D.C. Circuit holds IRS can assess Sec. 6038(b) penalties

Reversing the Tax Court, the D.C. Circuit held that the IRS has the statutory authority to assess penalties under Secs. 6038(b)(1) and (2). 

Background 

In 2004, Alon Farhy, a U.S. permanent resident, engaged in a scheme to falsely underreport his income from exercising certain stock options he received from his then-employer. As part of the scheme, he incorporated in Belize two companies, Katumba Capital Inc. in 2003 and Morningstar Ventures Inc. in 2005, both of which he owned until 2010. Farhy did not file Forms 5471, Information Return of U.S. Persons With Respect to Certain Foreign Corporations, to disclose his ownership in the two corporations for any of the years he owned them, as was required by Sec. 6038(a). 

The IRS caught on to Farhy’s underreporting scheme but did not prosecute him criminally for it. However, as part of a nonprosecution agreement he signed with the Tax Division of the Justice Department, Farhy remained liable for any civil penalties, including foreign information-reporting penalties related to Katumba and Morningstar Ventures, arising from the scheme.

In 2016, the IRS mailed Farhy a notice of his failure to file Forms 5471 for the corporations for 2003 through 2010. In 2018, the IRS assessed Farhy an initial penalty under Sec. 6038(b)(1) of $10,000 for failing to disclose his ownership in Katumba for 2003 through 2010 and in Morningstar Ventures for 2005 through 2010, as required by Sec. 6038(a), and assessed him continuation penalties under Sec. 6038(b)(2) totaling $50,000 a year for each corporation a week later. In January 2019, the IRS issued him a levy notice, seeking to collect the Sec. 6038(b) penalties it had assessed. 

In response to the levy notice, Farhy requested a Collection Due Process hearing. A hearing was held, but the Appeals Office upheld the proposed levy of Farhy’s property. Farhy then petitioned the Tax Court to review the IRS’s determination regarding the levy. The only argument he made in Tax Court was that the IRS was not authorized to assess penalties imposed under Sec. 6038(b). 

Farhy contended that the IRS instead was required to collect liabilities for Sec. 6038(b) penalties through a civil action brought in federal district court under 28 U.S.C. Section 2461(a). That subsection establishes a general cause of action authorizing the government to sue to collect any civil penalty “prescribed for the violation of an Act of Congress.”

The Tax Court sided with Farhy, holding that the IRS could not proceed with its proposed levy because it lacked statutory authority to assess the Sec. 6038(b) penalties as Congress had not explicitly authorized assessment for them (Farhy, 160 T.C. No. 6 (2023)). Thus, although the IRS had been collecting these penalties through assessment for over 40 years, under the Tax Court’s decision it was now required to collect them through a civil suit under 28 U.S.C. Section 2461(a). 

The IRS appealed the Tax Court’s decision to the D.C. Circuit.

Secs. 6038(b) and (c)

When initially enacted in 1960, the sole penalty (now codified as Sec. 6038(c)) imposed under Sec. 6038 for a failure to meet the information-reporting requirements of Sec. 6038(a) was a 10% reduction of the taxpayer’s foreign tax credit. By reducing a taxpayer’s foreign tax credit, the taxpayer’s amount of tax owed is increased. The penalty amount is thus necessarily reflected in a tax liability. As taxes are categorically assessable under Sec. 6201, the penalty under Sec. 6038(c) is assessable. 

Over time, the IRS and Congress found that the Sec. 6038(c) penalty was ineffective and underused in addressing failure to file information returns as required by Sec. 6038(a). Congress responded in 1982 by adding to Sec. 6038 subsection (b)(1) a streamlined, uniform penalty for the same failure to file an information return: a flat $1,000 penalty (now increased to $10,000) and, under Sec. 6038(b)(2), an additional incremental penalty of up to $50,000 for a continued knowing failure to file after an initial 90-day notice period. 

