Tax Court Finds IRS Lacked Authority to Assess Sec. 6038(b) Penalties

(Parker Tax Publishing April 2024)

The Tax Court held, in a case challenging the IRS's notice of determination related to approximately $11 million of foreign reporting penalties under Code Sec. 6038(b) and Code Sec. 6677, that a settlement officer did not violate the taxpayer's Fifth Amendment due process rights or abuse his discretion in rejecting the taxpayer's collection alternatives that were significantly below his reasonable collection potential. The court further held that the IRS lacked authority to assess penalties against a taxpayer under Code Sec. 6038(b) and therefore could not proceed with collection actions as they related to those penalties; in addition, the court held that penalties imposed under Code Sec. 6677 are not fines and therefore do not implicate the Excessive Fines Clause of the Eighth Amendment to the U.S. Constitution. Mukhi v. Comm'r, 162 T.C. No. 8 (2024).

Background

Between November 2001 and September 2005 Raju Mukhi created three entities: Sukhmani Partners II Ltd., a foreign corporation for U.S. tax purposes; Sukhmani Gurkukh Nivas Foundation, a foreign trust for U.S. tax purposes; and Gurdas International Ltd., a foreign trust for U.S. tax purposes. Through these entities, Mukhi opened several foreign brokerage accounts. From 2005 through 2007 Mukhi personally and through foreign entities transferred at least $9,729,249 to Gurdas International Ltd. From 2006 through 2008 Mukhi withdrew at least $4,763,464 from Gurdas International Ltd.

In 2014, Mukhi was indicted on two counts of subscribing to false U.S. individual income tax returns and four counts of willful failure to file reports of foreign bank and financial accounts (FBAR) related to the above-described transactions. Mukhi entered a guilty plea, admitting to one count of subscribing to false U.S. individual income tax returns and one count of failure to file an FBAR. The IRS then began an examination of Mukhi's liability for civil tax penalties related to the foreign entities. During the examination, Mukhi filed under protest various international information returns related to his foreign investments. Between July 2015 and January 2016, Mukhi filed Forms 5471, Information Return of U.S. Persons With Respect to Certain Foreign Corporations, related to his interest in Sukhmani Partners II Ltd. for tax years 2005 through 2013. In September 2016, Mukhi filed Forms 3520, Annual Return To Report Transactions With Foreign Trusts and Receipt of Certain Foreign Gifts, related to contributions he made and distributions he received from Sukhmani Gurkukh Nivas Foundation for tax years 2005 through 2013. Mukhi also filed Forms 3520 - A, Annual Information Return of Foreign Trust With a U.S. Owner, disclosing his interest in Sukhmani Gurkukh Nivas Foundation for tax years 2005 through 2013.

At the conclusion of the examination, the IRS assessed $5,072,449 in penalties under Code Sec. 6677 for failure to timely file Form 3520 for tax years 2005 through 2008. The IRS also assessed $5,920,419 in penalties under Code Sec. 6677 for failure to timely file Form 3520 - A for tax years 2005 through 2010. Under Code Sec. 6677(b), a penalty is imposed for failure to file to file an information return disclosing ownership of a foreign trust. The penalty is generally equal to the greater of $10,000 or 5 percent of the gross value of the portion of the trust assets that a United States person is treated as owning. In addition, the IRS assessed $120,000 in penalties under Code Sec. 6038(b) for failure to timely file Form 5471 for tax years 2002 through 2013. Code Sec. 6038(b)(1) imposes a penalty of $10,000 for each tax year for which a United States person does not file an information return disclosing ownership of a foreign corporation.

Mukhi filed a protest with the IRS Independent Office of Appeals (Appeals Office). The case was assigned to an Appeals Officer (AO). After reviewing Mukhi's challenge to the foreign reporting penalties, the AO concluded that there were no grounds for penalty abatement and that Mukhi's case with the Appeals Office was closed.

The IRS began taking collection actions related to the foreign reporting penalties. Mukhi requested a collection due process (CDP) hearing. He indicated that he was interested in an installment agreement and that he wanted to challenge the underlying liability. After meeting with a settlement officer (SO), Mukhi offered an installment agreement of $2,000 per month. Mukhi reported that his individual equity in his assets was $3,860,533. Mukhi also reported that his total household income was $22,761 and his total monthly household expenses were $20,479. Thus, Mukhi reported a net difference between his income and expenses of $2,282. After considering this financial information and Mukhi's substantial assets, the SO rejected Mukhi's installment offer. Rather than make an alternative installment offer, Mukhi asked to be considered for an offer in compromise (OIC).

