2nd Circuit Agrees: IRS Can Assess Foreign Business Reporting Penalties

Over the last couple of years, the United States Tax Court has been ruling in favor of taxpayers facing assessments for failure to report their foreign business interests. Tax Court judges have issued rulings saying that lawsuits, rather than assessments, were the tool the IRS needed to use to collect those penalties. Now a second Circuit Court of Appeals has ruled against the Tax Court, reaffirming the IRS’s authority to assess foreign business reporting penalties.

Tax Court Sticks to Its Position Against IRS Assessment of Foreign Business Reporting Penalties

The Internal Revenue Code requires U.S. taxpayers to provide the IRS information about any foreign business entity they own or control, whether or not the business entity generates taxable income for the taxpayer. Section 6038(b) says that failure to report a foreign business entity can result in a penalty of $10,000 per taxable year. But how are those penalties collected?

The United States Tax Court has recently taken a controversial stand on this issue in recent years. In IRS v Farhy, in August 2023, the Tax Court interpreted Section 6038 and found that the statute did not contain any language authorizing the IRS to issue assessments. Instead, the Tax Court found that the government would have to file lawsuits to collect the penalties.

That decision was overturned by the Circuit Court for the DC Circuit in May 2024. The Circuit Court called the assessment power a “cornerstone of the government’s tax collection authority” and restored the IRS’s ability to use the streamlined process to assess penalties for failure to report foreign business entities.

But the Tax Court was still not convinced. In Mukhi v Commissioner, the Tax Court doubled down on its earlier decision against the IRS. Because of the petitioner’s location, the Tax Court was able to rule on the case without being bound by the DC Circuit Court’s decision in Farhy. It used that authority to once again hold the IRS had to file a lawsuit to collect the foreign business reporting penalties.

Safdieh v Commissioner Raises Foreign Business Reporting Penalties Yet Again

Now the issue has come before a different circuit court. On December 5, 2024, Safdieh v Commissioner, the Tax Court once again granted the taxpayer summary disposition on his $50,000 foreign business reporting penalties because the IRS had issued an administrative process to assess the penalties against him, rather than filing a lawsuit in federal district court to collect the penalties. The IRS appealed, and this time it was up to the Second Circuit to determine whether assessment or litigation was the proper tax collection tool.

Second Circuit Says Statutory Silence Doesn’t Prevent Assessment Authority

The Second Circuit started from the assumption that “The IRS normally does not have to go to federal district court to take taxpayers’ money, though some might wish it did.” It said the IRS’s assessment power was a “vital” tool needed to “collect ‘all taxes’.” It “plays the singular role of triggering an all-important process: collection” unlocking the IRS’s authority to seize assets, freeze bank accounts, and create liens without a court order.

The Court said that the IRS’s assessment power “extends beyond ‘all taxes’ to include ‘assessable penalties.’” It asserted that “[v]irtually all civil penalties are assessed” and framed the question as whether 6038(b) was an exception to that general rule.

It acknowledged that “Section 6038(b)’s text is silent as to whether the penalty is accessible.” But unlike the Tax Court, the Second Circuit did not find that silence prevented assessment. Declining to determine the legal effect of the statutory silence, the Second Circuit instead focused on the history behind the statutory section to justify its decision.

Circuit Court Finds Authority in Legislative History for Foreign Business Reporting Assessments

The Second Circuit found 3 reasons the foreign business reporting penalty was an assessable penalty under the IRC: history, integration with 6038(c), and a lack of statutory authority to file a lawsuit in the same section.

Legislative History Makes Lawsuit Requirement “Implausible”

According to the Second Circuit, section 6038(b) was passed by Congress because its predecessor statute, which reduced a taxpayer’s foreign tax credit by 10 percent for failure to report a foreign business interest, was too complicated and generally not used. It could be “unduly harsh” and cause taxpayers to “incur a substantial penalty for a minor failure” while at the same time being unenforceable against taxpayers who paid no foreign taxes.

The Second Circuit came to the conclusion that Congress intended the new dollar penalty to make it easier for the IRS to enforce the reporting requirement. Making the penalty non-assessable would do the opposite, requiring the IRS to “make a detour to the nearest federal district court to wage a legal battle for the money” which the Court found “implausible,” especially because the law was passed when there was a backlog of civil cases in federal district court, and the original amount of the penalty was 10 times lower than the federal district court’s floor for jurisdiction over cases based on the parties’ diversity.

The Court said its interpretation was supported by the fact that despite seven amendments to the statute over 42 years, “Congress has never, to our knowledge, questioned the IRS’s practice. In fact, it has acquiesced.” While noting that it was not deferring to the IRS’s interpretation of the statute, the Court said Congress’s failure to amend the statute to curbIRS’s assessment power meant it must have intended it to exist.

Lawsuit Requirement Could Duplicate Judicial Efforts

Second, the Second Circuit noted that sections 6038(b) and (c) work in concert. The foreign business reporting penalties assessed under section (c) (the reduced tax credit) must be reduced by the yearly dollar penalty imposed under section (b). The Court said “The coordination clause suggests that Congress meant for the Commissioner to be able to impose the subsection (b) and (c) penalties at the same time.” Otherwise, the section (c) penalties could only be finalized after the section (b) lawsuit was complete.

There could be separate lawsuits for each penalty, one in federal district court and one in the Tax Court. Both courts would have to answer the same questions in determining whether the foreign business reporting penalties were appropriate, a process the Second Circuit found “would be wasteful” and could result in gamesmanship as the parties tried to rush to get each court to decide the issue first.

No Authority for the IRS to Sue

Mr. Safdieh and the Tax Court had relied on section 2461(a) of Title 28, saying, “[w]henever a civil fine, penalty or pecuniary forfeiture is prescribed for the violation of an Act of Congress without specifying the mode of recovery or enforcement thereof, it may be recovered in a civil action.” But the Second Circuit said that the placement of that statute outside the IRC was “telling,” as was the fact that the IRS never previously used the section to collect a tax penalty. The Second Circuit said, “It is doubtful that Congress silently meant to require the Commissioner to look for the first time to this provision outside the I.R.C. to be able to do its job.”

Based on these three reasons, rather than the plain language of the statute, the Second Circuit agreed with the DC Circuit that the IRS had the authority to assess foreign business reporting penalties without going to court. It vacated the Tax Court’s decision, and remanded the case for further proceedings. However, if the Tax Court’s previous decisions show anything, it is that there will likely be more litigation on this issue and maybe even a Supreme Court decision in the years to come.

Attorney Joseph R. Viola is a tax attorney in Philadelphia, Pennsylvania with over 30 years experience. If you have questions regarding foreign trust asset reporting penalties, contact Joe Viola to schedule a free consultation.