Supervisory Review Not Required for Substantial Underpayment Penalty Generated When Taxpayer Failed to Respond to Unreported Income Notice

The case of Walquist v. Commissioner, 152 TC No. 3, looks at first glance to be just a run of the mill tax protestor case, as the Court noted the taxpayer, in response to an automated IRS notice regarding unreported income, filed a Tax Court petition that contained the following:

On November 27, 2017, petitioners submitted to this Court a purported petition that consisted of a copy of the notice of deficiency, on each page of which they had written “REFUSAL FOR CAUSE.” Petitioners appended various documents containing assertions commonly advanced by tax protesters, including assertions that U.S. currency is not “lawful money” and that they “have no obligations or liability to even file a return” because they “intend to only handle legal money.” Petitioners also advanced the more novel (but equally frivolous) argument that this Court should garnish the wages of the Secretary of the Treasury for an amount equal to petitioners' outstanding tax liability.

As the tone of the Court’s description suggests, the arguments did not carry the day in front of Judge Lauber.

But the case is not a reported Tax Court case for how the opinion disposed of these arguments.  Rather the case took a look at how the provisions found at IRC §6751(b)(1) apply in the case of an automatically generated substantial underpayment penalty under IRC §6662.

IRC §6751(b)(1) provides a requirement before a penalty may be assessed against a taxpayer:

(b) Approval of assessment

(1) In general

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.

Recent cases have clarified how this should be applied in cases where the IRS asserts a penalty.  As the opinion notes:

The Commissioner’s burden of production under section 7491(c) includes establishing compliance with section 6751(b), which requires that penalties be "personally approved (in writing) by the immediate supervisor of the individual making such determination.” See Chai v. Commissioner, 851 F.3d 190, 217, 221-222 (2d Cir. 2017), aff'g in part, rev'g in part T.C. Memo. 2015-42; Graev v. Commissioner (Graev III), 149 T.C. __ (Dec. 20, 2017), supplementing and overruling in part Graev v. Commissioner (Graev II), 147 T.C. 460 (2016).

In this case, the penalty was triggered when the taxpayer failed to reply to the initial IRS inquiry regarding unreported income.

The IRS processed the examination of petitioners' 2014 return through its ACE system, employing its CEAS software program. This software program ascertained through third-party document matching that petitioners had total income of $95,327.5 The program computed a tax liability of $13,832 and calculated a penalty equal to 20% of that sum ($13,832 × 20% = $2,766.40). When petitioners failed to respond to the computer-generated 30-day letter, the CEAS program automatically generated a notice of deficiency setting forth a deficiency and penalty in these amounts.

There are two exceptions to the requirement to have supervisory approval, one of which the Court found relevant in this case, found at IRC §6751(b)(2)(B):

(2) Exceptions

Paragraph (1) shall not apply to—

(B) any other penalty automatically calculated through electronic means.

The penalty in question (the one at §6662(d)(1)(A) is described by the Court as follows:

For individual taxpayers, the substantial understatement penalty applies if the understatement of income tax for a particular year “exceeds the greater of(i) 10 percent of the tax required to be shown on the return * * *, or (ii) $5,000.” Sec. 6662(d)(1)(A). The penalty (as relevant here) is calculated at a flat rate of 20% of the “underpayment of tax required to be shown on * * * [the] return.” See sec. 6662(a). This penalty is thus calculated mathematically, both in terms of whether it applies and the rate at which it is imposed.

The Court found that, in this case, that exception applies:

Because the penalty was determined mathematically by a computer software program without the involvement of a human IRS examiner, we conclude that the penalty was “automatically calculated through electronic means,” sec. 6751(b)(2)(B), as the plain text of the statutory exception requires.

The Court also noted that the IRS has outlined a position on when the penalty is considered to be calculated through electronic means and when it is considered to require the supervisory approval:

This conclusion is consistent with the IRS' interpretation of its obligations under section 6751, as set forth in the IRM.6 The IRM explains that the agency's general practice is to require written approval of all penalties by the immediate supervisor of the examiner proposing the penalty, while noting that penalties automatically calculated through electronic means are excluded from this requirement. See IRM pt. (Jan. 1, 2016). In 2018 the IRM was amended to state explicitly that substantial understatement penalties determined by the CEAS software program are exempt from the supervisory approval requirement:

Correspondence examination cases in which the Substantial Under-statement Penalty is systemically asserted will fall within the exception for penalties automatically calculated through electronic means if the taxpayer does not submit any response to the 30-day letter pro-posing the penalty. However, if the taxpayer submits a response, written or otherwise, that challenges the penalty, or the amount of tax to which the penalty is attributable, then the immediate supervisor of the Service employee considering the response must input the CEAS non-action note specifically approving the penalty prior to the issuance of any SNOD [statutory notice of deficiency] that includes the penalty. [IRM pt. (Feb. 9, 2018).7]

The IRM sets out a similar position regarding other computer-determined penalties, such as those calculated through the Automated Underreporter program.

The opinion notes that Congress imposed the supervisory approval rule to insure that the IRS did not use the threat of penalties to pressure taxpayers into concessions. In this case, where the penalty had been computer generated without any human review, that risk of the “bargaining chip” issue doesn’t exist.

Computer-determined penalties likewise resemble additions to tax in that they typically do not raise the concern that prompted Congress to enact the supervisory-approval requirement. Congress' goal in enacting section 6751(b)(1) was to ensure that penalties are “only * * * imposed where appropriate and not as a bargaining chip.” See S. Rept. No. 105-174, at 65 (1998), 1998-3 C.B. 537, 601. “The statute was meant to prevent IRS agents from threatening unjustified penalties to encourage taxpayers to settle.” Chai, 851 F.3d at 219 (citing legislative history). Where, as here, a penalty is determined by a computer software program and never reviewed by a human being, it could hardly be considered a “bargaining chip.” Rather, like an addition to tax under section 6651, 6654, or 6655, it is added to the tax automatically according to a predetermined mathematical formula.

The Court found that it would not be practical to impose the supervisory approval requirement on this sort of penalty assessment:

… if we were to construe the penalty here as requiring supervisory approval, it is hard to imagine how the IRS would demonstrate satisfaction of this requirement. Section 6751(b)(1) requires that the initial determination of a penalty assessment be “personally approved (in writing) by the immediate supervisor of the individual making such determination.” The penalty at issue was calculated and instantiated in letter form by a computer software program. Because the computer did this without human intervention, no “individual making such determination” appears to exist. And if the computer itself were regarded as “the individual making such determination” — that would be difficult to square with the statute's plain text — we would have to determine who “the immediate supervisor” of the computer (or the software program) is. As Lear said prophetically on the heath: “[T]hat way madness lies.”9