To avoid penalizing a taxpayer twice, a coordination provision, Sec. 6038(c)(3), was also added by the 1982 amendments to Sec. 6038. Under that provision, the Sec. 6038(c) penalty is offset by the amount of any penalty under Sec. 6038(b). 

D.C. Circuit’s decision

The D.C. Circuit reversed the Tax Court’s decision and remanded the case to it with instructions to enter a decision in favor of the IRS. The D.C. Circuit held that “the text, structure, and function of section 6038 demonstrate that Congress authorized assessment of penalties imposed under [Sec. 6038(b)].” The D.C. Circuit noted that the text of Sec. 6038 does not explicitly say whether the penalties imposed for violating Sec. 6038(a) are assessable and that the IRS and Farhy relied on “dueling” presumptions that they argued applied to all penalties in the Code arising out of Sec. 6201(a). That section grants the IRS broad authority to assess “all taxes (including interest, additional amounts, additions to the tax, and assessable penalties).” 

The IRS argued that because the word “including” appears at the start of the list in the parenthetical phrase in Sec. 6201(a), the list is illustrative rather than exhaustive and that Congress meant it to encompass penalties generally, including the Sec. 6038(b) penalties. This conclusion was bolstered, according to the IRS, by the fact that the predecessor to Sec. 6201(a) had specified that it applied to “all taxes and penalties” and that Congress had recodified the statute “with no apparent intention to circumscribe its applicability to all penalties.” 

Farhy, on the other hand, read the term “assessable penalties” in Sec. 6201(a) to refer to penalties explicitly characterized as a tax or designated as assessable and to carry a negative implication that penalties not so characterized or designated, including the Sec. 6038(b) penalties, are not assessable. Proceeding under this theory, Farhy further argued that there are only four overlapping ways that a penalty can be assessable, which are if they: 

• Are designated as taxes for assessment purposes; 
• Are described in the Code section imposing them as a penalty that “shall be assessed” or through certain cross-references to Subchapter B of Chapter 68 of the Code; 
• Belong to a designated group of penalties authorized to be assessed by the Code; or 
• Result from a designated procedure, such as deficiency proceedings. 

The D.C. Circuit, however, found that it did not need to “embrace either party’s tax code-wide default rule to resolve this case.” Instead, it concluded that a narrower set of inferences was sufficient to show that Congress intended the Sec. 6038(b) penalties to be assessable. 

Congressional intent: According to the D.C. Circuit, “[a] close reading of section 6038 with an eye to the role of subsection (b) within it reveals that the Congress that amended the Code in 1982 intended the subsection (b) penalty to be assessable.” The court pointed to two changes effected by the amendment of Sec. 6038 in 1982 that it found particularly relevant. First, Congress added Sec. 6038(b) in response to difficulties experienced in applying the original penalty in Sec. 6038(c), adding the fixed-dollar penalty that could be more simply and consistently collected. Second, in Sec. 6038(c)(3), Congress required that the two penalties be coordinated. 

The D.C. Circuit observed that requiring the IRS to bring a civil suit under 28 U.S.C. Section 2461(a) to collect penalties under Sec. 6038(b) would treat Congress as having enacted a supplemental penalty process that is less streamlined, not more, than the preexisting collection process for Sec. 6038(c) penalties. The court found that it would have been “highly anomalous” for Congress to have responded to the identified problem of the underuse of Sec. 6038(c) penalties by creating a penalty that, while simpler to calculate, is much harder to enforce. 

Further, the D.C. Circuit found that the Sec. 6038(c)(3) coordination provision showed Congress contemplated that Sec. 6038(b) and Sec. 6038(c) penalties could be imposed at the same time. Requiring the IRS to file suit to collect a Sec. 6038(b) penalty, while a Sec. 6038(c) penalty could be assessed, the court reasoned, would thwart the purpose of Sec. 6038(c)(3). The court stated that to agree that Sec. 6038(b) penalties were not assessable, it would have to conclude that “Congress not only failed in its avowed quest to streamline, but also counterproductively threw sand in the gears of section 6038’s existing enforcement scheme.” 

