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Legal Alert

We’ll Take This Way Too Farhy: D.C. Circuit Reinstates Section 6038(b) Penalties

We’ll Take This Way Too Farhy: D.C. Circuit Reinstates Section 6038(b) Penalties

On May 3, 2024, the Court of Appeals for the District of Columbia reversed the Tax Court’s decision in Farhy v. Commissioner.1 The court determined that the Internal Revenue Service (the “IRS”) could assess and administratively collect penalties against a taxpayer for his failure to file information returns disclosing his ownership of foreign corporations. Taxpayers should be aware that the IRS will continue to issue penalties for failure to file international information returns such as the Form 5471. Importantly, Farhy shows that taxpayers need to be aware of their rights in the IRS’s collections due process hearing.

Trouble When the IRS Walked In

On February 9, 2016, the IRS notified Alon Farhy that, between 2003 and 2010, he had failed to file forms to disclose his ownership of certain Belizean corporations as required by Internal Revenue Code (“IRC” or the “Code”) section 6038(a).2 On November 5, 2018, Farhy had still not filed the forms, and the IRS assessed an initial penalty of $10,000 for his failure to file Forms 5471 for 2003 to 2010 (totaling $80,000).3 One week later, the IRS assessed continuation penalties totaling $50,000 for each year at issue.4 In total, the IRS assessed Farhy with $480,000 in penalties. Farhy did not contest the penalties and his case went to IRS collections. On June 4, 2021, after a collections due process (“CDP”) hearing, the IRS issued a Notice of Determination sustaining the collection action. Farhy sued for the Tax Court to review the determination.

IRC section 6038 provides that U.S. taxpayers who are officers and directors in certain foreign corporations must file Forms 5471 to furnish certain information, such as the corporation’s post-1986 undistributed earnings, balance sheet, and certain transactions. Under IRC section 6038(b), if any taxpayer fails to file this form, she will pay a penalty of $10,000 for each year that she fails to file it, and if the failure continues for more than 90 days, then the penalty increases by up to $50,000. Additionally, IRC section 6038(c) imposes a penalty that may reduce the taxpayer's foreign tax credit.

Farhy argued that the IRS did not have authority to assess the IRC section 6038 penalties because IRC section 6201(a) did not grant such authority to the IRS.5 IRC section 6201(a) confers authority to assess “all taxes (including interest, additional amounts, additions to the tax, and assessable penalties)” imposed by the IRC. Farhy argued that IRC section 6038(b) did not contain an “assessable penalty” because it did not contain language authorizing the IRS’s assessment.6 Tax Court Judge Marvel agreed, and accordingly held that the IRS could not collect IRC section 6038(b) penalties through collection letters, but only through a civil suit filed by the United States Department of Justice.7

Reading With Your Head Low

The D.C. Circuit reversed the Tax Court’s decision, holding that a “close reading of section 6038 . . . reveals that the Congress that amended the Code in 1982 intended the subsection (b) penalty to be assessable.”8 As a preliminary matter, the court established that the IRC section 6038(c) penalties were assessable by the IRS.9 Also, it noted that Congress had added the IRC section 6038(b) penalties on top of the IRC section 6038(c) penalties in 1982.10

The court made inferences of congressional intent from three features of the IRC section 6038(b) penalty to rule that it was assessable by the IRS. First, the D.C. Circuit noted that the fixed-dollar penalty of IRC section 6038(b) was likely a streamlined collection process, and wrote it was unlikely that the government would file lawsuits to recover from taxpayers the flat $10,000 penalty.11 Second, IRC section 6038(b) and (c) penalties are subject to a reasonable cause defense. The statute requires the taxpayer to establish reasonable cause “to the satisfaction of the Secretary.”12 In other words, the defense is granted or denied by the IRS, giving the IRS, and not a court, the authority to determine when the penalty is assessable. Finally, IRC section 6038 describes two penalties that the taxpayer may owe in parallel. If both penalties apply, to require the IRS to file suit for one penalty but not the other would cause “an inexplicable asymmetry and potential for inconsistent doctrinal development.”13

