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Tax Shelter Investor Relieved of Penalties by Graev

Posted on Oct. 29, 2020

In the latest precedential opinion from the Tax Court on Graev, Oropeza v. Commissioner, 155 T.C. No. 9 (2020), the Court refuses to impose any penalty on the petitioner despite his investment in a tax shelter. The case receives precedential treatment because it finds yet another way in which the Graev case impacts the IRS as it goes to impose penalties. Mr. Oropeza, as have several beneficiaries of the Graev precedent, benefits from the age of this case. The tax year is 2011 and he docketed his Tax Court petition in 2015. At the time the revenue agent worked this case, Graev had not burned into the IRS consciousness the need to obtain penalty approval prior to sending out the revenue agent’s report. The statute came into existence in 1998. So, it’s hard to build up significant sympathy for the IRS regarding the way it handled penalties after Congress had spoken, but timing here does matter.

If you are interested in this case, you should also read the excellent post by Bryan Camp in his Lessons from the Tax Court series. The IRS has also issued some guidance related to Graev that should be noted. I was alerted by Jack Townsend of a new IRM provision that provides important guidance to revenue agents in this area:

20.1.1.2.3.1 (10-19-2020)

Timing of Supervisory Approval

For all penalties subject to IRC 6751(b)(1), written supervisory approval required under IRC 6751(b)(1) must be obtained prior to issuing any written communication of penalties to a taxpayer that offers the taxpayer an opportunity to:

  • Sign an agreement, or
  • Consent to assessment or proposal of the penalty

Jack has blogged on this provision and you can find his post here.

Mr. Oropeza invested in microcaptive insurance. The upcoming Supreme Court argument in CIC Services presents the same type investment though, as with Mr. Oropeza, the case does not directly involve the taxation of the investment itself. The revenue agent audited Mr. Oropeza’s return and proposed, in Letter 5153 and a revenue agent report dated January 14, 2015 accuracy related penalties under 6662(a) of 20%. Prior to the sending of this letter, the immediate supervisor of the revenue agent had not signed the approval of the penalties and did not sign it until two weeks later.

On May 1, 2015, the revenue agent changed his recommendation proposing a penalty under 6662(i) for 40% for a transaction lacking economic substance. The revenue agent’s immediate supervisor signed the form approving this increase. A notice of deficiency issued on May 6 focused on the 40% penalty with the 20% penalty as a fallback position.

Based on Belair Woods, LLC v. Commissioner, 154 T.C. 1, 14-15 (2020) interpreting IRC 6751(b), we know that the 20% penalty will fail because the supervisory approval came after the agent transmitted the IRS position to the taxpayer. At the time it filed its original brief in the Oropeza case, the government attorneys did not have the benefit of the Belair Woods decision and argued that the notice of deficiency was the appropriate date for determining whether approval of the immediate supervisory had occurred. The IRS argued that it met the requirement of the statute. In subsequent briefing on the case, it had the opportunity to address the Belair Woods decision.

At issue here is the impact of 6751(b) on the 40% penalty for which the revenue agent obtained approval prior to notifying the taxpayer. (Some uncertainty on this issue exists because the immediate supervisor failed to date the approval form as he signed it; however, his testimony supported the fact that he signed on the same day as the revenue agent. Of course, the date of his signature does not matter given the outcome of the case.) The IRS argued that imposition of the penalty under IRC 6662(i) represented a separate penalty properly approved before notifying the taxpayer. The Tax Court decided the case on cross motions for summary judgment.

The IRS argued that Oropeza differed from Belair because the letters offering a conference with Appeals differed slightly. The Tax Court rejected the attempt to make a distinction based on the type of letter offering an Appeals conference. It stated:

The Letter 5153 clearly communicated the same message to petitioner: It told him that he could now go to Appeals, but only if he first executed a Form 872 that would give Appeals enough time to consider his case.

So, the IRS communicated the initial determination to the taxpayer in the Letter 5153 and sent it prior to supervisory approval. Does that lock the IRS into failure on the penalty issue or does the change in penalty position and the obtaining of a signature prior to communication with the taxpayer of the new penalty provide the IRS with a reprieve?

In approaching this issue, the Tax Court stated:

Litigants sometimes refer to section 6662(i) — like section 6662(h), applicable in the case of a “gross valuation misstatement” — as imposing a “40% penalty.” As the statute’s text makes clear, however, section 6662(i) does not impose a distinct penalty. It simply increases the rate of the penalty imposed by section 6662(a) and (b)(6) for engaging in a transaction lacking economic substance.

Given the statutory structure, we think the proper analysis requires that we answer two questions. The first is whether the RAR should be read as asserting a penalty under section 6662(a) and (b)(6) for engaging in a transaction lacking economic substance. If so, that penalty did not receive timely approval. The second question is whether, if the base-level penalty was not timely approved, the IRS can satisfy section 6751(b)(1) by later determining that section 6662(i) applies because the transaction was not disclosed on the return.

The Tax Court examined the IRS communication regarding the 20% penalty, noting that a taxpayer receiving the correspondence from the IRS would struggle to know which of the grounds of IRC 6662 the IRS sought to apply including “a transaction lacking economic substance.” The IRS argued that while the revenue agent’s report might have been ambiguous, additional evidence shows what it meant. The Court declines to look behind the information provided to the taxpayer and that information included the possibility that the penalty related to a transaction lacking economic substance.

The Tax Court then looked at IRC 6662(i). It concludes that this subsection does not impose a distinct penalty but simply increases the rate of the penalties imposed under 6662(a) and (b)(6). Based on this analysis, the Court finds that 6662(i) serves as something similar to an aggravating factor in criminal law leading to a higher punishment. It moves from that conclusion to the conclusion that the initial penalty proposed in Letter 5153 operates as the touch point that it must review to determine if the IRS timely approved the penalty. Looking at the transaction at that point, the IRS fails.

Linking the penalties imposed under 6662 in this way may benefit the IRS if it timely approves the first notice of a 6662 penalty but does not obtain a timely approval of an increase with the categories of 6662 penalties. Maybe the next case will fall in the IRS’s favor because of this linkage. There may be other implications of the linkage determined in Oropeza as we look at penalty cases in the future. Professor Camp’s post does a good job of looking at possibilities and inconsistencies. This case may have implications that reach beyond mere penalty approval.

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