Circuit Court Overturns Farhy Decision, Holds IRS Has Authority to Assess Section 6038 Penalties

The United States Court of Appeals for the District of Columbia Circuit on May 3 reversed the U.S. Tax Court's decision in Farhy v. Commissioner of Internal Revenue, holding that the IRS has the authority to assess penalties for failure to comply with the reporting requirements of Internal Revenue Code Section 6038(a). For prior coverage of the Tax Court decision, see IRS Lacks Authority to Assess Form 5471 Penalties.

In an opinion written by Circuit Judge Cornelia T.L. Pillard, a three-judge appellate panel found unanimously that “the text, structure, and function of Section 6038 demonstrate that Congress authorized the assessment of penalties imposed under subsection (b).” 

Background

Section 6038(a) requires U.S. persons to file information returns regarding their control of any foreign business. Appellee Alon Farhy acknowledged that he violated that statutory obligation when he failed to report his ownership of Belizean corporations on Form 5471; that failure to report resulted in nearly $500,000 in penalties under Section 6038(b), which imposes a fixed-dollar penalty for failure to comply with the requirements of Section 6038(a).

Farhy disputed the IRS’s method of collecting that sum: assessing the penalties owed and notifying Farhy that it would levy his property if he failed to pay them. Farhy argued that the IRS lacks the statutory authority to assess and administratively collect Section 6038(b) penalties. Instead, Farhy argued, the government must sue him in federal district court to collect the penalties owed under Section 6038(b).

The Tax Court agreed with Farhy, and in April 2023 ruled that the law didn't explicitly give the agency the collection power to assess and administratively collect Section 6038(b) penalties. The Tax Court held that Congress authorized assessment for a variety of penalties, notably for the penalties found in subchapter B of chapter 68 of subtitle F, that is, IRC Sections 6671–6725, but not for the penalties under Sections 6038(b)(1) and (2). Because the penalties were not assessable, the court held that the IRS was barred from proceeding with collection.

The circuit court has now reversed and remanded the case to the Tax Court, with instructions to enter a decision in favor of the IRS.

Circuit Court Decision

According to the circuit court’s opinion, the crux of this dispute is a simple question: Can the IRS assess a penalty for failure to file a required form, or must the Department of Justice sue and obtain a judgment from a federal district court before it can enforce the penalty?

The court delved into the legislative history of Section 6038 to consider the issue at hand. Section 6038 was enacted in 1960, and at the time, the sole penalty for the failure to file the information required by Section 6038(a) was a 10% reduction of the taxpayer’s s foreign tax credit. In 1982, Congress amended Section 6038 to boost enforcement, and added a streamlined, uniform penalty for the same failure to file an informational return for a controlled foreign business: a flat $1,000 subsection (b) penalty, which it has since increased to $10,000.

Because Section 6038 does not explicitly state whether the penalties imposed for violating Section 6038(a) are assessable, the court stated, “The only question on appeal is what mechanism Congress authorized for the Secretary of the Treasury to collect the fixed-dollar penalties authorized in I.R.C. § 6038(b) against a U.S. person who fails to file the requisite information returns regarding foreign businesses under her control.”

The court concluded that Congress intended to render the Section 6038(b) penalties assessable: “Read in light of its text, structure, and function, section 6038 itself is best interpreted to render assessable the fixed-dollar monetary penalties subsection (b) authorizes.” More specifically, the court stated that when Congress amended the Code in 1982, it intended the subsection (b) penalty to be assessable. The court noted that Congress had added the 6038(b) penalty in response to difficulties experienced in applying the original penalty under 6038(c), in the belief that a fixed-dollar penalty could be more simply and consistently collected. Reading subsection (b) to require the government to sue taxpayers to collect the penalty, as Farhy argued, “treats Congress as having enacted a supplemental penalty process that is less streamlined, not more, than the preexisting collection process for subsection (c) penalties.”

The court was also persuaded by the practical argument that If subsection (b) penalties are not assessable, the IRS would not be able to collect them at all without going to court in every case. But, as the court noted, it is unlikely the government would file lawsuits to recover from taxpayers the flat, $10,000 penalty authorized by Section 6038 (b): “If subsection (b) penalties are that hard to recover, they may not be worth the candle.” 

The court concluded that It would be “highly anomalous” for Congress to respond to the problem of the underuse of Section 6038 (c) penalties “by promulgating a penalty that, while simpler to calculate, is much harder to enforce.”

The court dismissed Farhy’s argument that the Section 6038(b) penalties are not assessable because the text of Section 6038 does not explicitly label them as such, noting that “Congress can make a penalty assessable by implication, and it did so here.”