Computer-generated penalties not subject to supervisory approval requirements

Tax Hot Topics newsletterThe Tax Court ruled on Feb. 25 that accuracy-related penalties determined by an IRS computer program without human review are exempt from the written supervisory approval requirement of Section 6751(b)(1).

In Walquist v. Commissioner, 152 T.C. No. 3 (Feb. 25, 2019), the taxpayers, a married couple, filed a federal tax return for 2014 reporting wages of $94,114 and claiming deductions of $87,648 based on frivolous arguments. After accounting for the standard deduction, the taxpayers reported negative taxable income of $5,731.

The IRS, through its automated correspondence exam system, issued automated notices to the taxpayers after being alerted to the underreporting through computer document matching. In 2017, IRS computers issued a 30-day letter, informing the taxpayers of the deficiency and proposing a substantial understatement penalty under Section 6662(b)(2). At this point, the taxpayers had an opportunity to respond to the automated notice, but they did not. Thereafter, IRS computers generated a notice of deficiency that included the penalty.

The taxpayers made various tax-protestor arguments to the Tax Court as well as in U.S.
District Court that challenged the legal authority of the IRS, the courts and the Department of Treasury. The taxpayers did not appear during the Tax Court trial and the court addressed the issue of whether the IRS met its burden of production in the proceeding with respect to complying with Section 6751(b), which requires that penalties be “personally approved (in writing) by the immediate supervisor of the individual making such determination.” In Chai v. Commissioner, 831 F.3d 190 (2d Cir. 2017), the Second Circuit Court of Appeals ruled that the IRS must meet the requirements of Section 6751(b) and a supervisor must approve the penalty determination in writing no later than the date the IRS issues a notice of deficiency.

Under Section 6751(b)(2)(B), however, supervisory approval is not required “for any other penalty automatically calculated through electronic means.” The Tax Court in Walquist determined that the substantial understatement penalty was not subject to the supervisory approval requirements. The computer system automatically computed the tax liability and then automatically calculated the penalty of 20% of the understatement. When the taxpayers failed to respond to the IRS’s computer-generated 30-day letter, the computer then generated a notice of deficiency. “Because the penalty was determined mathematically by a computer software program without the involvement of a human IRS examiner, [the Tax Court concluded] that the penalty was ‘automatically calculated through electronic means’” under Section 6751(b)(2)(B).

David Auclair
National Managing Principal
Washington National Tax Office
T +1 202 521 1515

Shamik Trivedi
Senior Manager
Washington National Tax Office
T +1 202 521 1511

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