Final Regulations Issued on Penalty Supervisory Approval

More than 25 years ago, Congress enacted Internal Revenue Code Section 6751(b) to protect taxpayers from the IRS using penalties as a bargaining chip in an effort to coerce taxpayers to settle. Generally, Section 6751(b) requires approval of the initial determination of the penalty by the immediate supervisor of the person making the initial determination. If the IRS does not obtain the required approval, it is barred from imposing the penalty.

Since the law was enacted, its interpretation has been the subject of significant litigation in the U.S. Tax Court and U.S. courts of appeal, with varying interpretations. In an effort to clarify the statute and make its requirements uniform nationwide, the U.S. Department of the Treasury and IRS proposed regulations in April 2023, and the final regulations were released Dec. 20, 2024.

Final Regulations

There has been significant litigation on when the IRS must obtain supervisory approval. The Tax Court has generally required approval before the 30-day letter or other document giving the taxpayer the right to pursue an administrative appeal. By contrast, several courts of appeal do not require supervisory approval until a notice of deficiency is issued. The final regulations adopt the later rule and require approval only on or before the date the notice of deficiency is mailed.

For penalties first raised in the Tax Court, the final regulations require approval before the penalties are first raised in the Tax Court proceeding. For those penalties that are not subject to pre-assessment review in the Tax Court, approval is required before assessment.

The regulations also define the statutory terms "immediate supervisor," "higher level official," "personally approved (in writing)" and "automatically calculated through electronic means," as well as "individual who first proposed the penalty." Of note, the regulations clarify that written approval can be in any written form, including electronic, and no signature is required. Though comments requested that the IRS require an electronic signature with a time date stamp to alleviate concerns of backdating approval raised by Lakepoint Land II, LLC v. Comm'r of Internal Revenue, the IRS rejected this comment.

The regulations also loosely define "immediate supervisor" and include an example to make clear that the immediate supervisor may be the issue manager or team manager. This rule will be important in audits involving multiple examiners and multiple managers.

The regulations apply to penalties assessed on or after Dec. 23, 2024. Therefore, penalties currently pending in the Tax Court will be subject to these final regulations, which interpret Section 6751(b) differently than the Tax Court.

Tips for Addressing Penalties Requiring Supervisory Approval

1. Work to Eliminate or Reduce the Penalty. If you are under audit and a penalty has been proposed, clearly articulate and support any penalty defenses – including supervisory approval – to resolve penalties at the earliest point. Elevate to the auditor's manager (and above) if necessary. However, if the Exam team does not assert a penalty, beware that IRS counsel may assert a penalty later if you file a petition with the Tax Court.
2. Request Proof of Approval. Approval must be documented in writing. Once in litigation, request proof of supervisory approval (with metadata) in discovery to determine if the approval was timely or backdated, including when the penalty is not asserted until the Tax Court proceeding. If not in litigation and the penalty has been assessed, consider making a Freedom of Information Act (FOIA) request for the penalty approval documents if the penalty approval is not clear on the face of documents already received.
3. Evaluate the Supervisory Approval. Evaluate whether the supervisory approval is timely under the final regulations, whether there are any irregularities in the document, such as inconsistent dating or metadata suggesting that the document was modified after the penalty approval deadline, and whether the approval is by the immediate supervisor of the individual who made the initial determination.

Though the Treasury Department and IRS no doubt hope that the final regulations provide certainty on the issue, the final regulations are hardly the last word, as a Loper Bright challenge is most likely coming. In addition, there will still be disputes on the sufficiency and timeliness of supervisory approval under the final regulations. Stay tuned – the litigation on supervisory approval is not over yet!

Information contained in this alert is for the general education and knowledge of our readers. It is not designed to be, and should not be used as, the sole source of information when analyzing and resolving a legal problem, and it should not be substituted for legal advice, which relies on a specific factual analysis. Moreover, the laws of each jurisdiction are different and are constantly changing. This information is not intended to create, and receipt of it does not constitute, an attorney-client relationship. If you have specific questions regarding a particular fact situation, we urge you to consult the authors of this publication, your Holland & Knight representative or other competent legal counsel.