Sec. 7491(c)'s Burden-of-Production Requirement for Penalties

In Higbee, 116 TC No. 28 (2001), the Tax Court ruled that the Service can satisfy Sec. 7491(c)'s burden-of-production requirement for all penalties assessed against individuals, by presenting sufficient evidence in court that the penalty is appropriate. This interpretation creates a minimal requirement and does not shift the burden of proof from the taxpayer to the IRS. The court also interpreted "credible evidence" in Sec. 7491(a), which shifts the burden of proof to the Service if the taxpayer satisfies several conditions.

In general, the courts have long held that a deficiency notice is presumptively correct, and the taxpayer must prove that it is incorrect. However, there are certain specific exceptions in the Code (e.g., fraud), when the IRS has the burden of proof on the issue. In 1998, Congress enacted Sec. 7491, effective for examinations occurring after July 22, 1998. Sec. 7491(a) shifts the burden of proof on any factual issue in any court proceeding from the taxpayer to the Service if the taxpayer introduces credible evidence. In addition, prior to trial, the taxpayer must comply with the recordkeeping and substantiation requirements of the Code and regulations, and also cooperate with the IRS's reasonable requests for documents, witnesses, information and meetings. Sec. 7491(a) applies to income, estate and gift taxes for all individuals, and for corporations, trusts and partnerships with net worth not exceeding $7 million.

Congress enacted Sec. 7491(a) because it believed that individuals and small businesses were at a disadvantage when forced to litigate with the Service. Under Sec. 7491(b), the IRS has the burden of proof for any item of income of individuals reconstructed by it solely through statistics on unrelated taxpayers.

Sec. 7491(c) specifies that, regardless of any other Code provision, the Service "shall have the burden of production in any court proceeding with respect to the liability of any individual for any penalty, addition to tax, or additional amounts imposed by this title." Sec. 7491(c) applies to penalties and additions to tax on all Federal taxes, but only for individuals. Unlike Sec. 7491(a), Sec. 7491(c) does not require the taxpayer to satisfy any conditions. Congress enacted Sec. 7491(c) because it believed that the IRS should not be able to rely on its presumption of correctness if it presents no evidence at trial regarding penalties.

In Higbee, the Service assessed deficiencies averaging over $11,000 per year for 19961997. It also assessed a Sec. 6651(a)(1) failure-to-file addition to tax for 1996 and a Sec. 6662(a) accuracy-related penalty for 1997. After concessions, disallowed deductions averaged approximately $40,000 per year. The remaining issues were a $1,920 Schedule C deduction, the addition to tax and the penalty. Also, the Higbees claimed additional itemized deductions and Schedules C and E expenses at trial. In support of a casualty loss, the Higbees submitted a court document without proper certification. They did not submit a reliable estimate of repairs. For a charitable contribution, the Higbees submitted authentic preprinted forms that they, not the charity, had completed.

Since Sec. 7491 does not define credible evidence, the Tax Court adopted the Conference Committee's characterization of "credible evidence," as evidence the court would find sufficient on which to base a decision if no contrary evidence was submitted. The Tax Court ruled that the Higbees did not submit credible evidence under Sec. 7491(a) for these deductions, and therefore the burden of proof did not shift to the IRS. The court also ruled that because the Higbees did not maintain adequate records or properly substantiate the additional itemized deductions and Schedules C and E expenses, they were disallowed.

Turning to Sec. 7491(c), the Tax Court adopted the Conference Committee's characterization of "burden of production," which is not defined in Sec. 7491. The Service "must initially come forward with evidence that it is appropriate to apply a particular penalty to the taxpayer before the court can impose the penalty." The same requirement applies to additions to tax. The court also followed the Conference Committee in ruling that the burden of proof remains with the taxpayer under Sec. 7491(c), as under prior law. Therefore, the taxpayer must prove he did not violate the penalty statute, or that he qualifies for any allowable exception, such as reasonable cause. The Tax Court noted that this analysis entails that a penalty is not a tax for Sec. 7491(c) purposes. If it were, Sec. 7491(a) would apply and shift the burden to the Service for penalties.

In Higbee, the parties stipulated that the Higbees filed their 1996 return in 1998, which the Tax Court ruled was sufficient to satisfy the IRS's burden of production. The Higbees presented no evidence of reasonable cause; therefore, the court sustained the addition to tax. The Tax Court also ruled that the Service satisfied its burden of production on the Sec. 6662(a) penalty, which was due to negligence, because it showed that the Higbees failed to keep adequate books and records and to substantiate their disallowed deductions and expenses properly. The court did not explain how the IRS made this showing. Perhaps the court considered the concessions the Higbees made plus the nature of evidence they submitted as equivalent to inadequate records and improper substantiation. The Tax Court concluded by sustaining the penalty, because the Higbees did not prove they were not negligent or that they acted with reasonable cause and in good faith.

Although Sec. 7491(c) will prevent the Service from presenting no evidence on penalties against individuals in court, Higbee clarifies that satisfying the burden-of-production standard appears to require the IRS simply to produce enough evidence to connect the taxpayer's behavior, inadequate evidence, etc., with the particular addition to tax or penalty statute.

For example, for negligence, pointing out examples of the taxpayer's inadequate records or disregard of the rules appears sufficient for those portions of the deficiency. On the other hand, taxpayers need more guidance to clarify how the Tax Court will interpret Sec. 7491(a) as the court explained only one element of Sec. 7491(a), "credible evidence," when it was arguably quite clear the taxpayers' evidence did not satisfy the standard.

From Peter Barton, MBA, CPA, J.D., Professor of Accounting, University of Wisconsin-Whitewater, Whitewater, WI (Not associated with DFK International)