife named Robert and Cynthia Gerard bought a residence as tenants by the entirety.  Although the Gerards bought the residence together, Robert paid at least 90% of the purchase price.  Between 2003 and 2008, Cynthia owned a business with outstanding employment and unemployment taxes.  The Gerards and the government generally agreed that the assessments for these tax liabilities attached to Cynthia’s interest in the property.  As time went on, Robert and Cynthia decided to convey the property solely to Robert.  The deed stated that the conveyance was “by way of gift and without any consideration other than for love and affection.”

The government, however, still wished to enforce the liens.  Litigation ensued, and the government moved for summary judgment.  The key issue was whether the liens that were attached to Cynthia’s interest in the property survived the severance of the tenancy by the entirety.  Section 6323 provides that a lien is not valid against a purchaser until the IRS files proper notice.  Thus, according to the court, Robert would not be liable for Cynthia’s outstanding tax balance if Robert was a “purchaser.”  A “purchaser” is “[a] person who, for adequate and full consideration in money or monies worth, acquires an interest (other than a lien or security interest) in property which is valid under local law against a subsequent purchaser without actual notice.”  IRC § 6323(h)(6).  “Adequate and full consideration in money or money’s worth” is “a consideration in money or money’s worth having a reasonable relationship to the true value of the interest in property acquired.”  Treas. Reg. § 301.6323(h)-1(f)(3).

The Gerards argued that Robert was a purchaser because Cynthia used marital assets to pay her business’s expenses and then transferred her interest in the property in repayment of those debts.  The government, however, pointed out that the deed specifically stated that the transfer was made “by way of gift and without any consideration other than for love and affection,” and that any consideration would have been past consideration, which was insufficient.

The court was not concerned that the deed stated that the property was a gift.  It noted that “[i]t is a well-known fact that often a conveyance recites a nominal consideration whereas the true consideration is not nominal.  It is therefore never certain that the recited consideration is the true consideration.”  Clark v. CSX Transp., Inc., 737 N.E.2d 752, 759 (Ind. Ct. App. 2000).  The court was, however, concerned with the fact that the parties agreed that the use of marital assets to pay Cynthia’s business expenses was “past consideration.”  Under the regulations, “adequate and full consideration” includes past consideration only if, “under local law, past consideration is sufficient to support an agreement giving rise to a security interest. . .”  Treas. Reg. § 301.6323(h)-1(a)(3); (f)(3).  Accordingly, the court turned to Indiana law to determine whether past consideration could create a security interest.

The Gerards could not cite any Indiana authority indicating that past consideration gives rise to a security interest.  Also, other federal courts hold that past consideration does not make a party a “purchaser” under section 6323(a).  See, e.g., United States v. Register, 727 F. Supp. 2d 517, 526 (E.D. Va. 2010).  Thus, the court concluded that Robert was not a purchaser under section 6323(a) and that the liens attached to Cynthia’s interest in the property survived the conveyance.

The parties still disputed the extent to which the liens attached to the property.  The government argued that the liens remained attached to a one-half interest in the property.  The Gerards, however, argued that Cynthia’s actual interest was worth less than one-half of the property when it was conveyed, so the liens only attached to something less than a one-half interest.  Here again, the court found that Indiana law did not support the Gerards’ argument.  For example, in Radabaugh v. Radabaugh, the court held that the trial court erred by “conclud[ing] that appellee was the owner of less than an undivided one-half interest in the mortgage loan” for real estate owned by a husband and wife as tenant by the entirety.  35 N.E.2d 114, 115-16 (Ind. Ct. App. 1941).  Thus, the court concluded that the liens were still attached to one-half of Robert’s interest in the property, even after the conveyance.

 

The Tax Cuts and Jobs Act, enacted in December 2017, is the most significant change to the U.S. Tax Code since 1986 and dramatically alters the tax landscape for individuals. A number of changes take effect this year, while other provisions will not take effect until 2019. Many provisions are temporary, set to expire in 2026, which creates uncertainty for tax planning.