The court also noted that Congress expected the IRS, not a district court, to assess Sec. 6038(b) penalties. The court asserted that this was shown by the fact that both the Sec. 6038(b) and Sec. 6038(c) penalties are subject to an affirmative reasonable-cause defense. Under Sec. 6038(c)(4)(B), the IRS determines whether the taxpayer has shown reasonable cause for a failure to file information returns. 

As the D.C. Circuit explained, making the IRS the arbiter of whether a taxpayer has demonstrated reasonable cause only makes sense in circumstances in which the IRS assesses the penalty. If a civil suit were required to enforce a violation of Sec. 6038(a) under subsection (b), a district court rather than the Service would decide whether the taxpayer proved that the defense excused their violation. According to the court, it would be hard to understand “what purpose would be served by the statutory requirement that the taxpayer’s reasonable-cause defense be ‘shown to the satisfaction of the Secretary’ ” as required by Sec. 6038(c)(4)(b) “if the claim subject to that defense must be decided in the first instance by a district court judge.” 

Moreover, the D.C. Circuit found that Congress’s specification that the IRS, not a district court, evaluate taxpayers’ assertions of reasonable-cause defenses to Sec. 6038(b) penalties fit in neatly with Sec. 6201(a). That provision, in addition to empowering and requiring the IRS to make assessments, requires it to “make the inquiries [and] determinations … of all taxes (including … assessable penalties).” If Sec. 6201(a) did not apply to Sec. 6038(b) penalties, the court found, the IRS would lack power under Sec. 6201(a) regarding not only the assessment of Sec. 6038(b) penalties but also “inquiries” and “determinations” into them as well. 

The D.C. Circuit in addition noted that the bifurcation of the review of penalties under Secs. 6038(b) and (c) could create parallel and substantively overlapping judicial tracks for the determination of penalties arising out of the same act of noncompliance. This could lead to potentially inconsistent doctrinal development and possibly generate duplicate court proceedings on the same issue. It could also incentivize parties to push forward more quickly in the forum they perceive to be more favorable, raising concerns of gamesmanship in the process. 

In summary, the D.C. Circuit held that Sec. 6038(b) penalties are assessable, refusing to adopt Farhy’s interpretation of the statute, which the court concluded attributed to Congress an intent to respond to the problem it identified with the original Sec. 6038(c) penalty in a manner that would be not only ineffective but counterproductive. 

Congressional acquiescence: In closing its opinion, the D.C. Circuit stated that its conclusion was buttressed by more than 40 years of congressional acquiescence to the IRS’s practice of assessing Sec. 6038(b) penalties. As the Supreme Court has stated, it is a well-established principle that when revising a statute, if Congress fails to revise or repeal an agency’s interpretation, it is persuasive evidence that the agency’s interpretation is the one intended by Congress (Commodity Futures Trading Comm’n v. Schor, 478 U.S. 833, 846 (1986)). The court noted that since adding Sec. 6038(b) in 1982, Congress has amended Sec. 6038 seven times, and each time it has left the IRS’s practice of assessing and administratively collecting penalties imposed under Sec. 6038(b) undisturbed. 

Reflections 

Here the D.C. Circuit takes away a huge undeserved (and what initially must have been a totally unexpected) win from Farhy. Given the applecart that the Tax Court was upsetting with its opinion in this case, Farhy can hardly be surprised by the D.C. Circuit’s decision. Whether Congress made a mistake in enacting the Sec. 6308(b) information-reporting penalties that should be required to be fixed by amending the statute is open to debate, but it cannot be seriously argued that Congress intended that the IRS file civil suits to collect the many Sec. 6038(b) information-reporting penalties it seeks to impose. As the D.C. Circuit pointed out, requiring the IRS to do this would be totally at odds with Congress’s intent in enacting the Sec. 6038(b) penalties. 

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

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.