D.C. Circuit reverses Tax Court on assessment of foreign entity ownership reporting penalties

The D.C. Circuit, reversing the Tax Court, upheld the IRS’s authority to assess penalties for failure to furnish information specified under Sec. 6038 regarding U.S. persons’ ownership of certain foreign corporations and partnerships.

Facts: Alon Farhy, the taxpayer, was a U.S. permanent resident who in 2004 created an illegal scheme to underreport his income to the IRS.  To do so, Farhy employed two corporations based in Belize that he created, transferring over $2 million to these entities to reduce his U.S. income by generating losses. To induce Farhy to cooperate with tax enforcement and collection, the Tax Division of the U.S. Justice Department (DOJ) extended a nonprosecution agreement making him immune from criminal prosecution for his failure to disclose foreign financial accounts, which he signed.

However, the agreement did not immunize him from civil penalties stemming from his violations of the Internal Revenue Code (IRC). In February 2016, the IRS mailed Farhy a failure-to-file notice for the forms he was required to file under Sec.  6038(a) to report his ownership of the Belizean corporations (generally, Form 5471, Information Return of U.S. Persons With Respect to Certain Foreign Corporations).  Two years later, Farhy had still not filed the required information returns, so the IRS in 2018 assessed initial penalties of $10,000 pursuant to Sec.  6038(b)(1) and continuation penalties of $50,000 for 2003 to 2010 for one of the Belizean companies and 2005 to 2010 for the other.  The IRS subsequently sent Farhy a notice of intent to levy to collect the penalties he owed, and in response Farhy requested a Collection Due Process (CDP) hearing upon assessment.  The IRS Appeals Office upheld the proposed levy on Farhy’s property.

Farhy filed suit in Tax Court, challenging the IRS’s determination. His main argument was that the IRS did not have authorization to collect the penalties under Sec.  6038(b) because Congress had not explicitly authorized the IRS to assess and collect penalties under Sec.  6038(b). Rather, he argued, it must bring a civil action against the taxpayer pursuant to 28 U.S.C. Section 2461(a), which requires the government to sue for civil penalties “prescribed for the violation of an Act of Congress.” The Tax Court agreed with Farhy (Farhy, 160 T.C. No.6 (2023)).  Thus, the IRS would have to initiate a civil lawsuit by the DOJ rather than collect the penalties through its administrative collections process. The IRS appealed this decision to the D. C. Circuit in July 2023.

Issues: Of primary concern to the D.C. Circuit was Treasury’s “power of assessment,” a foundational component of the IRS’s authority to collect tax.  Prior case law and the IRC establish that an assessment is the “official recording” of the amount a taxpayer owes the federal government” (Polselli, 598 U.S. 432, 438 (2023); see also Sec.  6203).  An assessment lays the foundation for the IRS’s administrative collection powers without judicial process and empowers the Service to pursue liens, levies, and other efforts for collection rather than pursuing civil judicial action (Philadelphia & Reading Corp., 944 F.2d 1063 (3d Cir.  1991); Galletti, 541 U.S. 114 (2004); Hibbs v. Winn, 542 U.S. 88 (2004)). Because of the authority granted to Treasury under Sec.  6201(a), the IRS can assess and collect “all taxes” outlined in that Code section, which, however, do not explicitly include penalties under Sec.  6038(b).

The D.C. Circuit noted that “the only question on appeal is what mechanism Congress authorized for the Secretary of the Treasury to collect the fixed-dollar penalties authorized in [Sec.] 6038(b) against a U.S. person who fails to file the requisite information returns regarding foreign businesses under her control.” The parties offered distinct interpretations of Sec.  6201(a) to support their opinions.

The IRS underscored Sec. 6201(a)’s “role in the Code, its history, and the absurdities that would result from a narrower interpretation” to support its stance that Sec. 6038(b) is assessable through its administrative collection process. The IRS also emphasized the broad language in Sec.  6201(a), such as that it applies to “all taxes,” implying that it is intended to “cover the waterfront.” This broad intent is further substantiated by the fact that when Sec.  6201(a) was recodified from Sec.  3640 (1940), Congress did not remove any language pertaining to “all taxes,” suggesting that it intended to maintain a broad application.

