Written Manager Approval for Penalties Not Required in Some Cases

An IRS agent is generally required to get written approval from their manager for a tax penalty can be assessed. This is requirement is set out in the Code. This begs the question as to what happens if the agent does not get written approval before he closes the audit? The court addressed this in Graev v. Commissioner, 147 T.C. 16, which explains how taxpayers should deal with cases where the IRS agent does not get written approval for penalties before they close the audit.

In Graev, the IRS agent assessed a Sec. 6662(h) 40% gross valuation misstatement penalty. This penalty is in lieu of the 6662(a) 20% penalty for an underpayment attributable to negligence or a substantial understatement of income tax. Put another way, the IRS can only assess one of these penalties. When the IRS assesses the higher Sec. 6662(h) 40% gross valuation misstatement penalty, it will often assert the lesser penalties as an alternative or fall-back position.

In Graev, the IRS issued a Notice of Deficiency that only included the Sec. 6662(h) 40% gross valuation misstatement penalty. It then issued a revised Notice that included the other penalty as an alternative position.

The taxpayer challenged the underlying tax issue in the U.S. Tax Court and lost. It then challenged the penalty before the same court.

The court examined Sec. 6751(b), which is the Code section that requires IRS agents to get written approval before assessing penalties.

The majority of the court concluded that this Code section does not require the IRS agent to get approval before the audit is closed. It merely requires the IRS agent to get written approval before the penalty is assessed.

The majority of the court then noted that with cases that are considered by the U.S. Tax Court, tax assessments are not final until after the U.S. Tax Court enters a final order in the case and the case is not appealed. This is one of the defining features of the U.S. Tax Court, namely, that it provides taxpayers with a pre-assessment and pre-payment forum for litigating tax certain cases. So the court concluded that the IRS agent could get manager approval at any time before the court case was final–even if the IRS agent obtained written authorization during the court proceeding.

The lone dissenting opinion concluded that the penalty should not be upheld given the nature of the U.S. Tax Court’s role in determining what amount should be assessed. This is the very function of the U.S. Tax Court. So the dissent reasoned that it would not make sense to put the U.S. Tax Court in the middle of the penalty determination, as the majority court decided to do.

So what should a taxpayer do if he discovers that the IRS agent did not get manager approval before closing the audit? One option might be to not respond to the Notice of Deficiency and let the IRS assess the tax and penalty, pay the penalty, file a refund claim, and, if the IRS did not refund the money, sue the IRS in U.S. District Court. This would mean that the IRS assessed the penalty without first obtaining the required written approval.