16 October 2020Accounting & tax analysis

US Tax Court rules IRS microcaptive penalties void on technical grounds

The US Tax Court has ruled in favour of Jesus Oropeza, the shareholder of a microcaptive called FIRM, in a case against the Internal Revenue Service, ruling that penalties imposed by the IRS were made improperly and do not stand.

The court’s decision was based on technical grounds, specifically that notice for the penalties was improperly communicated prior to the IRS securing management approval.

Having failed to follow the correct procedures before communicating the penalties to taxpayers, the IRS violated section 6751(b) of the tax code, the court ruled.

The IRS had imposed a 20 percent lack of economic substance penalty under (b)(6) of the code, as well as a 40 percent non-disclosure of non-economic substance penalty. Although the 40 percent penalty was properly asserted in its own right, it was merely an enhancement of the 20 percent penalty that had been improperly communicated. This rendered both penalties void.

The court concluded: “If we permitted the IRS to impose a 40 percent penalty in the circumstances here, the IRS could penalise a taxpayer more severely despite its own mistake. If the IRS recognised the failure to comply with section 6751(b)(1) for a 20 percent penalty, it could later assert (and get approval for) the same penalty at a 40 percent rate.”

This would leave taxpayers forced to make concessions or risk having their penalties doubled, the court added. “This was precisely the sort of problem that Congress aimed to prevent by enacting section 6751(b)(1).”

David Slenn, partner at Shumaker, Loop & Kendrick, said: “This means if there is a timeliness issue with regards to (b)(6), a properly asserted 40 percent penalty under 6662(i) for non-disclosure should fail as it is merely an enhancement of the underlying noneconomic substance penalty. It also means the tax court is continuing to accept communications as potential ‘initial determinations’ regardless of whether the communications notify the taxpayer of appeal rights.”