Tax Court again holds Sec. 6038(b)(1) penalties not assessable

The Tax Court held, as it did previously in Farhy, 160 T.C. 399 (2023) (Farhy I), that the IRS does not have the authority to assess the Sec. 6038(b)(1) penalty.

Background

Between November 2001 and September 2005, Raju Mukhi created three foreign entities, including Sukhmani Partners II Ltd., a foreign corporation for U.S. tax purposes. From 2002 through 2013, Mukhi did not timely file Forms 5471, Information Return of U.S. Persons With Respect to Certain Foreign Corporations, to disclose his ownership interest in this foreign corporation.

The IRS audited Mukhi’s liability for civil tax penalties related to the entities. As a result, the Service issued a notice letter to Mukhi in September 2017 informing him that it had assessed $120,000 in penalties under Sec. 6038(b)(1) for failure to timely file Form 5471 for tax years 2002 through 2013.

The IRS subsequently proposed a levy and filed a lien notice to collect Mukhi’s unpaid penalties. In response, Mukhi timely requested a Collection Due Process hearing. After the hearing, the IRS issued a notice of determination sustaining the collection activities related to the penalties.

Mukhi petitioned the Tax Court to review the notice of determination. Mukhi and the IRS filed cross-motions for partial summary judgment related to various aspects of the case.

After the parties filed their respective motions, the Tax Court held in Farhy I that the IRS lacks authority to assess the Sec. 6038(b)(1) penalty (see Beavers, “IRS Cannot Assess Sec. 6038(b) Penalties,” 54-7 The Tax Adviser 58 (July 2023)). The IRS appealed the Tax Court’s decision in Farhy I to the D.C. Circuit. While that appeal was pending, the Tax Court granted Mukhi partial summary judgment in his case (Mukhi, 162 T.C. No. 8 (2024)) related to the Sec. 6038(b)(1) penalties, holding that the IRS lacked the statutory authority to assess those penalties.

After the Tax Court issued its decision in Mukhi’s case, the D.C. Circuit reversed the Tax Court’s decision in Farhy I and held that the IRS has the authority to assess the Sec. 6038(b)(1) penalty (Farhy, 100 F.4th 223 (D.C. Cir. 2024), rev’g and remanding160 T.C. 399 (2023) (Farhy II)) (see Beavers, “D.C. Circuit Holds IRS Can Assess Sec. 6038(b) Penalties,” 55-7 The Tax Adviser 56 (July 2024)). As a result of this development, the IRS filed a motion for reconsideration of findings or opinion pursuant to Rule 161 of the Tax Court Rules of Practice and Procedure, requesting reconsideration of the Tax Court’s opinion in Mukhi’s case with respect to the Sec. 6038(b)(1) penalties in light of the D.C. Circuit’s decision.

The Tax Court’s decision

The Tax Court granted the IRS’s motion for reconsideration, but on reconsideration, it again held that, based on the plain language of the statute, the IRS lacks the authority to assess the Sec. 6038(b)(1) penalty. Consequently, it further held that the IRS could not proceed with the collection of Mukhi’s penalties through its lien or proposed levy.

Motion for reconsideration: Rule 161 authorizes a party to file a motion for reconsideration of a Tax Court opinion or findings of fact within 30 days after a written opinion has been served. Reconsideration is warranted when a subsequent decision of an apellate court calls into question the foundation of a prior opinion.

As the Tax Court explained, when one of its decisions is reversed by an appellate court, it will “thoroughly reconsider” the question at issue in light of the appellate court’s reasoning, and, if convinced by the appellate court’s decision, it will follow that court. However, if the Tax Court is convinced its original decision was correct, it will follow its own beliefs until the Supreme Court decides the issue. In an exception to this approach, when a decision of an appellate court to which an appeal would lie contradicts the Tax Court’s own precedent, the Tax Court will follow the appellate court’s decision (Golsen, 54 T.C. 742 (1970), aff’d, 445 F.2d 985 (10th Cir. 1971)).

The Tax Court observed that its decision in Mukhi’s case that the IRS did not have the authority to assess Sec. 6038(b)(1) penalties rested on its decision in Farhy I, which the D.C. Circuit had reversed in Farhy II. However,an appeal from the court’s decision in Mukhi’s case would lie in the Eighth Circuit, and, therefore, the Tax Court was not bound to follow the decision of the D.C. Circuit. However, the D.C. Circuit’s decision in Farhy II called into question the basis of the Tax Court’s determination that the IRS did not have the authority to assess the Sec. 6038(b)(1) penalty, so the Tax Court granted the IRS’s motion for reconsideration.

Sec. 6038(b)(1) and Sec. 6038(c) penalties: Under Sec. 6038(a), a U.S. person must file an information return with respect to a foreign business entity that the person controls. Failure to file such a return may result in at least one of two penalties: (1) the penalty under Sec. 6038(b)(1), which is $10,000 for each tax year for which the U.S. person does not file the required information return, and (2) the penalty under Sec. 6038(c), which reduces the amount of foreign tax credit available under Sec. 901. The IRS may impose both penalties, but the coordination clause in Sec. 6038(c)(3) reduces the Sec. 6038(c) penalty by the amount of the Sec. 6038(b) penalty. A U.S. person may avoid liability for both penalties by establishing that reasonable cause exists for the failure to file the information return.

IRS authority to assess Sec. 6038(b)(1) penalty: To resolve the dispute regarding whether the IRS had the authority to assess the Sec. 6038(b)(1) penalty, the Tax Court looked to the statute and presumed, quoting Conn. Nat’l Bank v. Germain, 503 U.S. 249 (1992), “that a legislature says in a statute what it means and means in a statute what it says there,” and when a statute’s text is unambiguous, a court’s sole function is to enforce the terms as written. In the Tax Court’s view, applying these principles produces a clear result with respect to the Sec. 6038(b)(1) penalty.

