Background
During the tax years at issue, Alon Farhy ("Taxpayer") knew of his reporting obligation under Section 6038 to file Forms 5471, Information Return of US Persons With Respect to Certain Foreign Corporations, and to report his ownership interests in several non-US corporations. He chose not to file the forms. Section 6038(b) provides that failure to furnish information regarding an individual's control over a foreign corporation or partnership is subject to a penalty of at least USD 10,000, up to a maximum penalty of USD 50,000.
The IRS notified the Taxpayer regarding his failure to file Forms 5471 and subsequently assessed penalties. When the Taxpayer failed to respond to the IRS notices, the IRS issued a final notice of intent to levy. The Taxpayer submitted a request for a collection due process hearing under Section 6330. After conducting a hearing, the IRS sent the Taxpayer a Notice of Determination upholding the collection of the Section 6038 penalties previously assessed. The Taxpayer then petitioned the Tax Court to determine whether the IRS had the authority to assess penalties under Section 6038(b).
In April 2023, the Tax Court held in Farhy v. Commissioner1 that the IRS lacked the authority to assess penalties under Section 6038(b) against the Taxpayer and, therefore, was unable to collect the penalties levied against him under the Code. However, the Court stated that the IRS could collect the Section 6038(b) penalties through a civil action filed under a non-tax statutory provision, 28 U.S.C § 2461(a). The IRS appealed the Tax Court's decision to the DC Circuit and the DC Circuit reversed and remanded the decision.2
DC Circuit Court opinion
The issue on appeal was what mechanism Congress allowed for the Secretary of the Treasury to collect the fixed-dollar penalties authorized under Section 6038(b).
Both parties relied on Section 6201(a) to support their positions. Generally, Section 6201(a) grants the Secretary of the Treasury the authority to assess "all taxes (including interest, additional amounts, additions to the tax, and assessable penalties)".
The IRS argued that the exactions listed in the "including" parenthetical, coupled with the term "all taxes", were a non-exhaustive list demonstrating the types of exactions upon which the IRS could assess as taxes. Unless otherwise stated in the Code, the IRS argued that all exactions were assessable as taxes.
The Taxpayer argued that a penalty must explicitly be labeled as a "tax" or designated as "assessable" in the Code to be assessed by the IRS. Additionally, the Taxpayer interpreted the term "assessable penalties" under Section 6201(a) to mean that there were some penalties that were not "assessable", including the Section 6038(b) penalties. Furthermore, the Taxpayer argued that there are four classes of assessable penalties under the Code, and any penalty outside these four classes is not assessable:
- Class 1: Penalties that are designated as taxes for assessment purposes. The Taxpayer argued that all penalties noted in Subtitle F, Chapter 68 of the Code fell under Class 1 because Section 6665(a)(1) explicitly states that all penalties are assessed in the same manner as taxes.
- Class 2: Penalties with standalone assessment authority. The Taxpayer argued that penalties fall under Class 2 when a section provides that the penalties listed thereunder are assessable or the section cross-references Subtitle F, Chapter 68 of the Code.
- Class 3: Penalties that have a group assessment authority. The Taxpayer argued that penalties fall under Class 3 when a section provides that the penalties listed thereunder belongs in a designated group, such as those referred to in Section 6671(a).
- Class 4: Penalties resulting from a designated procedure, such as deficiency proceedings.
Ultimately, the DC Circuit did not rule in favor of either party's arguments, but concluded that Congress intended that the penalties imposed under Section 6038(b) be assessable penalties. The court provided three reasons in support of its conclusion:
- As it was difficult to apply the Section 6038(c) penalties, Congress amended Section 6038 to include Section 6038(b) to easily collect a fixed-dollar penalty;
- Section 6038(c)(3) provides that the Sections 6038(b) and 6038(c) penalties are coordinated; and
- The Secretary of the Treasury's ability to determine a taxpayer's defense to Section 6038 penalties supports the fact that the Section 6038(b) penalties are assessable.
Ease of collection
In 1982, Congress amended Section 6038 to include Section 6038(b) to facilitate and simplify the collection process. The DC Circuit reasoned that interpreting Section 6038(b) to require the federal government to sue taxpayers to recover the fixed-dollar penalty treats Congress as having enacted a supplemental penalty that is less streamlined than the current collection process for Section 6038(c) penalties.
