D.C. Circuit Court Restores IRS’s Foreign Business Assessment Authority

U.S. taxpayers with foreign business interests must disclose those interests to the IRS or face substantial penalties. But for the past year, the IRS’s foreign business assessment authority has been off-line. A 2023 Tax Court decision held that the IRS Commission’s administrative authority did not extend to assessments related to disclosure of foreign business interests. But the D.C. Circuit Court reversed that decision, restoring the IRS’s foreign business assessment authority, and making it harder for taxpayers to contest the penalties imposed against them.

Tax Court Struck Down IRS’s Administrative Authority to Assess Foreign Business Penalties

The IRS imposed extensive penalties against Alton Fahry for his failure to disclose his interests in two Belize businesses between 2003 and 2010, as required by section 6038(a) of the Tax Code. The penalties occurred after Fahry entered a tax fraud non-prosecution agreement to avoid criminal tax consequences. Fahry sued to have the assessment reversed. He admitted he had not disclosed his property interest, but said the IRS had not properly assessed the penalties.

This blog reviewed the Tax Court’s Fahry v Commissioner decision last year. That decision held that the Tax Code did not explicitly include the penalties for failure to report ownership interests in a foreign business entity in the section authorizing the IRS to issue administrative assessments. This meant the IRS would need to file a civil lawsuit to collect its penalties rather than assessing them using its administrative process.

Court of Appeals Takes on a “Cornerstone” of Tax Collection: Assessments

On May 3, 2024, the United States Court of Appeals for the District of Columbia Circuit reversed that decision, restoring the IRS’s assessment authority for penalties related to undisclosed foreign business assets. The D.C. Circuit Court said “the text, structure, and function of section 6038 demonstrate that Congress authorized assessment of penalties imposed under subsection (b).”

The Circuit Court called the IRS’s assessment power a “cornerstone of the government’s tax collection authority” establishing the “official recording” of the amount taxpayers owe to the federal government. IRS assessment also “sets in motion the collection powers of the IRS” including the Commission’s ability to assess liens and levies.

The Circuit Court said “It is the rare federal tax that can only be recovered through a government-initiated lawsuit.” Instead, the IRS can assess most of its penalties by notifying the taxpayer of the amount owed and demanding payment. Taxpayers wanting to contest the assessment must “pay-first, challenge-later” by suing the IRS to recover the amount paid, or request a pre-collection review by the IRS itself through a Collection Due Process (CDP) hearing by the IRS Office of Appeal, and then challenge the result in Tax Court.

In determining whether this assessment process applied to section 6038 the Circuit Court noted that many provisions in the Tax Code require taxpayers to file information about foreign gifts and transactions with the IRS or face penalties, even when no taxes are directly related to the information disclosed. These disclosures assist the IRS in investigating international tax evasion schemes.

Initially, the only penalty for failing to comply with section 6038 was a reduction in the taxpayer’s foreign tax credit. However, the law later changed to add a streamlined, uniform penalty for the failure to disclose foreign business interests, using flat payments of $10,000 per year, with late penalties of a total of $50,000 per year. The new penalties were coordinated with the tax credit penalty to avoid double-charging for the same violation.

D.C. Circuit Court Restores IRS’s Foreign Business Assessment Authority

All tax liabilities can be assessed. However, the question was whether the assessment procedure extended to the streamlined penalty system.

The IRS argued that “absurdities would result from a narrower interpretation” of its assessment power, like that used by the Tax Court. It encouraged the Circuit Court to read the assessment statute to “cover the waterfront” of “all exactions assessable as taxes” except where the Tax Code explicitly required a different process. To support its position, the IRS relied on an earlier version of the assessment statute which gave it authority “to make the inquiries, determinations, and assessments of all taxes and penalties …” The Circuit Court said Congress “recodified” that law in section 6201 “with no apparent intention to circumscribe the applicability to all penalties.”

Fahry argued the opposite: that 6201(a) required a penalty to be explicitly characterized as a “tax” or designated as “assessable” in the Tax Code to be included as an “assessable penalty.” Where there is no such designation, such as in section 6038(a), the penalties would not be assessable by the IRS.

The Circuit Court’s ruling fell somewhere in the middle:

“We need not embrace either party’s tax code-wide default to rule to resolve this case. … Instead we conclude a narrower set of inferences suffices to show that Congress intended to render those penalties assessable. Read in light of its text, structure, and function, section 6038 itself is best interpreted to render assessable the fixed-dollar monetary penalties subsection (b) authorizes.

The Circuit Court ruled that section 6038(b) created assessable penalties, which the IRS can impose using the normal notice procedures.

To reach this decision, the Circuit Court relied on the streamlined nature of Congress’s changes to the penalty, giving IRS express authorization to evaluate penalty defenses as part of its authority to address the foreign tax-credit offset. It said that Fahry’s interpretation would have “enacted a supplemental penalty process that is less streamlined, not more, than the preexisting collection process” since the IRS would be unable to collect the penalties without first going to court. The Court said:

It would be ‘highly anomalous’ for Congress to have responded to the identified problem of the underuse of subsection (c) penalties by promulgating a penalty that, while simpler to calculate, is much harder to enforce.

The Court said the coordinated tax-credit reduction and non-disclosure penalties were intended to be imposed at the same time. If one were assessable and the other not, it would create a more complicated process. The Court also found that many of the same defenses apply to the failure to disclose foreign business interests as other assessable penalties, including the “reasonable cause” defense, which the IRS has explicit power to evaluate. If Congress had intended to require a lawsuit to impose the penalty, the “reasonable cause” defense would be up to the judge, not the Commissioner.

The D.C. Circuit Court’s decision restores the IRS’s assessment authority over taxpayers who fail to disclose their foreign business interests. Taxpayers will now need to request CDP reviews, or pay the assessments and sue to recover their costs. The ruling puts the procedural burden back on taxpayers, making it essential for taxpayers to discuss any assessments with a tax attorney right away. Otherwise, they risk owing penalties that quickly add up to hundreds of thousands of dollars when the IRS’s demands for payment are not met.

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.