New Income Tax Rates and Loss of Itemized Deductions

Most fundamentally, the new law significantly lowers income tax rates for individuals. The top individual rate is now 37 percent – down from 39.6 percent. Individuals can earn more before the top rate applies as well. Under the prior law, the top rate applied to any income over $470,000 for married individuals filing jointly. Now, the top rate for those individuals applies only to income over $600,000. These lower rates currently apply only to the 2018 through 2025 tax years.

The law also significantly increases the standard deduction. The standard deduction for married individuals filing jointly is now $24,000. For head-of-household filers, the standard deduction is now $18,000, and $12,000 for all other taxpayers. The law slashes a number of itemized deductions, however, such as the deductions for unreimbursed employee expenses, union dues, and tax preparation fees. As a result, more individuals should elect the standard deduction.

State and Local Deduction Limitation

Another major change is a new $10,000 limitation on the deduction for state and local tax, or SALT, which includes state and local income taxes, local real estate taxes and state sales taxes. Previously, there was no limitation on an individual’s SALT deduction. The new limitation is more unfavorable for individuals in high tax states, such as California and New York. The average SALT deduction in California was around $18,500, while the average deduction in New York was around $22,000.

Some states, notably New York and California, are attempting to work around the SALT limitation. The California Senate recently passed a bill that would allow taxpayers a credit against their state income tax for contributions to the newly created California Excellence Fund. The theory is that Californians could also deduct these contributions for federal tax purposes as charitable contributions. If the California bill becomes law, the IRS will likely challenge it. It is unclear whether these “contributions” would actually count as charitable contributions because there would be no real charitable intent.

New York, New Jersey and Connecticut are also preparing to sue the federal government to challenge the SALT deduction limitation.

Mortgage Interest Deduction Limitation

The law also reduces the amount of mortgage interest individuals can deduct. The previous limit was $1 million, but the new law caps mortgage interest deductions at $750,000 on acquisition indebtedness. Acquisition indebtedness is debt incurred in acquiring, constructing or substantially improving a residence. The new law also completely disallows the deduction for home equity indebtedness interest – even if the home equity loan was taken out before the new law was enacted.

Increased Charitable Contribution Deduction Limitation

The new law is more favorable to charitable contributions. It increases the limits on deductions for charitable contributions to public charities and some private foundations from 50 percent to 60 percent of an individual’s adjusted gross income. For tax purposes, however, the increased limit is helpful only for individuals whose itemized deductions are higher than the increased standard deduction.

One way to beat the higher standard deduction and take advantage of the increased limit on itemized charitable deductions is to “bunch” charitable contributions that would otherwise be made over several tax years into one year.

Other Changes to Consider

There are a number of other changes individuals should consider. The law removes the tax for failing to have health insurance, starting in 2019. This could effectively undermine the entire Affordable Care Act. It also modifies the alternative minimum tax, or AMT, by increasing the exemption amount. The higher exemption amount means that fewer taxpayers will be subject to the AMT. The law also curtails the availability of “like-kind” exchanges.

Under Section 1031, taxpayers could previously exchange all property for similar property and defer the tax. Now, however, real estate is the only property that qualifies for like-kind exchange treatment.

Finally, it is important to note the significant changes for taxpayers who hold interests in pass-through entities. The new law creates a 20 percent deduction for certain business income from pass-through entities. Importantly, however, the deduction does not apply to certain service businesses, including law and accounting firms.

In CRI-Leslie, LLC, the Eleventh Circuit confronted whether a taxpayer is entitled to capital gains treatment for a forfeited deposit on the sale of land.  CRI-Leslie, LLC, Donald W. Wallace, Tax Matters Partner v. Commissioner, 11th Cir., No. 16-17424, February 15, 2018.  It is not a stretch to describe this area as “among the most frustrating in income tax law.”  Sirbo Holdings, Inc. v. Commissioner, 509 F.2d 1220, 1223 (2d Cir. 1975).

