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The United States Tax Court Paves Way for Taxpayers to Escape Civil Penalties on Federal Income Tax Assessments

February 20, 2020

When the Internal Revenue Service conducts a tax audit, the Internal Revenue Service often looks to impose an additional tax liability upon the taxpayer.  Additionally, in more cases than not, the Internal Revenue Service also imposes civil penalties based on the asserted tax deficiency.  Explained differently, when the Internal Revenue Service proposes income tax adjustments as part of an audit, the Service also generally imposes a penalty in addition to the tax liability.  Most of the time, the civil penalty is an accuracy-related penalty under Internal Revenue Code Section 6662, which penalizes a taxpayer for his or her negligence for filing an inaccurate return.

The unfortunate reality is that federal audits are often very expensive for taxpayers, and a big reason for that is the Internal Revenue Code Section 6662 accuracy-related penalty mentioned above, is generally 20% of the tax deficiency being alleged.  This penalty accrues interest from the due date of the return, and as such the penalty itself can be a large sum of additional money.  Because of this, where available, taxpayers should ask for relief from the proposed penalty.  Luckily for taxpayers, recent federal case law has introduced a new effective method to obtain relief from civil penalties, including the Internal Revenue Code Section 6662 accuracy-related penalty. 

The new case law, which will be discussed in more detail below, can be summarized as follows:  A manager, or other designated person at the Internal Revenue Service, must approve the accuracy-related penalty prior to the issuance of a 30-day letter.  A 30-day letter contains a computation of the proposed audit adjustments to your tax return, and provides the taxpayer with the right to appeal the proposed results within 30 days.  If the Service fails to obtain proper approval prior to the issuance of a 30-day letter, the penalty does not apply.  In a large number of currently pending cases, and recently decided cases, the Service has failed to obtain the proper approval prior to assessing the accuracy penalty.  In these cases, including cases where the penalty has already been paid, the taxpayer may be able to have the penalty removed, and may even be able to obtain a refund for the amounts already paid.

The case which provides for this type of penalty relief was decided on April 24, 2019 by the United States Tax Court in the case of Clay v. Commissioner, 152 T.C. 223 (2019).  In this case, the court ruled in favor of the taxpayer that the Internal Revenue Service did not meet its burden of production to assess civil penalties.  The Court reached this decision because the Internal Revenue Service did not obtain proper approval of the penalty prior to asserting the penalty at issue.

Internal Revenue Code Section 6751(b) states 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.”  Prior to the ruling set forth in Clay, the United States Tax Court had held that a supervisor’s initial determination is “no later than the Statutory Notice of Deficiency,” which is the Internal Revenue Service’s written and formal notification of its intention to assess a tax deficiency and inform taxpayers of their opportunity to petition the United States Tax Court and dispute the proposed adjustments.  Taxpayers are issued a Statutory Notice of Deficiency at the conclusion of an audit or after a determination from the Internal Revenue Service Appeals division.

However, Clay has changed the landscape for taxpayers who are assessed civil penalties in federal tax audits.  There, the Court ruled that Revenue Agent Reports and the 30-day letters attached to the Revenue Agent Report are what constitute a supervisor’s initial determination rather than the Statutory Notice of Deficiency.  The Revenue Agent Report is the detailed document that describes the Internal Revenue Service’s audit findings and states the amount of the deficiency, and the attached 30-day letter informs taxpayers of their right to disagree with the report and file a formal protest with the Internal Revenue Service Office of Appeals division.  In other words, this is the first formal communication to the taxpayer of the initial determination to assess penalties.    

Clay already has and will continue to have a significant impact because Revenue Agent Reports and 30-day letters are issued to taxpayers early in the tax deficiency process, which increases the chances of an Internal Revenue Service error.  More significantly, Internal Revenue Service personnel have not fully caught onto the Clay requirements – the Internal Revenue Service must show that written supervisory approval for penalties was obtained before the first formal communication to the taxpayer to assess penalties – and are still operating under the notion that the Statutory Notice of Deficiency constitutes the Internal Revenue Service initial determination.  

As such, many taxpayers have been successful in getting the assessed penalties waived, and this is expected to continue until the Internal Revenue Service catches up to the newly issued case law.  Ultimately, taxpayers can save a lot of money simply by being aware of this new procedural requirement, and where taxpayers have already paid the penalty, these taxpayers may be eligible for a refund of the amounts paid.   

If you have been assessed an Internal Revenue Code Section 6662 accuracy-related penalty, please do not hesitate to contact our firm if you have any questions regarding whether the Service has followed proper legal procedures.