In an important decision for assessable international penalties, last week the D.C. Circuit reversed a Tax Court decision holding that the IRS could not assess international information return penalties without offering the taxpayer the opportunity to contest them through deficiency procedures before assessment. In Farhy v. Commissioner the D.C. Circuit held that Section 6038, which governs information reporting with respect to certain foreign corporations and partnerships, authorized the IRS to assess such penalties. The D.C. Circuit relied on Congressional history and contextual information in reversing the Tax Court’s decision that Section 6038(b) penalty assessments were not explicitly authorized by Congress. 

The case centers around two foreign business entities for which Mr. Farhy was required to file Form 5471, Information Return of U.S. Persons With Respect to Certain Foreign Corporations. Between 2003 and 2010, Mr. Farhy failed to disclose his ownership in these entities and, as a result, the IRS assessed penalties under Section 6038(b). In response Mr. Farhy initiated a Collection Due Process proceeding alleging that the agency lacked authority to assess penalties under Section 6038(b). Mr. Farhy argued in the Tax Court proceeding that Section 6201, which governs the IRS’s ability to assess tax, does not apply to Section 6038(b) because Congress did not provide explicit language authorizing the IRS to make such assessment. The IRS argued that the language of Section 6201 includes all penalties that are not within the scope of the Code’s deficiency procedures.

The Tax Court ruled for Mr. Farhy last April, with Judge Marvel noting that “[w]e are loath to disturb this well-established statutory framework by inferring the power to administratively assess and collect the [S]ection 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.” The Court’s decision called into question the IRS’s ability to assess and administratively collect a myriad of penalties, including several other international information return penalties.

The D.C. Circuit disagreed with the Tax Court on appeal, holding that an explicit authorization to assess penalties was not necessary when considered against the text, structure, and function of Section 6038. The opinion stated that “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.” The D.C. Circuit relied heavily on Congressional history in their ruling, noting that amendments to Section 6038 have never addressed the IRS’s authority to assess penalties. Additionally, the D.C. Circuit reasoned that the affirmative reasonable cause defense found in Section 6038(c)(4)(B) suggests that the IRS is the natural arbiter of Section 6038(b).

While adopting a broader reading of Section 6038, the D.C. Circuit still rejected the IRS’s argument that any penalty under Section 6201 may be assessed unless explicitly excluded. There are several other cases before the Tax Court, including at least one case appealable to a different Circuit Court of Appeals. It will be interesting to see whether the Farhy decision receives a rehearing en banc or gets selected for review by the Supreme Court of the United States.

The IRS has not indicated whether they will go back to assessing international information return penalties without giving taxpayers the opportunity to contest them through deficiency procedures. Taxpayers who receive an international return penalty assessment still have an opportunity to contest these penalties in Tax Court without payment through the Collection Due Process procedures. There is also an opportunity to contest the penalties in District Court by paying the penalties in full and pursuing a claim for refund.