In 2005, CRI-Leslie paid almost $14 million for a hotel and restaurant in Tampa on prime waterfront property.  It planned to eventually sell the property, but it hired a third party to run everything in the meantime.  Over a year later, CRI-Leslie agreed to sell the property for around $39 million.  As part of the deal, CRI-Leslie received a $9.7 million nonrefundable deposit to be credited to the purchase price at closing.  But in 2008, the buyer fell through and forfeited the deposit.  CRI-Leslie reported the $9.7 million deposit as long-term capital gain.  The IRS disagreed, and argued that the Code allows capital gains treatment only for finalized sales, not forfeited deposits.

The case made its way to the Eleventh Circuit, which began its analysis with section 1231.  Section 1231(a) states that “any recognized gain on the sale or exchange of property used in the trade or business” is “treated as long-term capital gains.”  (Emphasis added).  Section 1231 also provides that the “term ‘property used in the trade or business’ means property used in the trade or business, of a character which is subject to the allowance for depreciation provided in section 167, held for more than 1 year, and real property used in the trade or business, held for more than 1 year ….”  If CRI-Leslie had actually sold the property, the $9.7 million would have been taxed as long-term capital gain under section 1231.

But the deal never happened, so the tax treatment of the deposit was governed by section 1234A, not section 1231.  Section 1234 states that any gain or loss resulting from the termination of an agreement to buy property will still be treated as capital gain, if the property is a “capital asset” for the purposes of section 1234A.  Thus, the narrower issue was whether the hotel was a capital asset.

The Eleventh Circuit held that the answer could not be clearer based on a plain reading of the Code.  For the purposes of section 1234A, “the term ‘capital asset’ means property held by the taxpayer (whether or not connected with his trade or business), but does not include … property, used in his trade or business, of a character which is subject to the allowance for depreciation provided in section 167, or real property used in his trade or business.”  IRC § 1221(a)(2) (emphasis added).

The problem for CRI-Leslie was that it stipulated that the hotel was real property used in its trade or business.  The Eleven Circuit held that this concession by CRI-Leslie was fatal because “capital asset” does not include real property used in a trade or business under section 1221(a)(2).  That meant that the hotel was not a capital asset under section 1221, so section 1234A – the special rule that says that property from the termination of a contract for the sale of a “capital assets” is still subject to capital gains treatment – did not apply.  As a result, the Eleventh Circuit held that the $9.7 million forfeited deposit was taxable as ordinary income.

The White House released a statement on February 8, 2018 that President Trump nominated Charles Rettig as the new Commissioner of Internal Revenue Code for the remainder of a five year term that began in November 2017.  Unlike other recent presidential nominees that may have ignited fierce debate among political parties, Rettig’s nomination has been universally praised across party lines and by both the public and private sector of tax practitioners.  Rettig spent over thirty-five years in private practice defending clients against the IRS, but also recently published an article discussing the pitfalls of tax collection today and encouraging greater tax enforcement.  Although Rettig’s professional experience is in the private sector, he has consistently encouraged and advocated for voluntary tax compliance and tax enforcement.  Rettig will likely bring this perspective to his new position as IRS Commissioner.

Professional Experience

Rettig spent the last thirty-five years at Hochman, Salkin, Rettig, Toscher & Perez, P.C. in Beverly Hills, California representing clients in a variety of tax matters.  His peers and other national sources have deemed Rettig as a leading practitioner in tax fraud, tax law, and tax litigation and controversy.  See Charles P. Rettig, Biography, Hochman, Salkin, Rettig, Toscher & Perez, P.C.  Throughout his career, Rettig represented thousands of individual, business, and corporate taxpayers involved in civil examinations, tax collection matters, and criminal tax investigations, often representing clients against the IRS.

Concurrent to defending clients in tax matters, Rettig was appointed by the IRS to serve as Chair of the IRS Advisory Counsel (“IRSAC”), and was an active member since 2008.  The IRSAC receives commentary from the public regarding the public’s perception of IRS activities.  The IRSAC then advises the IRS Commissioner on its findings to encourage the public’s involvement regarding tax administration policy, programs, and initiatives.  See Internal Revenue Service Advisory Council Facts, IRS.

