Judicial Update

Graev II: Tax Court Upholds 20% Penalty in “Side Letter” Case

In a split decision released on November 30, 2016, the U.S. Tax Court has ruled against Lawrence and Lorna Graev’s latest legal challenge against the IRS. Specifically, the Tax Court held that the Graevs could properly be assessed a 20% penalty for substantial underpayment of tax. This was in connection with the Graevs’ failed attempt to claim a deduction for the façade easement that they had donated to the National Architectural Trust in 2004. The Tax Court had previously denied this charitable deduction in a 2013 decision—the infamous “side letter” case.

The Fatal Side Letter

Before the Graevs agreed to donate the façade easement on their New York property in 2004, at their request the National Architectural Trust had issued a letter to the Graevs promising, “In the event the IRS disallows the tax deductions in their entirety, we will promptly refund your entire cash endowment contribution and join with you to immediately remove the facade conservation easement from the property’s title.” (The Graevs donated cash in addition to the façade easement.)

The IRS discovered this side letter upon auditing the Graevs. Although this side agreement did not appear in the easement deed itself, the IRS used the letter as evidence to argue (1) that the easement was a conditional gift that the Graevs still had the power to rescind, (2) that the donation of the easement therefore had not yet been fully completed, and (3) that the federal tax code does not permit deductions for donations that have not been fully completed. The U.S. Tax Court upheld the IRS’s denial of the deduction in an opinion released on June 24, 2013 as Graev v. Commissioner, 140 T.C. 377, 2013 U.S. Tax Ct. LEXIS 18. The Graevs received zero tax benefits from their easement.

The 20% Accuracy-Related Penalty

The IRS was not done with the Graevs yet. The Tax Court’s recent opinion dealt with the penalties that the IRS could assess against the Graevs. In addition to disallowing the deduction for the easement, the IRS had sent the Graevs a notice that it would assess a 20% accuracy-related penalty against them pursuant to Section 6662(a) and (b) of the Internal Revenue Code. This penalty was applicable because the Graevs had substantially understated their tax obligations by virtue of claiming deductions that were not allowed. The notice to the Graevs alternatively asserted that the IRS would assess a 40% accuracy-related penalty. (The 40% penalty has different requirements; see my post on the Kaufman V decision for more details.)

In this latest case, the Graevs argued that the IRS had failed to follow certain procedural requirements in assessing the 20% accuracy-related penalty against them. Specifically, the Graevs focused on Section 6751(b)(1) of the Internal Revenue Code, which requires a supervisor at the IRS to approve the initial determination of the penalty. The Graevs argued that this statute had required the appropriate supervisory approval to be obtained before the IRS sent them a notice stating that it would assess the 20% penalty. That had not happened, although supervisory approval was properly obtained to assess a 40% penalty against the Graevs. Both the 20% penalty and the 40% penalty were asserted in the same notice to the Graevs.

The Tax Court disagreed with the Graevs’ argument. Rather, the Tax Court read the statute to mean that the supervisory approval had to be obtained before the penalty could actually be assessed, not before the notice was sent. Because the penalty could not be actually assessed until the Graevs’ appeals against the IRS were concluded, the appropriate supervisory approval could still be obtained, and the Graevs’ arguments were premature. The Tax Court therefore declined to set aside the assessment of the 20% accuracy-related penalty.

The Graevs also argued that the 20% accuracy-related penalty should not be applied to them because they fell within various statutory exceptions, including, among other exceptions, that they had relied in good faith on their CPA’s advice when claiming the tax deductions. However, the Graevs had never provided the side letter to their CPA. Because the CPA had not been provided “all necessary information” when preparing their tax returns, the Tax Court ruled that the Graevs were not protected by relying on their CPA’s advice.

A Split Decision

This was a surprisingly controversial opinion. Of the seventeen judges participating in this decision, only nine judges joined in the majority opinion that I have just discussed.

Three judges joined a concurring opinion, agreeing to uphold the IRS’s assessment of the 20% accuracy-related penalty but for a different reason: Even if the IRS had not strictly complied with the statute, the failure to obtain the appropriate supervisory approval of the 20% penalty did not harm the Graevs because the supervisory approval of the higher 40% penalty was obtained before the Graevs were sent the notice asserting both the 40% and 20% penalties. The IRS can assess either the 40% penalty or the 20% penalty, but not both; a combined 60% penalty was not possible.

The remaining five judges dissented from the majority opinion, agreeing with the Graevs that supervisory approval was required before sending the notice of assessment. They pointed out that the majority’s reading of the statute leads to absurd results. For example, a supervisor at the IRS cannot override the Tax Court; why would the supervisor be able to approve the 20% penalty after the Tax Court has issued its decision but before the time to appeal has expired? The dissenting judges concluded that, because the IRS failed to follow the procedural requirements in obtaining supervisory approval, the IRS could not assess the 20% accuracy-related penalty against the Graevs.

Which of these three opinions would prevail if the Graevs were to appeal to the U.S. Court of Appeals for the Second Circuit? So often in tax cases, the Tax Court will issue a pro-IRS opinion that is then overturned on appeal in favor of a position that is more taxpayer-friendly. My guess is that the same would happen here. The majority opinion bends over backward to interpret the statute in favor of the IRS, and I doubt that this interpretation would survive on appeal. Having said that, it’s anyone’s guess whether the Second Circuit would adopt the more pragmatic concurring opinion or the stricter dissenting opinion; both seem equally likely to me. Nonetheless, the Second Circuit’s opinion will be binding only in the Second Circuit, which includes New York, Vermont, and Connecticut, and so Virginians would do well to be aware of this latest Tax Court ruling.

You can read all three opinions at Graev v. Commissioner, 147 T.C. No. 16, 2016 U.S. Tax Ct. LEXIS 33.

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Derrick P. Fellows

Derrick P. Fellows is an attorney with Hawthorne & Hawthorne, P.C. in Victoria, Virginia. Follow him on Twitter at @dpfellows.

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