By: Oz Halabi and Richard Jean-Baptiste
The U.S. Tax Court recently held that the IRS could not collect penalties from a taxpayer, who willfully failed to file IRS Form 5471 (Information Return of U.S. Persons With Respect to Certain Foreign Corporations), because the IRS had no statutory authority to assess penalties under section 6038 of the Internal Revenue Code of 1986, as amended (the “Code”).[1]
As background, Mr. Alon Farhy (the “Taxpayer”) was the 100% owner of two foreign corporations, both incorporated in Belize, from 2003 through 2010. During the years at issue (2003-2010), the Taxpayer allegedly participated in an illegal scheme to reduce the amount of income tax he owed. He later signed an affidavit describing his role in the illegal scheme and was granted immunity. The Taxpayer had a reporting requirement under section 6038(a) of the Code to report his ownership interest in the foreign corporations he owned for the years at issue, and he failed to do so, willfully. The Internal Revenue Service (“IRS”) assessed an initial penalty of $10,000 for each year at issue for failure to timely provide certain required information with respect to the Taxpayer’s foreign business entities and later assessed a continuation of penalties (which was subject to a maximum of $50,000 for each year at issue). Both penalties were imposed under section 6038(b) of the Code.
The Taxpayer argues that the IRS lacks authority to assess section 6038(b) penalties and that there is no law giving the IRS authority to assess these penalties. Moreover, while the United States may be able to collect liabilities for these penalties through a civil action,[2] the IRS may not assess or administratively collect these penalties. The Taxpayer mentions, unlike a bevy of other penalty sections in the Code, section 6038(b) contains no provision authorizing assessment of the penalty it provides for. Therefore, a section 6038(b) penalty is not an assessable penalty, although it may be collected through a civil action.
Section 6201(a) of the Code authorizes and requires the Secretary of Treasury to make assessments of all taxes (including interest, additional amounts, additions to tax, and assessable penalties) imposed by the Code.[3] The Secretary of the Treasury has delegated these duties to the IRS. The IRS argued that the term “assessable penalties” includes any penalties found in the Code that are not subject to the Code’s deficiency procedures. The IRS also argued that in any case, the term “taxes” in section 6201 of the Code is broad enough to encompass section 6038 penalties.
The Tax Court concluded that the Taxpayer’s reading of the Code is the correct one. The Court reasoned that “Congress has explicitly authorized assessment with respect to myriad penalty provisions in the Code, but not for section 6038(b) penalties.”[4] Further, no mode of recovery or enforcement is specified for these penalties, unlike for myriad other penalties in the Code. Simply put, while section 6038(b) of the Code provides for penalties, it does not provide for assessable penalties.[5] The Court stated that the IRS’s argument that section 6038(b) penalties are necessarily assessable penalties because they are not subject to deficiency procedures assumes a faulty premise and must be rejected.[6] The mere fact a penalty is not subject to deficiency procedures does not automatically give rise to the conclusion that it is an assessable penalty, where Congress has not given the Commissioner the authority to assess the penalty.
The Court also rejected the notion that the assessment authority provided by section 6201(a) of the Code covers all penalties imposed by the Code simply because it covers taxes and certain other exactions specifically included.[7] The Court stated it, “loath to disturb this well-established statutory framework by inferring the power to administratively assess and collect the section 6038(b) penalties when Congress did not see fit to grant that power to the Secretary of the Treasury expressly as it did for other penalties in the Code.”[8] Thus, the Court held that the IRS assessed penalties under section 6038(b) of the Code against the Taxpayer without the statutory authority to do so and may not proceed with the collection of these penalties from the Taxpayer via proposed levy.
In summary, the IRS is prevented from using its administrative powers to collect penalties from the Taxpayer who willfully failed to file Form 5471. The Tax Court agreed that Congress did not grant the IRS the power to assess penalties under Section 6038(b) of the Code and the IRS lacks the authority to do so. As a result, the recent court decision may have a future impact on the IRS’s ability to enforce foreign information return penalties and significant implications for other taxpayers who are contesting 5471 penalties.
[1] Alon Farhy v. Commissioner, 160 T.C. No. 6 (April 3, 2023)
[2] 28 U.S.C. 2461(a)
[3] Alon Farhy v. Commissioner, 160 T.C. No. 6 (April 3, 2023)
[4] id
[5] id
[6] id
[7] id
[8] id
