The U.S. Court of Appeals for the District of Columbia Circuit (D.C. Circuit) on May 3, 2024, reversed the U.S. Tax Court (USTC) in Alon Farhy v. Commissioner, No. 23-1179 (D.C. Cir. May 3, 2024) by holding that foreign-related information return penalties under Section 6038(b) are "assessable" penalties. This is a significant development given that the USTC had concluded that the IRS lacks authority to assess penalties under Section 6038(b) of the Internal Revenue Code (Code).¹ (See Holland & Knight's previous alert, "Tax Court: IRS Lacks Authority to Assess Certain Foreign Information Return Penalties," April 18, 2023.)

Less than a month before the D.C. Circuit's reversal of Farhy, the USTC stated it would adhere to its decision under stare decisis in cases falling outside the jurisdiction of the D.C. Circuit. The continued validity of its position will be tested as the issue is decided in other circuits of the U.S. Courts of Appeals, thus potentially setting the stage for a split among circuits.

Background

Section 6038(b) penalties apply to the failure of a taxpayer to file, among other forms, Form 5471 to report information with respect to certain foreign corporations. Alon Farhy was assessed Section 6038(b) penalties that he contested before the USTC. The USTC held that the IRS lacks statutory authority to assess Section 6038(b) penalties because such penalties do not fall within, nor are they cross-referenced to, Chapter 68 of Subtitle F of the Code, for which assessment by the IRS is expressly authorized. Moreover, the Code does not specify the treatment of Section 6038(b) penalties as an "assessable penalty." The government appealed the decision to the D.C. Circuit.

At issue before the D.C. Circuit was whether the penalty for failing to file certain information reporting forms under Section 6038(b) may be assessed by the IRS, or whether the U.S. Department of Justice must sue and obtain judgment from a federal district court before the penalty can be enforced.

In setting up the analysis, the D.C. Circuit explained that the IRS may employ only administrative enforcement methods to collect penalties that have been "assessed" (i.e., the official recording of an amount a taxpayer owes the federal government). Certain penalties under the Code are subject to "deficiency" procedures whereby a taxpayer may challenge the appropriateness of such penalties prior to assessment in the USTC. Other penalties are characterized as "assessable penalties" such that the IRS can assess them without awaiting judicial review.

Rationale for the Reversal

The rationale of the D.C. Circuit's decision is based in large part on the historic penalty authorized under Section 6038(c) (codified as Section 6038(b) prior to 1982) and its interplay with the penalty authorized under Section 6038(b). As initially enacted in 1960, the sole penalty for failing to file international information reporting forms required under Section 6038(a) was a 10 percent reduction in the violator's foreign tax credit (FTC). Years later Congress amended the statute with a fixed-dollar penalty of $10,000 per failure, with successive monthly penalties of $10,000 for continued failure to file, up to a maximum of $60,000. The penalties are coordinated by requiring the FTC reduction to be offset by the amount of any fixed-dollar penalty for the same violation.

The D.C. Circuit concluded that a narrow set of inferences suffices to show that Congress intended to render Section 6038(b) penalties assessable. First, the fixed-dollar penalty was added in an effort to more simply and consistently collect the penalty. Thus, "[i]t would be 'highly anomalous' for Congress to . . . promulgat[e] a penalty that, while simpler to calculate, is much harder to enforce." Second, Congress required coordination to offset the FTC reduction by the fixed-dollar penalties imposed. Because the reduction in FTCs represents an assessable penalty (a conclusion conceded by Farhy), the recovery of such penalty would be even more complicated since any offset for fixed-dollar penalties could only occur after the conclusion of any federal court action to recover the fixed-dollar penalties. Third, any reasonable cause defense to the imposition of penalties must be "shown to the satisfaction of the Secretary." The express contemplation that the IRS will determine the reasonable cause defense supports treating both the fixed-dollar and FTC reduction penalties as assessable. Finally, the potential bifurcation of judicial review between the USTC for the FTC reduction penalty and federal district courts for the fixed-dollar penalty could lead to asymmetry and inconsistent doctrinal development, generate duplicate court proceedings on common issues and also raise potential preclusion issues when both penalties are imposed for the same conduct.