With Rettig’s professional backdrop in mind, an analysis of Rettig’s recent publication regarding IRS tax enforcement paints a full picture of Rettig’s viewpoints.  These viewpoints will most likely follow Rettig to his position as IRS Commissioner.

Viewpoint on the IRS and Tax Enforcement

In a fall 2017 issue of the Journal of Tax Practice and Procedure, Rettig published an article entitled A Lesson in Accountability and IRS Enforcement.  Overall, Rettig sets a tone for the need for a new era of increased tax enforcement. The article addresses three main areas: (1) facts on the IRS and current tax collection efforts; (2) the underlying causes of the problems with tax collection and enforcement; and (3) proposed solutions to increase tax collection.

Tax Facts

After providing statistics on the billions of tax dollars collected by the IRS, Rettig explains the current tax gap.  The gross tax gap is the difference between the amount of tax imposed on taxpayers in any given year and the amount that taxpayers voluntarily and timely pay.  The gross tax gap from 2008 to 2010 is about $458 billion.  The net tax gap is the portion of the gross tax gap that never gets paid.  It is the gross tax gap less the tax that the IRS will subsequently collect, either through voluntary payments or IRS enforcement.  Rettig says that it is estimated that the IRS will be able to collect $52 billion of the gross tax gap, leaving a net tax gap of $406 billion.

Problems with Closing the Tax Gap

Rettig addresses three issues that lead to the tax gap.  First, Rettig explains the direct causes of the tax gap: underreporting income, underpaying taxes owed, and not filing taxes at all.  Of those three, underreporting accounts for the greatest portion of the tax gap: $387 billion.  Underpayment accounts for $39 billion and non-filing accounts for $32 billion.  In addressing underreporting, Rettig explains that IRS research shows that people that have federal taxes withheld from income report 99% of their income.  Taxpayers that have reporting requirements under the law also tend to report almost all of their income (96%).  The problem lies with taxpayers that are not subject to withholding or information reporting, with that group only reporting only 68% of their income, and sole proprietors often reporting only 48% of their income.

Second, Rettig highlights that the IRS currently has a historically low number of enforcement agents, which is most likely attributable to the IRS budget.  Rettig cautions that the resource-challenged IRS impacts tax enforcement efforts, which in turn explains another contributing factor to the billion dollar tax gap.

Lastly, Rettig explains that the IRS relies on voluntary compliance.  Rettig states that research shows that increasing civil tax penalties do not increase voluntary compliance by taxpayers.  With IRS examination of taxpayers operating at low rate, Rettig suggests that this may only encourage tax payers to “push the compliance envelop” because it seems like there is not much risk of detection from the IRS.

Proposed Solutions to Close the Tax Gap

Rettig offers three solutions that will target this billion dollar tax gap.  First, Rettig suggests that the IRS should “hunt” for under-reporters and non-filers.  He suggests that technology can help target the taxpayers that fall in the categories of significant underreporting through electronic programs designed to identify these tax payers.  Technology can also be used to identify those tax payers that underreport foreign income, with the cooperation of foreign governments.

Second, Rettig discusses the need for tax practitioners to enhance professional responsibilities within their own fields.  Although the IRS is the governmental tax enforcement agency, Rettig suggests that tax practitioners also play an important role in the voluntary compliance aspect of our tax system.  Specifically, Rettig states that attorneys, accountants, and other tax practitioners must make sure their clients follow the law and observe the appropriate standards set within each profession.  Rettig states, “Tax returns are not to be perceived as an offer to negotiate with the government–information set forth on a tax return, signed by a paid return preparer, must be accurate with a reasonable foundation and reasonable support for the characterization of items set forth within the return.”

Lastly, Rettig suggests that the only way to increase voluntary tax compliance is to increase tax enforcement.  If tax payers know that there is a significant risk of IRS detection associated with underreporting, underpayment, or non-filing, tax payers will be more likely to voluntarily comply.  Because Rettig stated that research shows that increased civil penalties alone do not create the needed effect of increased compliance, only increased tax enforcement through civil examination, field (in-person) examination, and investigation will create the needed effect of increased voluntary compliance by taxpayers.