By default, under 28 U.S.C. Section 2461(a), an agency may collect a civil penalty through a civil action in a district court, but Congress may alter this default rule. The IRS’s authority to assess certain liabilities is derived from Sec. 6201(a), which authorizes and requires the Service to assess “all taxes (including interest, additional amounts, additions to the tax, and assessable penalties)” imposed by the Code. The IRS generally must take certain steps before making an assessment; however, it may immediately assess “assessable penalties” not subject to the Tax Court’s deficiency jurisdiction (Secs. 6201, 6665(a)(1), and 6671(a)).

The IRS argued for an expansive reading of Sec. 6201(a) that would encompass all exactions in the Code, advancing two arguments in support of this conclusion. Its first argument was that the parenthetical in Sec. 6201(a) provides an illustrative rather than exhaustive list of exactions covered, indicating that the Sec. 6038(b)(1) penalty could be considered a penalty covered by Sec. 6201(a).

The Tax Court acknowledged that the IRS was correct that the word “including” typically denotes an illustrative list. However, the court determined that it did not follow that the use of “including” meant that the “taxes” covered by Sec. 6201(a) were inclusive of all exactions. Such a reading, according to the court, would render the word “assessable” in the parenthetical superfluous. Therefore, the use of the word “assessable,” the court found, denoted that the IRS’s assessment authority was limited to less than all penalties in the Code.

The Tax Court also found that reading “taxes” in Sec. 6201(a) as including all exactions would also render superfluous the various Code provisions that deem penalties to be taxes for certain purposes. As the court noted, it has been firmly established that taxes and penalties are two distinct categories of exactions but that for various purposes of the Code, penalties are deemed to be taxes. Under the IRS’s theory, the court concluded that there would be no need for these deeming provisions because such penalties would already be included within the definition of “tax.” For these reasons, the court rejected this argument.

The IRS’s second argument was that when Congress recodified the Internal Revenue Code in 1954, it did not intend to change the scope of the IRS’s assessment authority in the Internal Revenue Code of 1939, under which all penalties were clearly included within the IRS’s assessment power. To support this argument, the IRS pointed to the silence in the legislative history regarding a material change to the IRS’s authority in Sec. 6201(a).

The Tax Court explained that this argument was based on an exception to the reenactment canon. This canon provides that when Congress amends legislation, courts must presume it intends the change to have real and substantial effect; however, an exception to this rule is that a court will generally presume no substantive changes were intended with Congress’s recodification of existing law unless the intent is clear. The Tax Court noted that the predecessor statute to Sec. 6201(a) in the Internal Revenue Code of 1939 provided that the IRS could assess all taxes and all penalties. However, Sec. 6201(a), in the Internal Revenue Code of 1954, provides that the IRS has assessment authority only over all taxes (including interest, additional amounts, additions to the tax, and assessable penalties).

The Tax Court found that the text of Sec. 6201(a) clearly expressed Congress’s intent to make a substantive change to the IRS’s assessment authority. It reduced the scope of the authority from a blanket power to assess all penalties to a power to assess only all taxes, which include assessable penalties. The court, citing the Supreme Court (Wells, 519 U.S. 482, 497 (1997)), found that because the statutory text was clear, it did not need to consider legislative history to discern Congress’s intentions.

Assessable penalty: Having determined that the IRS only had the power to assess “assessable penalties,” it next considered whether the Sec. 6038(b)(1) penalty is an assessable penalty that falls under the scope of Sec. 6201(a).

Sec. 6038(b)(1) provides that “[i]f any person fails to furnish, within the time prescribed … any information with respect to any foreign business entity … such person shall pay a penalty of $10,000 for each annual accounting period with respect to which such failure exists.”

The Tax Court stated that nothing in the text of Sec. 6038(b)(1) expressly authorizes the IRS to assess the Sec. 6038(b)(1) penalty or provides the procedure the IRS must use to collect it. Instead, the text merely sets forth that a taxpayer shall pay the penalty for a violation of the statute without specifying a mode of recovery. Furthermore, unlike the assessment text in other civil penalty statutes, the court noted that there is no text in the statute demanding that the penalty be treated as an assessable penalty, indicating the penalty should be treated as a tax, or directing the taxpayer to pay the penalty in the same manner as a tax.

Accordingly, the Tax Court found it was clear from Sec. 6038(b)(1)’s plain text and the text of similar civil penalty statutes that the Sec. 6038(b)(1) penalty is not an assessable penalty and thus the IRS did not have authority to assess it. In the absence of a specified mode of recovery or enforcement in the statute, the court determined that the default rules of collection under 28 U.S.C. Section 2461(a) applied to the penalty and that the IRS was required to recover it through a civil action.

Reflections

In Farhy II, the D.C. Circuit stated that if the Sec. 6038(b)(1) penalty were not assessable, it would not be pursued and would become “largely ornamental” because, due to the small amount of the penalty ($10,000), the Department of Justice would not have an incentive to bring a civil collection action to collect the penalty. The Tax Court in its opinion in Mukhi claimed that this would not be the case because the penalty can accumulate over several years, as it had in both Mukhi’s case ($120,000 in cumulative penalties) and in Farhy’s case ($80,000 in cumulative penalties). The court also found that “[e]ven if the Department of Justice does not bring a civil action against every taxpayer for the section 6038(b)(1) penalty, the mere possibility of such enforcement will have a deterrent effect.

Mukhi, 163 T.C. No. 8 (2024)

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.