IRS cannot assess Sec. 6038(b) penalties

The Tax Court held that the IRS lacks the statutory authority to assess penalties under Sec. 6038(b)(1) or (2).

Background

From 2003 to 2010, Alon Farhy owned 100% of Katumba Capital Inc., a corporation incorporated in Belize. From 2005 to 2010, he also owned 100% of the Belize corporation Morningstar Ventures Inc. While he owned both companies, Farhy participated in an illegal scheme to reduce his income, but he obtained immunity from prosecution for his misdeeds.

Sec. 6038(a) requires a U.S. person to furnish certain required information with respect to ownership of any foreign business entity. Farhy, as a U.S. person, had a Sec. 6038(a) reporting requirement with respect to his interests in Katumba and Morningstar Ventures in the years he owned them. To meet this requirement, Farhy was obligated to file Form 5471, Information Return of U.S. Persons With Respect to Certain Foreign Corporations. He did not file a Form 5471 for any of the years in question.

For failing to meet the Sec. 6038(a) reporting requirement, Sec. 6038(b)(1) imposes a penalty of $10,000 for each annual accounting period the U.S. person fails to timely file Form 5471. Sec. 6038(b)(2) imposes a continuation penalty of $10,000 for each 30-day period (or fraction thereof) during which the failure continues with respect to any annual accounting period after an initial 90-day notice period, up to a maximum penalty of $50,000. However, central to Farhy’s case, there is no statutory provision, in the Code or otherwise, specifically authorizing the assessment of these penalties.

The IRS assessed Farhy an initial penalty under Sec. 6038(b)(1) of $10,000 for each year at issue and assessed him continuation penalties under Sec. 6038(b)(2) totaling $50,000 for each year. In January 2019, the IRS issued him a levy notice, seeking to collect the Sec. 6038(b) penalties it had assessed.

In response, Farhy requested a Collection Due Process hearing. In the hearing, among other issues, he disputed whether the IRS had the legal authority to assess the underlying Sec. 6038(b) penalties. The notice of determination the IRS issued after the hearing sustained its proposed collection action.

Farhy then petitioned the Tax Court to review the IRS’s determination. After stipulations, the only issue left for the Tax Court to decide was whether the IRS had the authority to assess the Sec. 6038(b) penalties against Farhy and therefore could collect the penalties it had assessed through its proposed levy.

The Tax Court’s decision

The Tax Court held that the IRS did not have the statutory authority to assess penalties under Sec. 6038(b)(1) or (2) and, as a result, could not collect the penalties from Farhy through its proposed levy.

Sec. 6201(a), as the Tax Court explained, authorizes and requires Treasury to make assessments of all taxes (including interest, additional amounts, additions to tax, and assessable penalties) imposed by the Code. Treasury has delegated these assessment duties to the IRS. However, the term “assessable penalties” in Sec. 6201(a) is not defined, creating uncertainty about which penalties the IRS may assess and ultimately collect through administrative means.

The Supreme Court in West Virginia v. Environmental Protection Agency, 142 S. Ct. 2587, 2609 (2022), stated, “Agencies have only those powers given to them by Congress.” Farhy argued that, unlike many other penalty sections in the Code, Sec. 6038 does not contain a provision authorizing assessment of the penalty for which it provides, and, as a consequence, the Sec. 6038(b) penalties are not assessable penalties. Thus, Farhy maintained, while the United States may be able to collect liabilities for the Sec. 6038(b) penalties through a civil action, under 28 U.S.C. Section 2461(a), the IRS may not assess or administratively collect them.

The IRS, on the other hand, contended that the term “assessable penalties” includes any penalties found in the Code that are not subject to the Code’s deficiency procedures. According to the IRS, neither Sec. 6201 nor any other Code section limits the term “assessable penalties” to those found in Subchapter B of Chapter 68 of Subtitle F of the Code (titled “Assessable Penalties”). Reading that subchapter as the exclusive location for assessable penalties, the IRS argued, would contravene Sec. 7806(b), which provides in relevant part that:

[n]o inference, implication, or presumption of legislative construction shall be drawn or made by reason of the location or grouping of any particular section or provision or portion of this title, nor shall any table of contents, table of cross references, or similar outline, analysis, or descriptive matter relating to the contents of this title be given any legal effect.

The IRS also argued that the term “taxes” in Sec. 6201 is broad enough to encompass Sec. 6038 penalties, citing Ruesch, 154 T.C. 289 (2020), aff ’d in part, vacated and remanded in part, 25 F.4th 67 (2d Cir. 2022), for support of its statutory arguments. Finally, the IRS claimed that the legislative history surrounding the enactment of penalties in Sec. 6038(b) provided support for its position.