The D.C. Circuit rejected Farhy's assertion that Congress may render a penalty to be "assessable" only through specific historically recognized means. "The absence of the penalty from Chapter 68 and the lack of either a cross-reference to Chapter 68 or explicit language directing that the penalty 'shall be assessed' is not determinative. Congress can make a penalty assessable by implication, and it did so here."  

Implications for Continuing Assessment of Penalties

The USTC decision in Farhy had a stunning potential effect on penalty enforcement. Despite decades of routinely assessing and collecting international information reporting penalties, the assessment of Section 6038(b) penalties was immediately rendered invalid. The D.C. Circuit decision restores the IRS' authority for cases within its jurisdiction.

Notwithstanding the reversal by the D.C. Circuit, the USTC's conclusion that the IRS lacks statutory authority to assess Section 6038(b) penalties (as well as certain other potential penalties) remains. Indeed, in Raju J. Mukhi v. Commissioner, 162 T.C. No. 8 (Apr. 8, 2024), the USTC recently reaffirmed its decision in Farhy, adhering to the doctrine of stare decisis to find that the IRS lacks authority to assess the penalties under Section 6038(b). In Mukhi, the IRS asked the court to revisit and overrule its holding in Farhy on the basis that it was incorrectly decided. To the contrary, the USTC stated that the argument that a prior case was incorrectly decided is not sufficient justification alone to warrant reconsideration of its holding. Moreover, the USTC acknowledged that the Farhy case was (at that time) on appeal to the D.C. Circuit. Nevertheless, the USTC noted that Mukhi would be appealable to the U.S. Court of Appeals for the Eighth Circuit rather than the D.C. Circuit. Thus, under the Golsen doctrine, the USTC is not constrained by the precedent of the D.C. Circuit and will follow its own precedent under stare decisis.²

In Mukhi, the Section 6038(b) penalties totaling $120,000 represented a minor fraction of the challenged overall penalties totaling approximately $11 million that were otherwise upheld. Nevertheless, given the reversal in the D.C. Circuit, it is likely that the government will appeal the Mukhi decision to establish controlling precedent in that circuit as well. In the event the Eighth Circuit were to side with the USTC, the issue would be set up for potential review by the U.S. Supreme Court. In addition, the issue is currently before the USTC and federal district courts in several other circuits. As such, a future split among circuits would not be surprising.

Takeaways

Observations from the Farhy reversal include:

• The USTC and the D.C. Circuit found the language in Section 6038(b) to have different meanings. The USTC applying traditional statutory construction found the language of Section 6038(b) to be clear and refused to infer assessment authority where Congress otherwise omitted such authority. The D.C. Circuit, agreeing with the government, found to the contrary and made inferences as to how the statute should read based, in part, on a broad reading of the application of Section 6201 and policy considerations favorable to the government.
• Based on Mukhi, it is unlikely that the USTC will reverse its position as it did in Valley Park Ranch, LLC v. Commissioner.
• Unless and until the issue is conclusively decided by the Supreme Court, taxpayers and practitioners should challenge the IRS authority to assess Section 6038(b) penalties in USTC cases falling outside the jurisdiction of the D.C. Circuit.

For additional information or questions regarding tax and information return penalties, compliance and litigation, please contact the authors.

Notes 

¹ Unless otherwise indicated, all "Section" references are to the Internal Revenue Code of 1986, as amended.

² In Valley Park Ranch, LLC v. Commissioner, 162 T.C. No. 6 (Mar. 28, 2024), the USTC held that the conservation easement "proceeds regulation" under Treas. Reg. § 1.170A-14(g)(6)(ii) was procedurally invalid under the Administrative Procedure Act, thereby reversing its prior position that upheld the validity of such regulation just four years prior. Mindful of the role of stare decisis, the USTC explained that it was "obligated to thoroughly reconsider [its] position" when "faced with 'issues on which a Court of Appeals has reversed [its] prior decision.'" The dissenting opinion expressed concern that the USTC's opinion departed from stare decisis principles and "will result in instability of the law in the area of conservation easements."