A. Overview
On January 7, 2020, the United States Tax Court issued its division opinion in Frost v. Commissioner, 152 T.C. No. 2. For tax professionals who practice in the Tax Court, the decision in Frost is worth a quick read as it discusses the proper allocation (and shifting) of the burden of production in Section 6751(b) penalty cases, the latter of which is currently a hot issue.
B. Background
Mr. Frost was a former IRS collections officer. After his employment with the IRS, he set off on his own to become a self-employed salesman and consultant. He also prepared federal income tax returns. On his 2010 through 2012 returns, he reported his business income and expenses on Schedule C. He also reported a partnership loss on Schedule E of his 2011 return.
The IRS selected Mr. Frost’s returns for examination, resulting in the IRS Office of Appeals issuing a notice of deficiency (“NOD”) for the years at issue. The NOD disallowed many of Mr. Frost’s Schedule C deductions and his loss on Schedule E. In addition, the NOD determined that Mr. Frost was liable for accuracy-related penalties under Section 6662 for negligence and/or substantial understatements of income tax.
Mr. Frost timely filed a petition with the Tax Court. During those proceedings, the IRS produced a Civil Penalty Approval Form (“Approval Form”). The Approval Form was necessary to support the IRS’ burden of production on the penalties issue. See also Section 7491(c). However, the Approval Form indicated the accuracy-related penalty had been approved only for substantial understatement of income tax (and not negligence) for 2012. Thus, the Approval Form did not address the 2010 and 2011 penalties.
Because many of the deductions claimed by Mr. Frost required strict substantiation under Section 274(d), the Tax Court wasted little time in disallowing Mr. Frost’s Schedule C deductions. Moreover, because Mr. Frost was unable to substantiate his basis in the partnership, the Tax Court similarly disallowed his loss claimed on Schedule E.
C. The Shifting of Burdens under Section 6751(b)
The most significant part of the Frost opinion discusses the nuances of Section 6751(b). Under that provision, the initial determination of certain penalties (including accuracy-related penalties under Section 6662) must be approved in writing by an IRS manager or supervisor. In recent decisions, the Tax Court has held that the IRS must show that the agent imposing the penalty obtained written managerial approval prior to the first formal communication to the taxpayer of the penalties. See Clay v. Comm’r, 152 T.C. 223, 249 (2019); Belair Woods, LLC v. Comm’r, 154 T.C. No. 1 (Jan. 6, 2020).
Given these recent decisions, the Tax Court was confronted for the first time with the issue of which party (the IRS or the taxpayer) should bear the burden of production regarding the first formal penalty communication to the taxpayer. In Frost, the Tax Court held that the initial burden of production with respect to the Section 6751(b) penalty issue was on the IRS, provided the taxpayer properly challenged the IRS’ penalty determination. This is another cautionary tale to taxpayers and tax professionals to raise all issues in the Tax Court petition or risk having those issues waived. See also Tax Court Rule 34(b)(4) (“Any issue not raised in the assignments of error shall be deemed conceded”).
If the issue is properly raised, the IRS has the initial burden of production in providing evidence that Section 6751(b) managerial approval was obtained. Generally, the IRS meets this burden through producing the appropriate penalty approval form reflecting a date of approval prior to the first formal communication of the penalty to the taxpayer. If the IRS meets this burden of production, the burden then shifts to the taxpayer to provide contrary evidence that the IRS improperly communicated the penalty determination to the taxpayer prior to obtaining written managerial approval under Section 6751(b).
Here, the Tax Court concluded that the IRS had failed to meet its initial burden of production on the 2010 and 2011 accuracy-related penalties. Specifically, the Tax Court found that the Approval Form failed to cover those tax years, and therefore the IRS had failed to provide sufficient evidence that manager approval had, in fact, been obtained prior to the first formal communication of the penalty to the taxpayer.
Because the Approval Form covered 2012, the Tax Court held that the IRS had met its initial burden of production on the accuracy-related penalty for such year. But because the Approval Form only indicated managerial approval for the penalty on substantial understatement of tax grounds and not negligence, the Tax Court concluded that the IRS had failed to meet its burden of production to impose the accuracy-related penalty due to negligence.
Accordingly, the burden shifted to Mr. Frost to provide evidence that the IRS improperly communicated the initial penalty determination to him prior to the Approval Form signature date. Because Mr. Frost offered no such evidence, the Tax Court determined that the IRS had complied with the requirements of Section 6751(b). In the end, Mr. Frost, as a former IRS employee and tax preparer, could not show reasonable cause with respect to the 2012 accuracy-related penalty, and therefore the penalty was sustained.
D. Conclusion
If the IRS raises penalty issues in a notice of deficiency, taxpayers are almost always well advised to challenge the penalty determinations in the Tax Court petition. A taxpayer’s failure to do so may result in a waiver of the penalty issue. As shown in Frost, putting the penalty determinations at issue may result in a win on procedural grounds, regardless of the merits of the penalty determination.
Representation in Tax Audits & Appeals
Need assistance in managing the audit process? Freeman Law’s team of attorneys and dual-credentialed attorney-CPAs regularly represents taxpayers before the IRS and Texas Comptroller. Our team also provides tax return-related representations and helps taxpayers navigate state tax laws. Our Firm offers value-driven services and provides practical solutions to complex issues. Schedule a consultation or call (214) 984-3000 to discuss our tax representation services.