I Think I’ve Seen This Film Before

Farhy may appeal this decision, but even if he succeeds, it is possible that the issue for other taxpayers will be moot if Congress is able to pass new tax legislation including amendments to IRC section 6038. A similar situation occurred when the Tax Cuts and Jobs Act (“TCJA”) was passed in 2017. In July of 2017, the Tax Court ruled in Grecian Magnesite Mining, Industrial & Shipping Co., SA v. Commissioner,14 that the sale of a foreign partnership interest by a foreign partner was not subject to U.S. tax, even if the partnership was engaged in a U.S. trade or business. Four months later as part of the TCJA, Congress enacted IRC section 864(c)(8). Under IRC section 864(c)(8), gain or loss from the sale of a partnership interest may be effectively connected to a U.S. trade or business. Generally, it is effectively connected gain or loss to the extent that the share of assets in the partnership is used in a U.S. trade or business.

A repeat of this history is uncertain given the inaction in Congress during the election cycle. But it appears certain that Congress will need to pass legislation in the next two years, especially given that many of the TCJA provisions will sunset in 2025.

I’ve Got a Blank Space

One important takeaway from Farhy is that taxpayers who have outstanding international information return reporting requirements should be aware of the IRS collection process. It appears that the CDP hearing is a crucial tool for delinquent taxpayers, especially given that the D.C. Circuit describes it in great detail in Farhy.15

If the IRS determines that a penalties associated with delinquent Forms 5471 or other information returns can be assessed, the IRS notifies the taxpayer of the amount due and demands payment.16 The case goes to collections if the taxpayer does not pay. If the nonpayment continues, then the IRS sends a Notice of Intent to Levy.17 At that point, the taxpayer is entitled to file for a CDP hearing with the IRS Office of Appeals. This hearing may occur through written or oral correspondence and is meant to provide the taxpayer with “an opportunity for an informal oral or written conversation with the IRS before he must pay a tax.”18

During the hearing, the taxpayer may raise “any relevant issue relating to the unpaid tax or the proposed levy” and challenge the “existence or amount of the underlying tax liability.”19 The appeals officer conducting a CDP hearing must consider (1) the verification from the Service that the agency followed applicable laws and procedures, (2) any challenges raised by the taxpayer, and (3) whether “any proposed collection action balances the need for the efficient collection of taxes with the legitimate concern of the person that any collection action be no more intrusive than necessary.”20 An appeals office decision is appealable to the Tax Court and, from there, to a federal court of appeals.21

Although the CDP hearing is informal, it is a very important step in the process as it allows a taxpayer to raise defenses and settle the debt with the IRS before it files a lien. Taxpayers who receive letters from IRS collections should contact a representative to see how they can best exercise their rights.

1 100 F. 4th 223 (2024).
2 Id. at 229.
3 Id.
4 Id.
5 160 T.C. No. 6 (April 3, 2023).
6 Id. at *4.
7 Id.
8 Farhy, 100 F. 4th at 231.
9 Id.
10 Id.
11 Id. at 232.
12 Id. at 232 (quoting IRC section 6038(b), (c)).
13 Id. at 234.
14 149 T.C. No. 3 (July 13, 2017).
15 100 F. 4th at 226-8.
16 IRC section 6303(a).
17 IRC sections 6320(a), 6331(d).
18 Farhy, 100 F. 4th at 227 (quoting Our Country Home Enters., Inc. v. Comm'r, 855 F.3d 773, 780 (7th Cir. 2017))
19 IRC section 6330(c)(2)(B).
20 IRC section 6330(c)(3).
21 IRC sections 6330(d)(1), 7482(a)(1).

For More Information, Please Contact:

Bianca Ko
Bianca Ko
San Francisco, CA