Analysis of and reflections on recent cases and rulings.

• Author: Beavers, James A.

Procedure & Administration

IRS cannot assess Sec. 6038(b) penalties

The Tax Court held that the IRS lacks the statutory authority to assess penalties under Sec. 6038(b)(1) or (2).

Background

From 2003 to 2010, Alon Farhy owned 100% of Katumba Capital Inc., a corporation incorporated in Belize. From 2005 to 2010, he also owned 100% of the Belize corporation Morningstar Ventures Inc. While he owned both companies, Farhy participated in an illegal scheme to reduce his income, but he obtained immunity from prosecution for his misdeeds.

Sec. 6038(a) requires a U.S. person to furnish certain required information with respect to ownership of any foreign business entity. Farhy, as a U.S. person, had a Sec. 6038(a) reporting requirement with respect to his interests in Katumba and Morningstar Ventures in the years he owned them. To meet this requirement, Farhy was obligated to file Form 5471, Information Return of U.S. Persons With Respect to Certain Foreign Corporations. He did not file a Form 5471 for any of the years in question.

For failing to meet the Sec. 6038(a) reporting requirement, Sec. 6038(b)(1) imposes a penalty of $10,000 for each annual accounting period the U.S. person fails to timely file Form 5471. Sec. 6038(b)(2) imposes a continuation penalty of $10,000 for each 30-day period (or fraction thereof) during which the failure continues with respect to any annual accounting period after an initial 90-day notice period, up to a maximum penalty of $50,000. However, central to Farhy's case, there is no statutory provision, in the Code or otherwise, specifically authorizing the assessment of these penalties.

The IRS assessed Farhy an initial penalty under Sec. 6038(b)(1) of $10,000 for each year at issue and assessed him continuation penalties under Sec. 6038(b)(2) totaling $50,000 for each year. In January 2019, the IRS issued him a levy notice, seeking to collect the Sec. 6038(b) penalties it had assessed.

In response, Farhy requested a Collection Due Process hearing. In the hearing, among other issues, he disputed whether the IRS had the legal authority to assess the underlying Sec. 6038(b) penalties. The notice of determination the IRS issued after the hearing sustained its proposed collection action.

Farhy then petitioned the Tax Court to review the IRS's determination. After stipulations, the only issue left for the Tax Court to decide was whether the IRS had the authority to assess the Sec. 6038(b) penalties against Farhy and therefore could collect the penalties it had assessed through its proposed levy.

The Tax Court's decision

The Tax Court held that the IRS did not have the statutory authority to assess penalties under Sec. 6038(b)(1) or (2) and, as a result, could not collect the penalties from Farhy through its proposed levy. Sec. 6201(a), as the Tax Court explained, authorizes and requires Treasury to make assessments of all taxes (including interest, additional amounts, additions to tax, and assessable penalties) imposed by the Code. Treasury has delegated these assessment duties to the IRS. However, the term "assessable penalties" in Sec. 6201(a) is not defined, creating uncertainty about which penalties the IRS may assess and ultimately collect through administrative means.

The Supreme Court in West Virginia v. Environmental Protection Agency, 142 S. Ct. 2587, 2609 (2022), stated, "Agencies have only those powers given to them by Congress." Farhy argued that, unlike many other penalty sections in the Code, Sec. 6038 does not contain a provision authorizing assessment of the penalty for which it provides, and, as a...