Farhy argued that Sec.  6201(a) should be interpreted much more narrowly. He suggested that Sec.  6201(a) applies only to a “tax” or items “designated as ‘assessable,’ ” contending that penalties are not a form of tax and that not all penalties are assessable.

The D.C. Circuit’s decision relied heavily on the congressional intent of Sec.  6038, with an emphasis on subsection (b) .  That intent appeared to be for the penalty to be assessable by the IRS, it concluded.  Although the penalty was originally a percentage-based reduction of the taxpayer’s foreign tax credit (which remains under present Sec. 6038(c)), Congress amended the penalty to add a flat fee to simplify it and make it easier to collect.

The D.C. Circuit also emphasized the links between the Sec.  6038(b) and Sec.  6038(c) penalties, in that Sec. 6038(c) penalties are reduced by Sec. 6038(b) penalties, thereby suggesting that Sec.  6038(b), like Sec.  6038(c) penalties, should be assessable.  The court found that the Sec.  6038(b) penalty resulted from a streamlining of collection rather than a change in intent of assessment and stressed that Sec.  6038(c) penalties are assessable “without entering a courtroom.”

Further, the D.C. Circuit noted that the inability to assess Sec.  6038(b) penalties through administrative collections would put an undue burden on the IRS in that it would need to initiate a civil suit through the DOJ for each $10,000 penalty.  In oral arguments, Farhy’s counsel conceded that the “Justice Department wouldn’t touch that with a ten-foot pole.” Thus, the court determined that Sec.  6038(b)’s flatdollar amount was not consistent with Farhy’s interpretation, which would make it nearly impossible to enforce. The court underscored that because the penalties under Secs.  6038(b) and (c) can be imposed simultaneously, it would appear odd if one penalty were not assessable while the other one was.

The D.C. Circuit highlighted another reason for its conclusion that Congress clearly expected the IRS, rather than the courts, to enforce Sec. 6038(b) penalties.  Specifically, Secs. 6038(b) and (c) are both subject to a reasonable-cause affirmative defense, which requires taxpayers to establish that they “exercised ordinary business care and prudence” in attempting to meet their obligations (Flume, T.C. Memo.  2017-21; Boyle, 469 U.S. 241 (1985)).  Sec.  6038(c)(4)(B) grants the IRS the authority to “grant or deny that defense” by “requiring reasonable cause to be ‘shown to the satisfaction of the Secretary’.” This language, according to the court, indicates that the IRS is the intended enforcement agency for the penalty.  The language in the Treasury regulations regarding reasonable-cause showings during CDP hearings is also consistent with this notion (Regs.  Sec.  1.6038-2(k) (3) (ii)), which further supports the idea that Sec.  6038(b) penalties are intended to be within the purview of Sec.  6201(a).

As a final issue, the D.C. Circuit noted that “the potential bifurcation of the review of penalties arising from the same violation underscores the anomalous implications of interpreting subsection (c), but not subsection (b) , penalties to be assessable.” If these subsections were treated differently, taxpayers could easily game the system by choosing the more favorable subsection to their situation, circumventing the congressional intent of Sec.  6038.

Holding: The D.C. Circuit reversed the Tax Court’s decision and remanded the case to the Tax Court with instructions to enter a decision in favor of the IRS, holding that the IRS has the authority to assess Sec. 6038(b) penalties for failure to file an information return for ownership of foreign financial corporations.  The court stated, “It is hardly anomalous that [Sec.] 6038(b) penalties are assessable even though the text of [Sec.] 6038 does not explicitly label them as such.” The court cited additional circumstances where penalties are assessable but not explicitly so described, such as under Sec.  45(b)(7)(B).

■ Farhy, No.  23-1179 (D.C. Cir. 5/3/24) .  

—Thomas Godwin, CPA, CGMA, Ph.D., and John McKinley, CPA, CGMA, J.D., LL.M., are professors of the practice in accounting and taxation in the SC Johnson College of Business at Cornell University. To comment on this column, contact Paul Bonner, the JofA’s tax editor.