Tax Court: IRS Lacks Authority to Assess Certain Foreign Information Return Penalties

The U.S. Tax Court (USTC) on April 3, 2023, issued its opinion in Alon Farhy v. Commissioner, which held that the IRS lacks authority to assess certain foreign-related information return penalties pursuant to Section 6038(b).¹

Although the immediate impact of the Farhy opinion is apparent, the subsequent fallout will certainly be subject to future litigation that taxpayers should closely monitor for years to come.

Background

For tax years 2003 through 2010, Alon Farhy (Taxpayer) owned various foreign corporations. For these years, the Taxpayer failed to file requisite Form 5471, Information Return of U.S. Persons With Respect to Certain Foreign Corporations (Form 5471).

In 2016, the IRS mailed a notice to the Taxpayer informing him of his failure to file the required Forms 5471. The Taxpayer failed to comply. On Nov. 5, 2018, the IRS assessed an initial $10,000 penalty under Section 6038(b)(1) for each year at issue, and on Nov. 12, 2018, the IRS assessed continuation penalties under Section 6038(b)(2) totaling $50,000 for each of the years at issue.

Thereafter, the IRS issued a levy notice to collect the Section 6038 penalties, and the Taxpayer timely requested a collection due process (CDP) hearing pursuant to Section 6330. As a result of the CDP hearing, the IRS issued a Notice of Determination Concerning Collection Actions under IRC Sections 6320 or 6330 of the Code (Notice of Determination) sustaining the liabilities for the Section 6038 penalties.

The Taxpayer timely petitioned the USTC for review of the Notice of Determination. The sole issue before the USTC was whether the IRS had statutory authority to assess Section 6038(b) penalties.

The Taxpayer argued that the Code lacks any provision authorizing the IRS to assess Section 6038(b) penalties but that liabilities for such penalties may be collected in a civil action under Title 28 (and not under the Code). The IRS argued, among other contentions, that "assessable penalties" includes any penalties in the Code not subject to deficiency procedures and, pursuant to Section 6201(a), the IRS (by delegation from the Secretary of the U.S. Department of the Treasury) is authorized and required to make assessments of all taxes (including interest, additional amounts, additions to tax and assessable penalties) imposed by the Code.

The Decision

In concluding the Taxpayer's reading of the Code is correct, the USTC held that the IRS lacks statutory authority to assess Section 6038(b) penalties. In doing so, the USTC analyzed the Code and relevant Title 28 provisions and made the following determinations:

• Congress has explicitly authorized the IRS to assess penalties pursuant to numerous provisions under Chapter 68 of Subtitle F of the Code
• Code Sections outside of Chapter 68 of Subtitle F for which violations are specifically penalized commonly:
  • contain their own express provision specifying the treatment of penalties or other amounts as a "tax" or an "assessable penalty" for purposes of assessment and collection
  • contain a cross-reference to a provision within Chapter 68 of Subtitle F providing a penalty for their violation or
  • are expressly covered by a penalty provision within Chapter 68 of Subtitle F
• In contrast, Section 6038 neither specifies the treatment of Section 6038(b) penalties as a "tax" or "assessable penalty," nor does it contain or cross reference to a provision authorizing assessment of the 6038(b) penalties
• The IRS' reliance on Section 6201(a) was misplaced as the term "assessable penalties" is undefined and could not be used by the IRS to assess Section 6038(b) penalties
• The government's remedy to collect Section 6038(b) penalties is filing a civil action under Title 28 U.S.C. § 2461(a), which allows penalties to be recovered when there is no specified mode of recovery or enforcement²

Farhy Fallout – Where Does the IRS Go from Here?

