Key takeaways:

• The United States Court of Appeals for the D.C. Circuit issued a ruling overturning a Tax Court decision that had created doubt as to the manner in which the IRS may collect penalties for failure to file certain tax information forms.
• Under the Tax Court decision, penalties for failing to file a tax form for reporting ownership of foreign companies could only be collected through the IRS filing a lawsuit in court, which is time-consuming and costly for the IRS and may make it less likely that the IRS would in fact seek to collect the penalties in certain cases.
• This latest decision makes it easier for the IRS to collect these penalties, but the door remains open for taxpayers litigating in other courts to argue that the IRS lacks this collection authority.

On April 3, 2023, the United States Tax Court issued its opinion in Farhy v. Commissioner of Internal Revenue,[1] which upset long-standing views on how the IRS may assess and collect penalties for failure to file certain tax forms.

United States taxpayers must file tax information forms to report their interests in a variety of foreign entities and activities, including their ownership of foreign companies, receipt of large gifts from foreign persons and interests in foreign trusts.

In the relevant case, Alon Farhy failed to report his ownership of two Belize companies and was assessed penalties by the IRS. He was assessed a penalty of $10,000 under Section 6038(b) of the Internal Revenue Code (the Code) for each year he failed to file the requisite form. Subsequently, the IRS issued an intent to levy notice, and Farhy requested a hearing with the IRS in which, among other issues, he disputed whether the IRS has legal authority to assess Section 6038 penalties. After the IRS sustained the penalties, Farhy filed a petition with the Tax Court for a review of the IRS’ determinations.

Under Section 6201(a) of the Code, the IRS is authorized to make assessments of “all taxes (including interest, additional amounts, additions to the tax, and assessable penalties),” which means the IRS may assess penalties and use its various means of collection (e.g., levies, liens, seizures) to collect them. The Tax Court in its Farhy decision stated that because Section 6038(b) (which imposes the penalty for failure to report ownership of foreign companies) does not explicitly state that the IRS has the authority to assess the penalty, such penalty is not an “assessable penalty” and the IRS must follow the general approach of filing a lawsuit to collect such penalty.

Because the IRS may be reluctant to file a lawsuit in federal court each time it imposes a $10,000 penalty for failure to report ownership of a foreign company, and because the IRS also may be reluctant to file a lawsuit for failure to file other tax information forms in which the statute imposing the penalty does not explicitly give the IRS authority to assess the penalty, the government appealed. Further, in November 2023, the IRS issued an internal memorandum to collection appeals employees in which it stated it will determine “litigation hazards in cases similar to Farhy.”

The U.S. Court of Appeals for the D.C. Circuit recently issued its opinion overturning the Tax Court in Farhy and agreeing with the IRS.[2] The court acknowledged that Section 6038 does not explicitly say whether penalties imposed for violating Section 6038(b) are assessable by the IRS. Nevertheless, the court stated that because Section 6038(c) contains a separate but interrelated assessable penalty that is collectible by the IRS, it reasons that when Congress amended Section 6038 to add the subsection (b) penalty, it did not mean to deviate from the position that all penalties under that Code section are assessable. The court said the purpose of adding subsection (b) was to make the penalty imposed under Section 6038 more streamlined, and it would be anomalous for Congress to amend a Code section with a previously existing penalty (Section 6038(c)) that is assessable by creating a penalty that is not assessable and therefore less likely to be enforced. The court cites other reasons, including that there are defenses to Section 6038(b) penalties that are to be heard by “the Secretary” (i.e., the IRS) and not courts, meaning it was intended for defenses for penalties imposed under Section 6038 to be heard in the IRS appeals process and not by a court after the IRS is required to file a lawsuit to collect the penalty.

The consequence of this ruling is that for many taxpayers facing penalties for failure to report ownership of foreign companies, their defenses will be heard by the IRS, and if the IRS disagrees, it will seek to assess any unpaid penalties using its powers to do so. Taxpayers may pay a penalty initially imposed by the IRS and then file a refund claim in federal district court. If that court is not in the District of Columbia, then they may continue to make Farhy claims that the penalties are not assessable by the IRS.

[1] Farhy v. Commissioner of Internal Revenue, 160 T.C. No. 6 (2023).

[2] Farhy v. Commissioner of Internal Revenue, No. 23-1179 (D.C. Cir. May 3, 2024).

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