Rethinking international penalty administration

Editor: Mark Heroux, J.D.

Maintaining integrity in tax administration often requires the use of penalties to encourage voluntary compliance. However, it is crucial that the tax authority does not abuse these penalties, as it may discourage participation in tax compliance. Recently, Farhy, 160 T.C. No. 6 (2023), demonstrated checks and balances in tax administration. The Tax Court found that the IRS could not enforce penalties under Sec. 6038 administratively due to a lack of authority (see also Beavers, “IRS Cannot Assess Sec. 6038(b) Penalties,” 54-7 The Tax Adviser 58 (July 2023)). It is now up to Congress and Treasury to respond and ensure that taxpayers continue to provide valuable information about their international business practices. This item explores the Farhy decision and its impact on international penalties.

The IRS does not have authority to assess Sec. 6038 penalties

Alon Farhy petitioned the Tax Court after the IRS assessed penalties for failing to file Forms 5471, Information Return of U.S. Persons With Respect to Certain Foreign Corporations, for tax years 2003 through 2010. Farhy owned two foreign corporations incorporated in Belize during this time and failed to file Form 5471 despite clearly falling under its filing requirement. Farhy admitted that he had used the corporations to participate in an illegal scheme to reduce his income tax burden and stipulated these facts in 2012 when the government uncovered the scheme.

The IRS notified Farhy that he did not file Forms 5471. Shortly thereafter, the Service summarily assessed the initial penalty under Sec. 6038(b)(1) of $10,000 for each year of Farhy’s failure and the continuation penalties under Sec. 6038(b)(2) of $50,000 for each year. The IRS’s notices, letters, and assessments had been administrative up to this point. In other words, an IRS agent and manager agreed to issue the notices of assessment at the applicable intervals. At no point had the IRS issued notices of deficiency or referred the case to the Department of Justice to assess the penalties in litigation.

Farhy timely requested a Collection Due Process or equivalent hearing. His primary argument during this hearing was that the IRS did not have the statutory authority to assess Sec. 6038 penalties through administrative means. The IRS issued a notice of determination that upheld the penalties as valid. Farhy timely petitioned the Tax Court for review. In a well-reasoned, published opinion, the court agreed with Farhy that the IRS’s assessment of penalties under Sec. 6038 was invalid.

The Tax Court held that Congress did not provide Treasury statutory authority for the IRS to assess penalties under Sec. 6038. Under Sec. 6201(a), Congress authorized the secretary of the Treasury (who has delegated the authority to the IRS) to assess taxes, interest, additions to tax, and assessable penalties. However, Sec. 6038 does not fall into any of these categories. The Internal Revenue Code does not define “assessable penalties.” Congress has used specific language that categorizes penalties as assessable, but Sec. 6038 does not follow this language. Congress’s omission is damning, as the Tax Court explains: “We are loath to disturb this well-established statutory framework by inferring the power to administratively assess and collect the Sec. 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.” Simply put, there is no statutory basis for an administrative assessment under Sec. 6038.

Form 5472, Form 3520, and other international penalties

Thus, the Tax Court removed the Damocles’s sword that the IRS historically has used to administer international penalties. Although the Farhy case specifically addressed Form 5471, the court’s holding has greater implications for international penalties and tax administration.

In determining that Sec. 6038 provides a cause of action only, the court first determined that Sec. 6038 penalties are not a tax, addition to tax, or assessable penalty. Taxes and penalties are distinct categories, precluding Sec. 6038 penalties from being a tax. Sec. 6038 penalties are not additions to tax because they are not enumerated in Chapter 68 nor assessed, collected, or paid in the same manner as taxes.

Congress has specified which penalties are assessable under the Code. Secs. 6671 and 6665 both provide that penalties found in specific sections “shall be assessed.” Outside these sections (found in Chapter 68), penalty provisions expressly provide the IRS an ability to assess such penalties for purposes of assessment and collection. Sec. 6038 does not provide an assessable penalty without either a governing section providing for assessment or an express subsection doing so within Sec. 6038. The court thus found that 28 U.S.C. Section 2461 applied: “Whenever 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” (emphasis added).

Farhy has broad implications for the international community. Secs. 6038A through 6038E do not provide for a tax, addition to tax, or assessable penalty, for the same reasons as Sec. 6038. Congress did not provide that the $25,000 penalty for failure to file Form 5472, Information Return of a 25% Foreign-Owned U.S. Corporation or a Foreign Corporation Engaged in a U.S. Trade or Business, is an “assessable penalty,” nor does any other provision of the Code. In fact, Sec. 6038A mirrors the penalty provisions of Sec. 6038. Regs. Sec. 1.6038A-4(a) (1) provides that “a penalty of $25,000 shall be assessed” by the IRS “for each taxable year with respect to which such failure occurs” (emphasis added). However, Treasury cannot provide its own assessment authority, as “[a]gencies have only those powers given to them by Congress,” and Congress speaks through statute, not regulations (Farhy, citing West Virginia v. EPA, 142 S. Ct. 2587, 2609 (2022)). Interestingly, Sec. 6038A provides Treasury only the ability to issue regulations addressing information that taxpayers shall furnish and records that they shall keep. Congress does not provide a blanket regulatory authority. Instead, Treasury’s authority is supplied in specific subsections, and Sec. 6038A(d) (Penalty for Failure to Furnish Information or Maintain Records) is not one of those subsections. It seems logical to assume that the Tax Court will rule in any future cases that the IRS may pursue Form 5472 penalties via civil action, as the court did in Farhy.