From a legal and administrative perspective, this decision is problematic for the agency. With respect to Section 6038(b) penalties, the IRS's role has been reduced to that of a private litigant. The enforcement of Section 6038(b) will rest on the U.S. Department of Justice (DOJ), which will need to file a lawsuit seeking a judicial determination. Assuming the parties agree that there was a Section 6038(b) violation, the central issue in the de novo proceeding will be the defenses raised by the taxpayer on which the taxpayer will have the burden. If the DOJ is successful, then it must seek judicial collection of the judgment lien.³

Although Section 6038(b) penalties are not subject to the USTC's deficiency jurisdiction, the court had jurisdiction to review the IRS's Notice of Determination sustaining the Section 6038(b) penalties resulting from the Taxpayer's CDP hearing. Because the USTC opinion found that the IRS lacks authority to assess Section 6038(b) penalties, this should mean such penalties (and other similar penalties for which the IRS lacks authority to assess) should not be subject to administrative collection actions because the penalties should have never been assessed. Based on the Farhy opinion, taxpayers who have been assessed Section 6038(b) or other penalties for which the IRS lacks authority should consider timely requesting a CDP hearing (if available) to preserve the right to challenge the penalties in USTC.

Section 6751(b) generally provides that no penalty under the Code shall be assessed unless the initial determination of such assessment is personally approved (in writing) by the immediate supervisor (or higher-level official as designated by the IRS) of the individual making such determination. But if the IRS cannot assess Section 6038(b) penalties, are such penalties (and other similar penalties) excluded from Section 6751(b)'s supervisory approval requirement? Or must the penalties be supervisory-approved before the government initiates a civil action under Title 28 U.S.C. § 2461(a)?

The judicial action may be ongoing while the substantive tax matter is proceeding in USTC or other judicial forum. This may allow for discovery tools to be utilized by the government that the USTC may not have granted.

It should be expected that the IRS will seek an appeal and may also seek Congress to amend Section 6038 and other similar Code Sections in which the IRS lacks authority to make assessments.

Collateral Implications

Beyond the direct implications of the Farhy case to Section 6038(b) penalties, this USTC decision could have significant further implications by extension to other information reporting obligations as well as determining the relevant statute of limitations that should apply to enforcement of the penalty provisions.

Similar to Section 6038(b), there are several other penalty provisions outside Chapter 68 that do not expressly specify treatment as a tax or assessable penalty. For example, none of the information reporting penalties under Sections 6038A(d) (Form 5472), 6038B(c) (Forms 926 and 8865)⁴, or 6038D(d) (Form 8938) specify that such penalties shall be treated as a tax or assessable penalty. Thus, based on Farhy, the IRS has no authority to assess these penalties and may only enforce or recover such penalties through a civil action as authorized by 28 U.S.C. § 2461(a).

Because the court concluded that the term "taxes" in Section 6201 is not broad enough to encompass Section 6038(b) penalties, the term "tax" under Section 6501 (dealing with statute of limitations) presumably is not broad enough to encompass such penalties. This is consistent with the IRS' longstanding position that penalties assessed outside of Chapter 68 are not subject to any period of limitations under the Code (see Internal Revenue Manual section 20.1.9.1.1(3) "Penalties that are not considered taxes generally have no statute of limitation for assessment"). The statute of limitations contained in Section 6501 applies only to penalties imposed under subchapter B of Chapter 68 of the Code (deemed a "tax" per Section 6671(a)), not penalties imposed under Chapter 61 (such as Section 6038(b) penalties). As a result, there are no statute of limitations provisions in the Code that would govern penalties imposed under Section 6038(b) or similar provisions. Alternatively, however, such penalties could be subject to the limitations period provided in 28 U.S.C. § 2462, which provides, "Except as otherwise provided by Act of Congress, an action, suit or proceeding for the enforcement of any civil penalty shall not be entertained unless commenced within five years from the date when the claim first accrued." Since no statute of limitations is "otherwise provided" for Section 6038(b) or similar penalties, the enforcement of such penalties should be subject to the limitations of 28 U.S.C. § 2462.

For additional information or questions regarding tax and information return penalties, compliance and litigation, please contact the authors.

Notes

¹ Unless otherwise indicated, all "Section" references are to the Internal Revenue Code of 1986, as amended (the Code).

² The IRS may be time-barred from collecting the Section 6038(b) penalties from the Taxpayer. See Title 28 U.S.C. § 2462.

³ See Tax Division Judgment Collection Manual - 3. Entering Judgment, Stays of Collection, and Obtaining a Judgment Lien.

⁴ In contrast, penalties for failing to report certain changes in ownership of foreign partnership interests under Section 6046A (also satisfied by filing Form 8865) are determined by cross-reference to Section 6679 (i.e., an assessable penalty within Chapter 68).

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.