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Privilege and Proving Penalty Approval

Posted on Apr. 13, 2020

By now you are no doubt tired of reading cases of penalty approval and whether the IRS did what it needed to do in order to approve a penalty. Just when you tire of this genre of cases and you start to question why PT would write yet another blog post on this subject, a case with facts that could not be made up happens to be assigned to the Tax Court’s most eloquent writer on this subject (and many other subjects as well).

Here’s the teaser from the first lines of a recent order entered by Judge Holmes:

In it [a motion for summary judgment filed by the IRS], the Commissioner acknowledges that he must show supervisory approval of a penalty determination. But he does so with a document entirely blacked out because he claims deliberative-process privilege for its contents. To preserve that privilege neither Cannon [the corporate petitioner in the case] nor the Court have been allowed to peek behind the mask covering the document that, we are told, contains the required approval.

Does this work?

The answer is no.

Cannon claimed credits on its 2011 return that it earned in 2007 through 2010. In an earlier ruling on summary judgment the Tax Court had ruled in favor of the IRS on the timing issue while noting that Cannon’s arguments were nontrivial. That decision on the merits left only the accuracy penalty to be decided in the case and the IRS moved for summary judgment on that as well.

The Court notes that a penalty determination usually turns on whether the taxpayer acted reasonably and in good faith and determinations of that type generally require fact gathering not susceptible to summary judgment motions. Of course, in asserting the penalty, the issue of the appropriate timing of the approval is now a part of the arsenal of any taxpayer seeking to fend off having to pay the penalty.

The Court starts by discussing burden. IRC 7491(c) enacted in the same legislation as the penalty approval provisions in IRC 6751(b) puts the burden of production in penalty cases on the IRS if the taxpayer is an individual. Here, the taxpayer is a corporation and so the burden of production rests with the taxpayer. The Commissioner of the IRS, however, seeks the summary judgment so “he must show that “there dispute as to any material fact and that a decision may be rendered as a matter of law.” Rule 121(b); see also Sundstrand Corp. v. Commissioner, 98 T.C. 518, 520, aff’d, 17 F.3d 965 (7th Cir. 1994).”

This case raises the same timing issues for penalty approval raised in Clay v. Commissioner, 152 T.C 223 (2019), appeal docketed, No. 19-14441 (11th Cir. Nov. 6, 2019).  See our post on Clay here.  The IRS can show that the appropriate supervisor approved the penalty prior to the sending of the notice of deficiency; however, in Cannon the IRS mailed the same type of letter to Cannon that it mailed to Clay, which caused the problem in that case.  The IRS needs to show that it approved the penalty prior to the mailing of this letter but it does not need to show that the approval took any special form. 

Before the IRS sent the crucial letter to Cannon, the agent’s supervisor sent to the agent an email telling the agent she had reviewed the draft, suggesting changes and directing where to send the Form 886-A within the IRS. The IRS argues in its summary judgment motion that the email meets the necessary criteria for supervisory approval prior to the mailing of the letter to the taxpayer in which the IRS proposes to impose a penalty. The email could work to satisfy the prior approval language in the statute.

But he [the Commissioner] also claims that this attachment to Hussain’s email is protected by the deliberative-process privilege.2 This assertion of the deliberative-process privilege may or may not be justified (Cannon hasn’t moved for in camera review or disclaimed any intent to object to its introduction at trial). But the Commissioner’s assertion of the privilege does prevent us from verifying that the changes Hussain recommended or the language that she possibly approved without change would qualify as supervisory approval.

Without being able to see the Form 886-A draft, Cannon makes the reasonable point that this email might just cover editorial changes to Guenther’s draft without actually approving the penalty. It also makes the very good point that the Commissioner’s assertion of a predecisional privilege means that the drafts were just drafts, and not a final anything, much less the required decision or approval made by a supervisor. It may well be that Hussain [the supervisor] made no actual decision to approve Guenther’s [the agent] determination to assert the I.R.C. § 6662 penalty.

So, the Court denies the motion for summary judgment. Of course, this does not mean that the IRS will not succeed in the trial on the penalty. It does not mean that the IRS will not relent and show more of the document. It also does not mean that when revealed the document will support the prior approval assertion. The case shows yet another issue that arises in penalty approval, both in its alleged approval through an email exchange and its alleged approval in a privileged document.

Because the IRS has appealed the Clay decision, the outcome in the 11th Circuit could also impact the outcome in Cannon. Unfortunately, it looks like 6751(b) will continue to provide fodder for PT for some time to come.

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