Mukhi submitted two alternative OICs. He proposed a one-time payment of $1,000,000 and withdrawal of 22 refund lawsuits. His alternative OIC sought a global settlement of all outstanding tax issues by offering to liquidate specific assets and transfer the proceeds to the IRS, valued at approximately $2,672,717, and to withdraw 22 refund lawsuits. As part of the alternative OIC, Mukhi also sought to be absolved from any income tax generated from the liquidation of these assets. Mukhi's case was assigned to a new SO who determined he had no prior involvement and reviewed the casefile. The new SO referred the case back to International Operations to address outstanding issues relating to the underlying liability. The case was assigned to the same AO who handled Mukhi's appeal. The AO contacted the SO to explain that he had already considered the issues. The SO reviewed the file and determined that he agreed with the AO's determinations regarding the underlying liability. The SO also concluded that Mukhi's OICs were insufficient because of the large equity he had in assets. In a letter of determination, the SO sustained the collection actions.

Mukhi filed a petition with the Tax Court asking for review of the notice of determination. Mukhi argued that the SO violated his Fifth Amendment due process rights by engaging with AO during the CDP hearing, that the SO erred in concluding that he was liable for the foreign reporting penalties and the calculation of such penalties, that the SO erred in denying his proposed collection alternatives, and that the foreign reporting penalties violated the Excessive Fines Clause of the Eighth Amendment to the U.S. Constitution. Mukhi filed a motion for summary judgment, asking the Tax Court to decide as a matter of law that the IRS violated his Fifth Amendment due process rights. The IRS also filed a motion for summary judgment, asking the court to find as a matter of law that (1) the notice of determination was valid, (2) the SO did not violate the Fifth Amendment, (3) the SO did not abuse his discretion in rejecting Mukhi's OICs, and (4) the foreign reporting penalties under Code Sec. 6038(b) and Code Sec. 6677 do not violate the Excessive Fines Clause.

After the parties filed their respective motions, the Tax Court held in a separate case, Farhy v. Comm'r, 160 T.C. No. 6 (2023), that the IRS lacks the authority to assess the Code Sec. 6038(b) penalty. The IRS appealed Farhy to the D.C. Circuit. In this case, the IRS argued that the Tax Court should overrule Farhy, hold that the IRS has the authority to assess penalties under Code Sec. 6038(b), and resolve the Excessive Fines issue. In contrast, Mukhi argued that, if affirmed, Farhy resolves this case with respect to the Code Sec. 6038(b) penalties.

Analysis

The Tax Court held that Mukhi's Fifth Amendment due process rights or CDP rights were not violated by the SO's interactions with the AO. The court found that the SO had no prior involvement related to the tax liabilities for the years at issue and was required to refer Mukhi's case to International Operations because his challenge to his underlying liabilities involved international reporting penalties. The court also held that the SO also did not abuse his discretion in rejecting Mukhi's OIC proposals because Mukhi's offers were significantly less than his reasonable collection potential.

Next, the court determined that it did not need to reach the constitutional issue of whether the Code Sec. 6038(b) penalties violate the Excessive Fines Clause because there was an independent, nonconstitutional basis to resolve the issue of whether the IRS's determination to sustain collection actions related to Code Sec. 6038(b) was an abuse of discretion. Specifically, the court found that under Farhy, the IRS lacks the authority to assess penalties under Code Sec. 6038(b). According to the court, the IRS assessed penalties under Code Sec. 6038(b) against Mukhi without the authority to do so, which consequently meant that the IRS may not proceed with the collection of the Code Sec. 6038(b) penalties via the proposed levy or lien. Adhering to the doctrine of stare decisis, the court rejected the IRS's argument that the court should overrule its holding in Farhy. The mere fact that Farhy was currently on appeal was, in the court's view, insufficient since this case was appealable to the Eighth Circuit and therefore, any ruling from D.C. Circuit would not be binding on this proceeding.

The court also rejected Mukhi's argument that the Code Sec. 6677 penalties violate the Excessive Fines Clause. The court explained that to determine whether a penalty is a fine, the court must examine whether the penalty serves the purpose of punishing the offense. The court noted that it has consistently found that the purpose of civil tax penalties and additions to tax is to encourage voluntary compliance and therefore they are not punitive. In the court's view, the Code Sec. 6677 penalties serve the purposes of protecting revenue and reimbursing the government for the heavy expense of investigation and fraud. The court found that the Code Sec. 6677 penalties are primarily a method to safeguard the collection of revenue, as without such reporting many foreign entities having U.S. tax effects would be difficult to find and monitor. The court further found that, even if the Code Sec. 6677 penalties are fines for purposes of the Excessive Fines Clause, the penalties are not so grossly disproportionate as to violate the Eighth Amendment.

For a discussion of foreign-related information reporting requirements, see Parker Tax ¶203,120.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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