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Tax Court Addresses Burden of Production in Penalty Supervisory Approval Cases

(Parker Tax Publishing January 2020)

The Tax Court held that, with respect to the assessment of an accuracy-related penalties, the IRS bears the initial burden of production to offer evidence of compliance with the requirement in Code Sec. 6751(b)(1) that the IRS officer initially determining accuracy-related penalties against a taxpayer obtained written supervisory approval. The court further held that, once the IRS satisfies its initial burden of production under Code Sec. 7491(c) by offering evidence of compliance with the requirement in Code Sec. 6751(b)(1), the taxpayer must come forward with contradictory evidence suggesting that the IRS did not comply with Code Sec. 6751(b)(1) in order to negate the finding that the IRS satisfied its initial burden of production under Code Sec. 7491(c). Frost v. Comm'r, 154 T.C. No. 2 (2020).


Charles Frost is a self-employed insurance salesman and consultant. Before selling insurance, Frost was an enrolled agent who prepared tax returns for about 25 years. He had also been an IRS revenue agent for 15 years.

During 2010-2012, Frost served clients throughout Oregon and other states, including Texas. Frost traveled to Texas to service his clients there but mostly traveled to Texas for personal reasons. Frost also owned an 80 percent interest in a partnership. During 2011 and 2012, the partnership did not earn any income or incur any liabilities. Other partners made capital contributions to the partnership around 2011, but Frost did not make any capital contribution to the company in 2011 or 2012.

On his 2010-2012 tax returns, Frost reported business income which he offset in part with business expense deductions, including travel and meal and entertainment expenses. Frost also reported a loss for 2011 related to his distributive share of the partnership's losses. The partnership reported business expenses incurred in 2011 without any offsetting income. The amounts for many of these business expenses were nearly identical to the amounts for business expenses that Frost reported on his 2011 Schedule C.

The IRS issued notices of deficiency for tax years 2010 - 2012 that reduced Frost's Schedule C deductions for those years and disallowed all of his Schedule E deductions relating to the partnership loss for 2011. The IRS determined deficiencies and underpayment penalties under Code Sec. 6662 for negligence and/or substantial understatements of income tax for all of the years at issue. A Civil Penalty Approval Form prepared by the examining agent in April of 2014 listed year 2012 as the penalty year and bore an electronic signature approving the substantial understatement penalty but not the negligence penalty. There was no penalty approval for 2010 and 2011. Frost challenged the deficiencies and penalties in the Tax Court.

The Burden of Production and Penalty Supervisory Approval

Under Code Sec. 7491(c), the IRS bears the burden of production with respect to an individual taxpayer's liability for any penalty, addition to tax, or additional amount, and requires the IRS to come forward with sufficient evidence indicating that imposition of penalties is appropriate. Code Sec. 6751(b)(1) requires the initial determination of certain penalties to be approved in writing by the immediate supervisor of the individual making the determination.

In Graev v. Comm'r, 149 T.C. No. 23 (2017), the Tax Court held that, as part of the IRS's burden of production, the IRS must produce evidence that it complied with the penalty supervisory approval requirements of Code Sec. 6751(b)(1). In Clay v. Comm'r, 152 T.C. No. 13 (2019), the Tax Court concluded that written supervisory approval of penalties must be obtained before the first formal communication to the taxpayer of the penalties. In Belair Woods, LLC v. Comm'r, 154 T.C. No. 1 (2020), the Tax Court held that the initial determination of a penalty assessment - the "consequential moment" of IRS action - is embodied in the document by which the Examination Division formally notifies the taxpayer, in writing, that it has completed its work and made an unequivocal decision to assert penalties.

In Higbee v. Comm'r, 116 T.C. 438 (2001), the Tax Court held that, for the IRS to meet its burden of production, it must come forward with sufficient evidence indicating that it is appropriate to impose the relevant penalty. In Wheeler v. Comm'r, 127 T.C. 200 (2006), the Tax Court expanded its analysis of Code Sec. 7491(c) with respect to additions to tax under Code Sec. 6651(a)(1) (failure to file a timely tax return), Code Sec. 6651(a)(2) (failure to pay the tax shown on a return), and Code Sec. 6654 (underpayment of estimated taxes). The Tax Court held that the IRS's burden with respect to the Code Sec. 6651(a)(1) addition to tax was to show that the taxpayer did not file a return or request an extension; having done so, the IRS met its burden. The court held that the IRS's burden with respect to the Code Sec. 6651(a)(2) addition to tax was to show that a return was filed or a substitute return was made. In Wheeler, no return was filed and the IRS failed to produce sufficient evidence of a substitute return, so the court held that the IRS failed to satisfy its initial burden of production. Finally, the court held that the IRS's burden with respect to the Code Sec. 6654 addition to tax was to provide evidence of a required annual payment payable in installments. The IRS introduced evidence of the taxpayer's liability for the year at issue but no evidence of a return for the previous year or the amount of tax on that previous year's return, so the IRS did not satisfy its burden as to that addition to tax.

Tax Court's Analysis

The Tax Court sustained the IRS's adjustments to Frost's deductions and the disallowance of Frost's distributive share of partnership losses for 2011 because it found that Frost provided insufficient evidence to support the deductions and losses.

Next, the Tax Court addressed the burden of production with respect to the penalties. The Tax Court observed that, while it has held that the IRS's initial burden of production includes producing evidence that it complied with Code Sec. 6751(b)(1), to date its cases have not addressed when the burden shifts to the taxpayer to show otherwise. Following its methodology in Higbee and Wheeler, the Tax Court held that if the taxpayer has challenged the IRS's penalty determinations, the IRS must come forward with evidence of penalty approval as part of its initial burden of production, and once the IRS makes that showing, the taxpayer must come forward with contrary evidence to negate the IRS's showing that it met its initial burden. The court held that the IRS's introduction of evidence of written approval of a penalty before a formal communication of the penalty to the taxpayer is sufficient to carry its initial burden to show that it complied with the requirements of Code Sec. 6751(b)(1).

Applying this framework to Frost's case, the court found that the IRS produced no evidence of written supervisory approval for 2010 or 2011 and therefore failed to carry its initial burden for those years. However, the court found that the Civil Penalty Approval Form for 2012 was signed by the manager of the examining agent in May of 2014, over a year before the notice of deficiency was issued. The Civil Penalty Approval Form showed approval of the substantial underpayment penalty so the court held that the IRS met its burden for that penalty. However, the form did not show approval for a negligence penalty, so the burden did not shift to Frost with respect to negligence.

The Tax Court held that Frost had to offer evidence that the approval of the substantial understatement penalty was untimely - e.g., that there was a formal communication of that penalty before the proffered approval. As Frost did not claim that the IRS formally communicated its initial penalty determination to him before the date of the Civil Penalty Approval Form, the court concluded that the penalty was approved in writing before the first formal communication to Frost. Frost then bore the burden of showing he had reasonable cause for the underpayment and acted in good faith. The court found that, given Frost's tax experience, he had a better understanding of tax matters, including the need for documentation, than do members of the general public, and therefore did not have reasonable cause for failing to substantiate his business expenses.

For a discussion of the burden of production with respect to penalties, see Parker Tax ¶263,525.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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