IRS Cannot Assess Penalties for Failing to Report Interests in Foreign Corporations

(Parker Tax Publishing April 2023)

The Tax Court held that the IRS does not have the statutory authority to assess penalties under Code Sec. 6038(b) against a taxpayer who failed to file Forms 5471, Information Return of U.S. Persons With Respect to Certain Foreign Corporations, as required by Code Sec. 6038(a). Farhy v. Comm'r, 160 T.C. No. 6 (2023).

Background

During 2003 through 2010, Alon Farhy owned 100 percent of Katumba Capital, Inc., a foreign corporation incorporated in Belize. From 2005 through 2010 Farhy also owned 100 percent of Morningstar Ventures, Inc. a foreign corporation incorporated in Belize. During 2003-2010 Farhy participated in an illegal scheme to reduce the amount of income tax that he owed. In 2012, Farhy was granted immunity from prosecution pursuant to a non-prosecution agreement.

Farhy had a reporting requirement under Code Sec. 6038(a) to report his ownership interests in both Katumba and Morningstar on Form 5471, Information Return of U.S. Persons With Respect to Certain Foreign Corporations. Farhy did not comply with this reporting requirement. In 2016, the IRS mailed Farhy a notice of his failure to file the required Forms 5471, but Farhy never filed them. For each year at issue, Farhy's failure to file the Form 5471 was willful and not due to reasonable cause.

Code Sec. 6038(b)(1) imposes a penalty of $10,000, with respect to each annual accounting period for which a failure exists, if any person fails timely to furnish certain required information with respect to any foreign business entity. Code Sec. 6038(b)(2) imposes a continuation penalty of $10,000 for each 30-day period (or fraction thereof) during which such failure continues with respect to any annual accounting period after an initial 90-day notice period, subject to a maximum of $50,000. There is no statutory provision, in the Code or otherwise, specifically authorizing assessment of these penalties.

The RS assessed an initial penalty against Farhy under Code Sec. 6038(b)(1) of $10,000 for each year at issue. The IRS also assessed continuation penalties under Code Sec. 6038(b)(2) totaling $50,000 for each year at issue. In 2019, the IRS sent Farhy a Letter 1058, Final Notice of Intent to Levy and Notice of Your Right to a Hearing (levy notice), seeking to collect the Code Sec. 6038 penalties. Farhy requested a collection due process (CDP) hearing in which he disputed whether the IRS has legal authority to assess Code Sec. 6038 penalties. After the IRS sustained the proposed levy, Farhy took his case to the Tax Court. He again argued that there is no law giving the IRS the authority to assess penalties under Code Sec. 6038(b) and that while the government may be able to collect liabilities for these penalties through a civil action, the IRS may not assess or administratively collect these penalties.

Code Sec. 6201(a) authorizes the assessment of all taxes (including interest, additional amounts, additions to tax, and assessable penalties) imposed by the Code. When a tax (including for this purpose a deemed tax, such as an additional amount, addition to tax, assessable penalty, or interest, as explained below) is assessed, the IRS may take certain actions to collect the tax administratively. However, the term "assessable penalties" as used in Code Sec. 6201(a) is not defined. The IRS contended that "assessable penalties" includes any penalties found in the Code that are not subject to deficiency procedures and is not limited to the penalties found in Code Secs. 6671-6725 (i.e., subchapter B of chapter 68 of subtitle F of the Code, entitled "Assessable Penalties"). The IRS further argued that the term "taxes" in Code Sec. 6201 is broad enough to encompass Code Sec. 6038 penalties.

Analysis

The Tax Court agreed with Farhy's reading of the Code and held that the IRS lacked the statutory authority to assess penalties under Code Sec. 6038(b)(1) or (2). The court found that Congress has explicitly authorized assessment with respect to myriad penalty provisions in the Code, but not for Code Sec. 6038(b) penalties. For example, Code Sec. 6671(a) provides that the numerous penalties found in Code Secs. 6671-6725 "shall be assessed, and collected in the same manner as taxes," subjecting those penalties to the IRS's assessment authority under Code Sec. 6201. In contrast, the court observed that Code Sec. 6038 contains only a cross-reference (in Code Sec. 6038(f)(1)) to a criminal penalty provision, Code Sec. 7203.

The court noted that under 28 U.S.C. Section 2461(a), whenever a civil fine, penalty or pecuniary forfeiture is prescribed for the violation of a federal law without specifying the mode of recovery or enforcement thereof, it may be recovered in a civil action. The Code Sec. 6038(b) penalties at issue in this case are prescribed for the violation of Code Sec. 6038(a)(1) and (2). However, the court noted that no mode of recovery or enforcement is specified for these penalties, unlike for many other penalties in the Code. The court reasoned that it was loath to disturb this well-established statutory framework by inferring the power to administratively assess and collect the Code Sec. 6038(b) penalties when Congress did not see fit to grant that power to the IRS expressly as it did for other penalties in the Code.

The court agreed with the IRS that the term "assessable penalties" in Code Sec. 6201(a) is not limited to the penalties found in Code Sec. 6671-6725. However, the court disagreed with the IRS that the term "assessable penalties" applies to all penalties in the Code that are not subject to deficiency procedures. According to the court, "assessable penalties" is not a term used to distinguish between penalties subject to deficiency procedures and those that are not. The label "assessable penalty," in the court's view, does not automatically bar a taxpayer from using the deficiency procedures to challenge the liability; rather, an assessable penalty is one that must be paid upon notice and demand and assessed collected in the same manner as taxes.

The court also rejected the IRS's argument that the term "taxes" in Code Sec. 6201(a) encompasses the Code Sec. 6038(b) penalties. According to the court, it is firmly established that taxes and penalties are distinct categories of exactions, at least in the absence of a provision treating them as the same. The court also observed that the adjective "assessable" would be unnecessary to modify the term "penalties" in Code Sec. 6201 if Code Sec. 6201 authorized the IRS to assess all penalties provided in the Code.

For a discussion of information reporting for certain controlled foreign business entities on Form 5471, 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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