There is no shortage of statutory penalties provided in the Internal Revenue Code. The Internal Revenue Service in general has operated under the assumption that it has the authority to access and take action to collect these penalties.
As has become increasingly common, taxpayers in litigation with the IRS are challenging the facts and law applicable to their particular case, but also challenging the procedures followed by the IRS in handling the case. These challenges have included the failure of the IRS to follow Administrative Procedure Act requirements and the deference that should be given to IRS positions. In recent years these challenges have also come to focus on the IRS authority to assess penalties authorized by statute without first seeking court authority.
The Tax Code in Subchapter B of Chapter 68 of Subtitle F authorizes the IRS to assess certain penalties under Code Sections 6671-6725. However, other penalties are not mentioned. These include penalties under Code Sec. 6038(b) related to failure to file information returns to report control of any foreign business (Form 5471). Also potentially impacted are reports of related party transactions (Form 5472), reports of foreign financial assets (Form 8938), reports of property contributed to foreign corporations (Form 926), and reports of receipt of gifts from foreign persons (Form 3520).
Farhy
In the case of Farhy v. Commissioner, the IRS assessed penalties for failure to report control of a foreign corporation. Farhy challenged the assessment in Tax Court on the basis that the IRS did not have authority to assess penalties under Code Sec. 6038 because those penalties were not mentioned in Chapter 68. In April 2023, the Tax Court agreed with Farhy and held that the IRS needed to go to court to assess penalties for failure to report control of a foreign corporation.
Having been pushed by higher courts into a strict reading of Tax Code language in the conservation easement and other cases, the Tax Court took a strict reading of the code by finding that the IRS only had authority to assess penalties where it was expressly given that authority in Chapter 68. Where such specific authority is lacking, either in Chapter 68 of Subtitle F of the Tax Code or in the penalty provision itself in the code, the IRS must get the U.S. Department of Justice to sue and obtain a judgment for the penalty from a federal district court before the penalty can be enforced.
In May 2024, the U.S. Court of Appeals for the District of Columbia reversed the Tax Court in Alon Farhy v. Commissioner, No. 23-1179 (D.C. Circuit May 3, 2024), taking a reasonableness approach. Looking at the history of Code Sec. 6038, the D.C. Circuit concluded that Congress had been focused on simplifying the ability of the IRS to collect the penalties, not creating enforcement roadblocks by denying the IRS the ability to assess the penalty.
The D.C. Circuit also determined that the reasonable cause defense provided for in the statute only made sense if the IRS had the ability to assess the penalties. As a practical matter, the D.C. Circuit pointed out that the time and costs involved in seeking a court decision on penalties that may involve only $10,000 would discourage the IRS from taking that action and defeat the purpose of the penalty.
Contrary to the reversal of its position on conservation easements and the Administrative Procedures Act, the Tax Court is continuing to follow its original position in Farhy in cases arising outside of the D.C. Circuit, creating a potential for a conflict among the circuit courts of appeal.
What happens now?
The Tax Court approach may produce a split among the circuit courts, and the Supreme Court may take a case to resolve the split among the circuits. The Farhy case may be appealed; however, it is not clear that the Supreme Court would take the case until there is a split among the appellate courts. In the case of Mukhi v. Commissioner, 162 T.C. No. 8 (April 8, 2024), the Tax Court has already followed their decision in Farhy in a decision that the IRS is likely to appeal to the Eight Circuit.
Taxpayers outside of the D.C. Circuit may also follow the Farhy challenge to the authority of the IRS to assess penalties for foreign information returns, and perhaps other statutory penalties where the authority of the IRS to assess the penalty is not expressly stated in the Tax Code. They will have some assurance that they will be successful in the Tax Court, but also that the IRS will appeal the case to the relevant circuit court. Similar cases are already working their way through the Tax Court and federal district courts.
It is also possible that Congress could step in to clarify the authority of the IRS to assess penalties. It could be a while, however, before either Congress or the courts manage to finally resolve the issue.