The Tax Court concluded that Farhy was correct. The court observed that for penalties and additions to tax within Subchapter B of Chapter 68 of Subtitle F (i.e., in Secs. 6671–6725), Sec. 6671(a) and Sec. 6665(a)(1), respectively, state that penalties and additions to tax will be assessed in the same manner as taxes. For Code sections outside of Chapter 68 of Subtitle F whose violations the Code specifically penalizes, the court stated, citing numerous examples, that they commonly (1) 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; (2) contain a cross-reference to a provision within Chapter 68 of Subtitle F providing a penalty for their violation; or (3) are expressly covered by a penalty provision within Chapter 68 of Subtitle F. However, no way of recovering or enforcing the Sec. 6038(b) penalties is specified in the Code.

Moreover, the Tax Court pointed out that 28 U.S.C. Section 2461(a) expressly provides that “[w]henever a civil fine, penalty or pecuniary forfeiture is prescribed for the violation of an Act of Congress without specifying the mode of recovery or enforcement thereof, it may be recovered in a civil action.” The Sec. 6038(b) penalties at issue in Farhy’s case are prescribed for the violation of Secs. 6038(a)(1) and (2), but unlike many other penalties in the Code, Sec. 6038 does not provide for the administrative assessment or collection of the penalties. The court stated, “We are loath to disturb this wellestablished statutory framework by inferring the power to administratively assess and collect the section 6038(b) penalties when Congress did not see fit to grant that power to the Secretary of the Treasury expressly as it did for other penalties in the Code.”

Regarding the IRS’s assessablepenalties argument, the Tax Court found that while the term “assessable penalties” as used in Sec. 6201(a) is not limited to penalties found in Subchapter B of Chapter 68 of Subtitle F, it does not automatically apply to all penalties in the Code not subject to deficiency procedures. The court stated, “Simply put, while section 6038(b) provides for penalties, it does not provide for assessable penalties. [The IRS’s] argument that section 6038(b) penalties are necessarily assessable penalties because they are not subject to deficiency procedures assumes a faulty premise and must be rejected.”

The Tax Court similarly rejected the IRS’s argument that the penalties were taxes assessable under Sec. 6201(a). It found that its precedent firmly establishes that unless there is a provision treating them the same, taxes and penalties are distinct categories of exactions. It further found that while Sec. 6201(a) did not indicate that it applied only to the items listed as included in taxes (i.e., interest, additional amounts, additions to the tax, and assessable penalties), it rejected the idea that the assessment authority provided by Sec. 6201(a) covers all penalties, or virtually any exaction, imposed by the Code simply because it covers taxes and certain other exactions specifically included. The court found this position did not contravene Sec. 7806(b) because the term “assessable penalties” as used in Sec. 6201(a) was not defined by reference to the title of Subchapter B of Chapter 68 of Subtitle F nor by reference to the grouping of similar provisions in that subchapter.

The Tax Court also found that the IRS’s reliance on Ruesch was misplaced because the decision in that case had no bearing on the issue before it. In Ruesch, the taxpayer challenged the IRS’s certification of her liability for unpaid Sec. 6038(b) penalties as a seriously delinquent tax debt for purposes of Sec. 7345(b) and the propriety of the penalties. The IRS, finding that it had erroneously certified the debt, reversed its certification and filed a motion to dismiss the taxpayer’s challenge to the underlying penalties for lack of jurisdiction. The court granted the IRS’s motion, and thus it did not address the issue of whether the IRS could assess Sec. 6038(b) penalties in the case.

The IRS also pointed to three statements in the legislative history of current Sec. 6038(c) to support its position. The court found that the statements were immaterial to Farhy’s case, as the statements said nothing about the issue before the court, which was the manner in which Sec. 6038(b) penalties are to be collected.

Reflections

If penalties are authorized for not meeting the information requirements imposed by Sec. 6038(a), it would seem that the appropriate way to collect them would be to authorize the IRS to assess and collect them administratively. However, in what was likely an oversight, Congress did not include a provision in Sec. 6038 to allow the IRS to do so. On the other hand, given the various ways that different penalties are handled throughout the Code, it might not have been an oversight, and the Tax Court properly did not interpret the law to allow the IRS to administratively assess and collect the penalties in the absence of a clear congressional mandate.

Farhy, 160 T.C. No. 6 (2023)

Contributor

James A. Beavers, CPA, CGMA, J.D., LL.M., is The Tax Adviser’s tax technical content manager. For more information about this column, contact thetaxadviser@aicpa.org.