The Tax Court issued its third decision in two days dealing primarily with penalties, and the second published case on the matter, in the case of Frost v. Commissioner, 154 TC No. 2.[1]

The case generally is a rather standard case where the taxpayer fails to have records to back up deductions claimed on his Schedule C, as well as failing to show he had basis in the partnership in which he had claimed losses.

But the taxpayer was not the only sloppy party in this case—the IRS lost the ability to assess penalties for two years because the agency had failed to get the supervisory approval for such penalties required by IRC §6751(b)(1).

But the unique question arose for the penalties in the final year.  The initial burden falls on the IRS to show that penalties should be applied in a case, and that includes showing that the agency complied with the requirement that supervisory approval was received prior to formal communication to the taxpayer of the IRS proposed assessment of the penalty.[2]

In this case the IRS introduced a Civil Penalty Approval Form signed on May 20, 2014 for the penalties proposed on the taxpayer’s 2012 return.  That date was over one year before the notice of deficiency was issued.  That was the only document the IRS claimed to have sent that met the burden of being the formal communication of the penalty to the taxpayer.

The key question is whether this showing is sufficient for the IRS to carry its initial burden, or if the agency must also show that no other formal communication of the penalty to the taxpayer took place before the approval was obtained to carry its initial burden.[3]

The Court determined that the IRS did not have the burden to prove the negative—that is, that no other communication was made to the taxpayer that would amount to a formal communication of the penalty.  Rather, the burden now shifts to the taxpayer on this issue, requiring the taxpayer to show that he had received some communication that would rise to the level of the formal communication of the penalty prior to the date of the approval of the penalty by the supervisor.[4]

The opinion justifies the holding as follows:

The burden now shifts to petitioner to offer evidence suggesting that the approval of the substantial understatement penalty was untimely--e.g., that there was a formal communication of the penalty before the proffered approval. If a taxpayer makes that showing, we will weigh the evidence before us to decide whether the Commissioner satisfied the requirements of section 6751(b)(1). This rule is faithful to the requirement that the Commissioner come forward initially with evidence of written penalty approval. By shifting the burden to the taxpayer after the Commissioner makes the initial showing, we avoid imposing the burden of proving a negative (i.e., that there were no prior formal communications). If the taxpayer introduces sufficient evidence to contradict the Commissioner’s initial showing, then the Commissioner can respond with additional evidence and argument, and the Court can weigh all of the evidence (that is after all the business of judging). And evidence of prior formal communication (if it exists) would be available to the taxpayer since he would have received such a communication and therefore could introduce it to challenge a claim that the supervisory approval was timely. In other words, the rule we articulate today will not require the Commissioner to show that there was no prior formal communication as part of his initial burden.[5]

Since the taxpayer introduced no such evidence of prior communications, the Court found that the IRS had complied with the supervisory review requirements of IRC §6751(b) and the Court could now move to look at the facts surrounding whether actual imposition of the penalty was appropriate.[6]

The taxpayer didn’t fare well there.  First, the amount of tax the Court found was due exceeded the $5,000/10% amount necessary to trigger the imposition of the substantial understatement penalty of IRC §6662(b)(2). [7] There was no suggestion that the position had substantial authority as a matter of law or that it had a reasonable basis in the law and was properly disclosed—all of the issues that led to the tax being imposed were based on factual determinations of the Court, not issues of law.

So that left the only defense available to the taxpayer that he had reasonable cause for the understatement and had acted in good faith per §6664(c)(1). 

But the taxpayer suffered from some significant disadvantages in his attempt to seek refuge under the provision.  The taxpayer was a former IRS revenue agent and an enrolled agent who had been preparing returns for profit for 25 years.[8]  Clearly, he would be expected to know the requirements for having proper documentation.

The taxpayer did have mitigating circumstances that might have worked better had he not been a tax professional—he had health issues, his brother-in-law was diagnosed with cancer and died and he was attempting to reconcile with his wife who now lived in a state other than that in which the taxpayer resided.[9]

The Court noted, though, that this taxpayer wasn’t your average taxpayer and the bar for reasonable cause is higher than he could clear with his facts:

But petitioner was an enrolled agent who prepared tax returns for about 25 years and had been an IRS revenue agent for 15 years. He therefore had a better understanding of tax matters, including the need for documentation, than do members of the general public. See Green v. Commissioner, T.C. Memo. 2010-109. He continued to prepare returns for others during the years in issue. See Fitch v. Commissioner, T.C. Memo. 2012-358, supplemented by T.C. Memo. 2013-244. And he failed to explain how his difficulties in obtaining records affected his preparation of his 2012 Form 1040. While we are sympathetic to the challenges he faced over this period, cannot excuse his failure to substantiate his business expenses. We therefore hold that petitioner is liable for the section 6662(a) penalty for 2012.[10]

[1] Frost v. Commissioner, 154 TC No. 2, January 7, 2020, https://www.ustaxcourt.gov/USTCInOP/OpinionViewer.aspx?ID=12134 (retrieved January 7, 2020)

[2] Frost v. Commissioner, p. 21

[3] Frost v. Commissioner, p. 21

[4] Frost v. Commissioner, p. 22

[5] Frost v. Commissioner, pp. 22-23

[6] Frost v. Commissioner, p. 23

[7] Frost v. Commissioner, p. 23

[8] Frost v. Commissioner, p. 5

[9] Frost v. Commissioner, p. 4

[10] Frost v. Commissioner, pp. 24-25