The penalty for failure to file Form 3520, Annual Return to Report Transactions With Foreign Trusts and Receipt of Certain Foreign Gifts, or 3520-A, Annual Information Return of Foreign Trust With a U.S. Owner, however, seems clear in comparison to Sec. 6038. Sec. 6048 enumerates the information that taxpayers must report with respect to certain foreign trusts, but it does not provide any civil penalty. Sec. 6677 outlines the penalty for failing to timely file or filing an incomplete Form 3520 — the greater of $10,000 or 35% of the gross reportable amount, plus a continuation penalty. At first glance, Sec. 6677 appears to mirror Sec. 6038 by providing that the taxpayer “shall pay a penalty” (Sec. 6677(a)(2)) instead of using assessment language. Congress, however, provides the ability for the IRS to assess such penalties in Sec. 6671(a): “The penalties and liabilities provided by this subchapter [Chapter 68, Subchapter B, (Secs. 6671 to 6725)] shall be paid upon notice and demand by the Secretary, and shall be assessed and collected in the same manner as taxes.”

The difference in treatment seems inexplicable. Sec. 6677 provides a much steeper penalty than Sec. 6038 or Sec. 6038A, often reaching millions of dollars. Nevertheless, the IRS’s assessment of seven-figure penalties can be as quick and easy as a computer-issued notice. The consequence of the Farhy opinion is likely either congressional intervention or a more thoughtful approach to enforcement, as the IRS would have to determine there is an issue and then follow deficiency procedures or refer the case to Justice for litigation. As the Tax Court has provided a pause for reflection, perhaps Congress should reconsider Sec. 6677 as well as Sec. 6038.

The Form 5471, Form 5472, and Form 3520 reporting requirements and related penalties target individuals and corporations that may use tax havens or other vehicles to reduce their domestic tax burden. However, the provisions cast a wide net that will invariably ensnare innocent taxpayers as well as those evading tax. Imagine, for example, a taxpayer who receives a modest inheritance from a family member domiciled in another country. The taxpayer speaks with his tax adviser, who counsels that the inheritance is not taxable. Neither catches the Form 3520 filing requirement. The IRS’s computer system summarily assesses a six-figure penalty. Technically, the IRS appropriately imposed the penalty as provided by the IRC. This situation, however, feels predatory and punitive. The taxpayer lost a loved one and was not trying to hide income. The taxpayer also conducted due diligence by contacting a tax professional. Congress should consider amending international penalty administration to avoid such undesired results.

Congressional intervention

Currently, the Tax Court has placed a moratorium on the IRS’s ability to assess penalties under Sec. 6038. Congress must step in to clarify how the IRS should move forward. The Tax Court would not accept anything less, as the commissioner’s judgment does not substitute for Congress’s express intentions. Requiring the IRS to pursue Sec. 6038 in a civil proceeding would make the Form 5471 (and Form 5472) reporting regime ineffective. International penalties should also support voluntary compliance and be commensurate with the underlying failure.

Congress could simply add “assessment” language to Sec. 6038 or input a cross-reference to Sec. 6671. An overview of the international penalty landscape implies that this is how Congress meant to institute Sec. 6038 penalties. Sec. 6677 imposes much harsher penalties, and Congress allows the IRS to automate these penalties. However, Sec. 6677 penalties punish with a six-figure assessment well-meaning taxpayers who have conducted due diligence. It is worth considering that international penalties often align with information returns, and as much as 88% of the dollar amount of Sec. 6638 and 6638A penalties have been abated (Taxpayer Advocate Service, National Taxpayer Advocate Annual Report to Congress pp. 119–31 (2020)). Strengthening and streamlining Sec. 6038 penalties may not be the best approach.

The IRS may administer international penalties through deficiency proceedings. In contrast to immediate assessment, deficiency proceedings afford taxpayers judicial review and negotiations with the Office of Chief Counsel (OCC). Thus, taxpayers who have acted in good faith may find penalty relief sooner than under the current regime because of quicker access to competent counsel. Prior to trial, the OCC can consider “softer” aspects of a taxpayer’s case, as well as technical arguments such as whether the form is substantially complete. The advancement of equitable considerations appears to outweigh the increased burden on the Tax Court’s docket.

Assessment and deficiency are well-worn tools of civil penalty administration, but Farhy provides a moment to consider something new. Congress may consider creating an international appeals group that has immediate jurisdiction over international penalties. This would provide similar benefits to having OCC intervention but with cost-effective resources. Congress could require withholding of certain amounts from transfers with international companies or trusts and require an information return before it will refund the money. This withholding regime would incentivize taxpayers to report information required by Congress while avoiding penalties. Taxpayers should also have more opportunities to cure defects in filings and have a chance to comply with the law.

International reporting does not raise revenue by itself but only through its hefty penalties. The regime seems to focus on raising revenue rather than promoting compliance. By providing leniency in the statute, Congress could obtain accurate information while encouraging voluntary compliance and faith in tax administration.

Editor Notes

Mark Heroux, J.D., is a tax principal in the Tax Advocacy and Controversy Services practice at Baker Tilly US, LLP in Chicago.

For additional information about these items, contact Heroux at mark.heroux@bakertilly.com.

Contributors are members of or associated with Baker Tilley US, LLP.