/>iWe once again want to bring to your attention the Internal Revenue Service’s (IRS) new favorite penalty provision: Internal Revenue Code (IRC) Section 6676. We have reported on this provision several times before (See here and here), but this time we’re analyzing it in the context of protective refund claims.
As background, IRC Section 6676 was enacted in 2007 in response to the high number of presumed meritless refund claims being filed at the time. It imposes a 20% penalty to the extent that a claim for refund or credit with respect to income tax is made for an “excessive amount.” An “excessive amount” is defined as the difference between the amount of the claim for credit or refund sought and the amount that is actually allowable. For example, if a taxpayer claims a $2 million refund and the IRS allows only $1 million, the taxpayer can still be penalized $200,000 (e.g., 20% of the amount of the refund that was disallowed). Significantly, IRC Section 6676 does not require the IRS to show any fault or culpability on the part of the taxpayer (e.g., negligence or a disregard of rules or regulations). Neither the IRC nor the regulations provide for any defense to the Section 6676 penalty other than “reasonable cause.” Moreover, the penalty is immediately assessable, and generally taxpayers cannot fight the IRS on the penalty in a prepayment forum like it can the US Tax Court. Instead, the taxpayer must first pay the penalty and seek redress in a refund forum in either the relevant US federal district court or the US Court of Federal Claims.
Now that the IRS is asserting the IRC Section 6676 penalty more frequently, taxpayers are asking whether the penalty can apply to a protective refund claim. A protective refund claim is a judicial creation under which a taxpayer files a “protective” refund claim that is expressly contingent on a specified future event, like a taxpayer-friendly holding in a relevant court case. The Supreme Court of the United States has endorsed protective refund claims to toll the statute of limitations on the refund claim and thereby protect the taxpayer’s right to claim the refund if the favorable event should occur. (See, e.g., United States v. Kales, 314 US. 186 (1941), and CCA 201136021 (describing protective claims in detail).)
So, does the IRC Section 6676 penalty apply to a protective refund claim? Based on IRS internal guidance from 2022, the IRS believes that the IRC Section 6676 penalty applies to any filing that constitutes a “claim for credit or refund” of income tax, including a protective refund claim. To apply the penalty, the IRS would have to process the protective refund claim, deny the claim and then assert the IRC Section 6676 penalty.
Processing and denying a protective refund claim go against most tax practitioners’ experience and understanding of how the IRS treats protective refund claims. Typically, the refund claim is filed pending the outcome of a court case (e.g., if the Supreme Court is hearing a particular tax case). If the contingency resolves favorably for the tax position, the taxpayer then “perfects” the protective refund claim and asks the IRS to process it. If the contingency resolves unfavorably, the protective refund claim is not perfected or acted upon.
It should be noted that the IRS’s internal guidance on the potential application of IRC Section 6676 penalties to protective refund claims directs IRS examiners to coordinate with IRS counsel before asserting the penalty, highlighting the uncertainty surrounding – and lack of precedent supporting – the imposition of the penalty to a protective refund claim.
We have been unable to find any authority or precedent that supports applying an IRC Section 6676 penalty to a protective refund claim.
Practice Point: When determining whether to file a protective refund claim, consider consulting with a tax advisor on the pros and cons of filing. If you decide to file a protective refund claim, it may make sense to put yourself in a position to have a reasonable cause defense if the IRS asserts an IRC Section 6676 penalty.
