Our federal tax system is code-based. This means that most of what the law is can be found in statutes. The premise is that one can read the statutes and get a general idea of what the law is.
This is why when it comes to tax law, each word matters. Adding or removing a few words can change the outcome, resulting in substantial taxes due or not due. It can also greatly expand or limit the IRS’s administrative powers.
That is why it always draws attention when the courts interpret tax statutes by adding words that do not exist in the statutes. The appeals court did just that in Farthy v. Commissioner, No. 23-1179 (D.C. Cir. 2024) in the context of international information reporting forms, namely, the Form 5741 and the penalty for this form.
Contents
Facts & Procedural History
The case involved a U.S. person who failed to file the required Form 5471 with the IRS to report his ownership of Belizean corporations from 2003 to 2010. The IRS assessed penalties under Section 6038(b) totaling $60,000 per year for his non-compliance.
The IRS then sought to collect the penalties, prompting the taxpayer to request a collection due process hearing to contest them. The dispute ended up in the U.S. Tax Court, where the taxpayer challenged the IRS’s authority to assess the penalties.
The taxpayer argued that Section 6038(b) does not explicitly state the penalties are “assessable” and claimed the IRS could only collect them through a civil lawsuit in federal court. The U.S. Tax Court agreed with the taxpayer.
The case garnered attention in the tax press last year, as it called into question the IRS’s routine practice of assessing international information reporting penalties. Some taxpayers who had paid these penalties and learned of this case filed refund claims to recover amounts paid for these purportedly “assessable” penalties.
The IRS appealed the U.S. Tax Court’s decision, resulting in the current appellate opinion a year later.
About Information Reporting
Information reporting provides information to the IRS. It is similar to a tax return filing, generally, but it does not report tax. It just provides information.
The IRS asserts that it uses this information to ensure taxpayer compliance and combat tax evasion. This is probably true for international and foreign transactions. The IRS has struggled with international and foreign transactions. This is largely due to the nature of our tax system, which imposes tax on foreign transactions, etc.
By requiring taxpayers to disclose their foreign interests and transactions, the idea is that the IRS gains visibility into offshore activities that may generate taxable income or facilitate tax avoidance schemes.
Section 6038 specifically targets U.S. persons who control foreign corporations. It requires them to file an annual information return on Form 5471, disclosing various details about the foreign corporation, including its income, balance sheet, and transactions with related parties. This disclosure helps the IRS identify potential sources of unreported income and detect abusive tax shelters.
Section 6038 is just one of many tax provisions mandating foreign information reporting. Others include:
- Section 6038D: Requires U.S. individuals to report foreign financial assets exceeding certain thresholds on Form 8938.
- Section 6048: Requires reporting of transactions with foreign trusts and receipt of foreign gifts on Forms 3520 and 3520-A.
- Section 6039F: Requires reporting of large foreign gifts received by U.S. persons on Form 3520.
- Section 6046: Requires reporting of interests in foreign corporations on Form 5471.
Failure to comply with these reporting obligations can result in significant penalties, even if no tax is ultimately due. The penalties are likely designed to incentivize compliance, and the amount of the penalties can be quite large. One only has to look to the foreign gift reporting penalties to see the inequity.
Assessable vs. Non-Assessable
The crux of the taxpayer’s argument was that because Section 6038(b) does not explicitly characterize its penalty as “assessable,” the IRS lacks the power to assess it administratively.
The term “assessment” has a special meaning in tax law. It refers to the IRS’s official recording of tax liabilities as due on its books. This is more than just an accounting entry. The assessment date triggers various collection statutes and time periods for the taxpayer and the IRS.
The key distinction is that assessable taxes and penalties can be imposed by the IRS without first affording the taxpayer an administrative and judicial review. This contrasts with fundamental principles of due process before the government takes one’s property. Given this broad power, most assessable taxes and penalties are expressly designated as such in the tax code.
Section 6038(b) does not explicitly state its penalty is assessable, which was the core dispute in this case. The taxpayer emphasized the statute’s silence means that the penalty is not an assessable penalty. The IRS argued the Code presumes assessability for all exactions unless Congress specifies otherwise. The IRS pointed to Section 6038’s overall structure and purpose to show Congress intended subsection (b) penalties to be assessable like the related subsection (c) penalties.
Rules of Statutory Interpretation
In ruling for the IRS, the D.C. Circuit looked beyond Section 6038(b)’s plain text. It considered its views on the provision’s context within Section 6038 as a whole, particularly its relationship to the indisputably assessable subsection (c) penalty.
The appellate court reasoned that in its opinion it would be anomalous for Congress to address the underuse of subsection (c) penalties by adding a streamlined subsection (b) penalty that is harder to enforce. It also found the IRS’s longstanding interpretation of Section 6038(b) penalties as assessable persuasive, noting Congress’s acquiescence through subsequent amendments.
The court’s holding is understandable considering the implications. The IRS needs the ability to assess penalties for administrative efficiency. Requiring litigation to start the assessment process would effectively preclude the IRS from imposing these penalties in many cases.
One can see the taxpayer’s side of it too. Giving the IRS the ability to seize taxpayer property without due process, when Congress did not expressly sanction such action, is concerning. This is a power wielded by an administrative agency that has repeatedly abused its power–with new IRS scandals continuing every few years. One doesn’t have to think back very far to recall the IRS non-profit group targeting conservatives based on political beliefs, or even the RRA 98′ congressional hearings. This is the agency that the court is allowing to assess penalties without any due process. Needless to say, this raises concerns about the proper balance between administrative practicality and taxpayer rights.
The Takeaway
This dispute illustrates how courts can construe seemingly clear statutes to reach an intended result. That is more of a topic for academics. Taxpayers have to plan for the implications. It remains to be seen whether the taxpayer will appeal to the Supreme Court and, if the Supreme Court hears the case, how it will rule on it. As a practical matter, taxpayers outside the D.C. Circuit will likely need to continue disputing this issue using the collection due process hearing procedure, as the taxpayer did in this case. This would put the cases before the U.S. Tax Court, which would then apply the law of the taxpayer’s resident circuit. The U.S. Tax Court may reach the same conclusion as in its initial decision in this case, potentially creating a split among the circuit courts of appeals.
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