Conclusion

In sum, Rettig offers both sides of the coin: extensive experience in advocating from the taxpayer’s point of view against the IRS and extensive experience with the inner workings of the IRS and the contributing factors to the billion dollar tax gap.  With this two-sided experience, taxpayers can expect a new frontier of the IRS focusing its resources on targeting the greatest causes of the tax gap, increasing examination of these taxpayers, and hopefully adding millions, if not billions, of uncollected tax revenue to the federal treasury.

The Tax Court’s recent opinion in Roth v. Commissioner, T.C. Memo. 2017-248, raises interesting issues about the need for supervisor approval when the IRS asserts penalties.  In 2007, the petitioners in Roth donated a conservation easement encumbering 40 acres of land in Colorado to a charitable organization.  The petitioners claimed a charitable contribution deduction of $970,000, but the IRS disallowed the deduction.

On examination, the IRS determined that the petitioners improperly valued the conservation easement and that the easement was actually worthless.  The examiner also determined that the petitioners were liable for a 40% gross valuation misstatement penalty under section 6662, and his determination was approved in writing by his immediate supervisor.  The examiner determined that the petitioners were alternatively liable for a 20% accuracy-related penalty.

The petitioners submitted a protest letter to IRS Appeals.  The parties did not reach an agreement, however, and Appeals ultimately issued a notice of deficiency.  In a closing memorandum, the Appeals officer informed the petitioners that “[t]he proposed penalties are fully sustained for the government.”  The closing memorandum was signed by the Appeals officer’s immediate supervisor.

The notice of deficiency omitted the 40% penalty and included only the 20% accuracy-related penalty.  The petitioners then filed a petition in Tax Court.  In its answer – which was signed by an IRS senior counsel and her immediate supervisor – the IRS asserted the 40% penalty.

The parties eventually settled the case.  They agreed that the petitioners were entitled to a charitable contribution deduction of $30,000 and that the petitioners had reasonable cause for the value of the conservation easement.  As a result, the IRS conceded that the petitioners were not liable for a 20% accuracy-related penalty.

The difference between the settlement value of $30,000 and the claimed value of $970,000, however, met the gross valuation misstatement test under section 6662(h).  Unlike for the 20% accuracy-related penalty, taxpayers cannot claim reasonable cause to avoid liability for the 40% penalty.  So the petitioners tried another escape route – they argued that the 40% penalty was inappropriate because the IRS failed to comply with the procedural requirements of section 6751(b).

Section 6751(b)(1) states 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 or such higher level official as the Secretary may designate.”  Complying with this requirement is part of the IRS’ burden of production under section 7491(c).  See Graev v. Commissioner, 149 T.C. __ (Dec. 20, 2017), supplementing 147 T.C. __ (Nov. 30, 2016).

The petitioners argued that “initial determination” means the issuance of the notice of deficiency.  Although written approval for the 40% penalty was obtained before the notice of deficiency was issued, the petitioners argued that the Appeals officer made the “initial determination,” not the examiner.  As a result, the petitioners argued that, because the Appeals officer did not receive approval from his immediate supervisor before issuing the notice of deficiency, the IRS did not comply with section 6751(b) and could not assess the penalty.

The court observed that this issue was controlled by its decision in Graev and Chai v. Commissioner, 851 F.3d 190 (2d Cir. 2017), vacating and remanding in part, aff’g in part, and rev’g in part T.C. Memo. 2015-42.  The court held that each time the IRS sought to assert penalties, the individual proposing the penalties received approval from his or her immediate supervisor.  The examiner who proposed the 40% penalty received written approval from his group manager.  The Appeals officer received written approval from his team manager.  The senior counsel who filed the IRS’ answer received written approval from her associate area counsel, which was demonstrated by the associate area counsel’s signature on the answer.

The Tax Court held that regardless of which of these instances was the initial determination of the 40% penalty, section 6751(b) was satisfied because each instance was approved in writing by an immediate supervisor.  Thus, the court concluded that the IRS complied with section 6751(b) and found the petitioners liable for the 40% penalty.