DC Circuit: IRS Can Assess Sec. 6038(b) Penalties

The IRS has the statutory authority to assess penalties for failing to report control of foreign businesses, the DC Circuit Court ruled, disagreeing with the Tax Court. (Farhy, (CA Dist Col 5/3/2024) No. 23-1179)

The DC Circuit’s May 3 opinion in Farhy v. Commissioner, authored by Judge Cornelia Pillard, concluded that the “text, structure, and function” of Code Sec. 6038 show Congress’ intent for the assessment of Code Sec. 6038(b) penalties, handing a win to the IRS. The case was reversed and remanded to the Tax Court, which ruled in favor of petitioner Alon Farhy last April.

For tax years 2003-2010, Farhy did not disclose controlling interest in two Belizian corporations on Forms 5471, Information Return of U.S. Persons With Respect to Certain Foreign Corporations, as part of a scheme to avoid US taxes. Farhy transferred over $2 million to a “sham foreign entity” as described by Pillard, which sent funds to a bank account under the name of a corporation “created solely for that purpose.”

Farhy did not file Forms 5471 after the IRS mailed an initial notice, prompting the agency to assess $60,000 in section 6038(b) penalties for each year. A subsequent notice informed Farhy of the IRS’ intent to levy his property.

At issue was whether the penalties are assessable and administratively collectible under Code Sec. 6201(a) or if the government must sue in federal court – the distinction being if the penalties are subject to “deficiency” procedures.

Section 6038 was first enacted in 1960 but underwent several changes over the years. According to the DC Circuit, a “close reading of 6038” shows that Congress intended the subsection (b) penalty to be assessable when it amended the Tax Code in 1982. Originally, the sole section 6038 penalty was a percentage reduction from a taxpayer’s Foreign Tax Credit (FTC). Now, it is a flat-dollar amount, $10,000, that can increase up to an additional $50,000 should the taxpayer continue to not comply. The FTC reduction penalty became Code Sec. 6038(c).

The circuit opinion said Congress made the change to address “difficulties experienced in applying” the percentage-based penalty and that a fixed amount would be simpler and more consistently collected. Further, “Congress required (in subsection (c)(3)) that the two penalties be coordinated,” the opinion continued.” The subsection (b) penalty must be offset from any subsection (c) penalty in cases in which both penalties apply.”

The IRS’ authority to assess section 6038(c) penalties makes it “plain” that section 6038(b) penalties can also be assessed, the court reasoned. “Section 6038’s express authorization of the IRS rather than a district court to evaluate a taxpayer’s defense to penalties imposed under the section reinforces that conclusion.”

For more information about information penalties for US persons controlling foreign entities, see Checkpoint’s Federal Tax Coordinator  ¶V-1962.