On May 3, 2024, the United States Court of Appeals for the District of Columbia Circuit issued its decision in Farhy v. Comm’r of Internal Revenue, No. 23-1179, 2024 WL 1945977 (D.C. Cir. May 3, 2024), reversing the Tax Court, and confirming that the Internal Revenue Service (the Service) has statutory authority for its decades long practice of assessing, and administratively collecting, penalties under Section 6038(b) of the Internal Revenue Code for a U.S. person’s failure to file informational returns in reporting their control in a foreign business.
The Case
In 2004, U.S. permanent resident Alon Farhy (Farhy) developed a scheme to falsely underreport to the Service his income from exercising certain stock options he received from his then employer. To fabricate his losses and reduce his U.S. reportable income, Farhy transferred more than $2M to a sham foreign entity, which then transferred the funds to a bank account in the name of a Belize-based corporation Farhy created solely for that purpose. Farhy failed to report to the Service his control of foreign financial accounts and foreign corporations he used in his scheme.
On Feb. 9, 2016, the Service notified Farhy that he failed to file forms to disclose his ownership of the Belizean corporations between 2003 and 2010, as required by Section 6038(a). More than two years later when Farhy still had not filed the required forms, the Service assessed penalties pursuant to Section 6038(b), totaling $60K per year for his non-compliance. After the Service sent notice of its intent to levy Farhy’s property to collect the penalties owed, Farhy requested a Collection Due Process (CDP) hearing. The Appeals Office upheld the proposed levy of Farhy’s property. Upon further review, however, the Tax Court invalidated the proposed levy holding the Service was not authorized to assess these penalties.
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The Decision
The sole issue before the Court of Appeals for the District of Columbia was what mechanism had Congress authorized the Service to collect penalties under Section 6038(b). Specifically, whether the Service can assess these penalties, triggering its collection powers, or whether it must wait for the Department of Justice to file suit and obtain a judgment for these penalties.
The Court of Appeals held Congress intended the Service to be able to assess Section 6038(b) penalties based on the statute’s text, structure, and function. The Court reasoned: Section 6038 was amended in 1982 in response to concerns about the statute’s not being enforced. It would be “highly anomalous” for Congress to have sought to curtail the statute’s underuse by making it harder on the Service to enforce these penalties. Similarly, given that the 1982 amendment was designed to streamline the statute’s enforcement, and given that penalties under subsection (c) are to be offset by penalties imposed under subsection (b), it would be counterproductive for the statute to be read in the manner proposed by the Tax Court. It would force the Service to wait for the judiciary to enter judgment for subsection (b) penalties while allowing it to assess subsection (c) penalties. Even worse, this interpretation could potentially lead to inconsistent results because it would require subsection (b) penalties to be assessed by the judiciary and subsection (c) penalties to be assessed administratively. Finally, and as with other penalties imposed across the Tax Code, penalties under Section 6038 are subject to a “reasonable cause” affirmative defense, which the Service—not the court—is empowered to grant or deny.
In short, this recent decision reaffirms the breadth of penalties that the Service can assess and that these types of penalties will largely be handled administratively with a limited opportunity for judicial review. In most cases, taxpayers will need to request a CDP hearing after receipt of a lien and levy notice from the IRS. CDP hearings generally lack the hallmarks of a judicial hearing in that they do not provide a right to written discovery or the ability to subpoena documents or witnesses. Indeed, these hearings sometimes occur through written correspondence in lieu of an in-person hearing.
This article originally appeared on Freeman Mathis & Gary, LLP.
About the authors:
Nancy M. Reimer is a partner at Freeman Mathis & Gary, LLP.
William R. Covino is a partner at Freeman Mathis & Gary, LLP.