While the Taxpayer was unable to respond to the DC Circuit's argument, the Taxpayer argued that Congress made the Section 6038(b) penalties nonassessable to "withhold the IRS's super-charged collection powers." The DC Circuit countered that the Taxpayer's argument contradicts Congress' intent.
Coordination of penalties under Sections 6038(b) and 6038(c)
In instances where Section 6038(c) and Section 6038(b) apply, Section 6038(c)(3) provides that Section 6038(b) penalties offset Section 6038(c) penalties. The Taxpayer and the IRS agreed that Section 6038(c) penalties are assessable. The DC Circuit reasoned that if the Section 6038(b) penalties were nonassessable, then it would be more difficult to collect the Section 6038(c) penalties because the penalties work in tandem. The DC Circuit illustrated that if the IRS were asserting both Sections 6038(b) and 6038(c) penalties against a taxpayer, then the IRS would have to wait for the conclusion of the proceedings relating to the Section 6038(b) penalties in federal court before being able to offset the Section 6038(c) penalties. The DC Circuit reiterated that this process would not streamline the collection process as Congress intended.
Reasonable cause exception
Section 6038(c)(4)(B) provides a reasonable cause exception for taxpayers who fail to file Form 5471 by the due date. The reasonable cause exception applies to penalties assessed under Section 6038(b) and 6038(c). A taxpayer seeking relief under the reasonable cause exception must prove to the Secretary of the Treasury that the taxpayer qualifies for such exception. As the Section provides that the Secretary determines whether a taxpayer met the requirements for the reasonable cause exception, the DC Circuit reasoned that the reasonable cause exception is within the IRS's purview.
The DC Circuit stated that if the Section 6038(b) penalties were not assessable, then there would be no post-administrative procedure by which a taxpayer could claim relief under the reasonable cause exception. Additionally, the DC Circuit stated that the Taxpayer's interpretation of Section 6038(b) would result in a district court having to determine whether a taxpayer met the reasonable cause exception, which is contrary to the Secretary of the Treasury's power to determine whether the taxpayer met the reasonable cause exception under Section 6038(b). The DC Circuit also referred to Section 6201(a), which provides that the Secretary has the power to make inquiries and determinations of all taxes, including assessable penalties. The DC Circuit continued to state that the reasonable cause exception is one of the "determinations" within the purview of the Secretary, and to accept the Taxpayer's interpretation of Section 6201(a) would render the Secretary powerless under Section 6201(a) regarding the assessment of and inquiries and determinations into the Section 6038(b) penalties.
Duplicative court proceedings
The Taxpayer argued that the Section 6038(b) penalties are not assessable and, thus, the IRS must pursue a civil action to recover the penalties. However, the Taxpayer agreed that the Section 6038(c) penalties are assessable and, therefore, the IRS does not need to pursue a civil action to recover them. The DC Circuit stated that to accept the Taxpayer's interpretation would subject the Section 6038(b) penalties and the Section 6038(c) penalties to be review under two separate proceedings—the federal district court for Section 6038(b) penalties and the Tax Court for Section 6038(c) penalties. The DC Circuit further stated that this would result in two courts ruling on the same issues. Moreover, the first-issued judgment on an issue presented to each court would be binding on the other court.
Conclusion and takeaways
The DC Circuit's holding that the IRS has authority to assess penalties under Section 6038(b) overrides the Tax Court's decision in the DC Circuit. Following the DC Circuit's decision, the Taxpayer petitioned for a panel rehearing and a rehearing en banc. On June 13, 2024, the DC Circuit denied the Taxpayer's petitions.
As of the date of this article, the Taxpayer has yet to appeal the decision to the United States Supreme Court. However, cases surrounding the IRS's ability to assess penalties under Section 6038(b) are becoming more prevalent. Given the frequent litigation of these penalties, it is likely that any decision around them will be appealed to the United States Supreme Court.
1 Farhy v. Commissioner, 160 T.C, No. 6 (April 3, 2023).
2 Farhy v. Commissioner, No. 23-1179 (D.C. Cir. May 3, 2024), rev'g 160 T.C, No. 6 (April 3, 2023).