Tax Court Says IRS Can’t Assess Penalties on Foreign Informational Returns, Again
The Tax Court has paved the way for the U.S. Supreme Court to determine whether the IRS has the authority to assess penalties on informational returns disclosing interests in foreign corporations. Rejecting the DC Circuit’s reversal of an earlier decision on the same topic, the Tax Court said those penalties were not “assessable penalties” for IRS collections purposes.
IRS Assesses Penalties for Failure to File Foreign Informational Return
U.S. taxpayers must file informational returns disclosing foreign trust and corporate ownership interests. This occurs on Form 5471, Information Return of U.S. Person With Respect to Certain Foreign Corporations. Failure to file a foreign informational return under Section 6038(b)(1) results in two penalties: a penalty of $10,000 for each tax year, and a reduction in the foreign tax credit otherwise allowed to taxpayers. The amount of the penalties under 6038(c) by the amount of the penalty imposed under 6038(b). The taxpayer can also avoid liability for either penalty by proving that reasonable cause exists for the failure to file the informational return.
In this case, Raju Mukhi created two foreign trusts and a foreign corporation, Sukhmani Partners II Ltd., between November 2001 and September 2005. However, he never filed Form 5471, disclosing his ownership interest in the foreign corporation. Mr. Mukhi pleaded guilty to criminal tax violations related to a false U.S. individual income tax return and willful failure to file FBARs. That wasn’t the end of his tax trouble, though. The IRS then investigated his case to impose additional civil tax penalties.
On September 7, 2017, the IRS assessed $120,000 in foreign informational return penalties under Section 6038(b)(1). Mr. Mukhi’s appeal to the IRS Office of Appeals was unsuccessful, and the IRS issued a Notice of Intent to Levy and then a Notice of Federal Tax Lien in 2018. Mr. Mukhi requested a collection due process hearing, but the lien and levy were both affirmed. He then filed a lawsuit in Tax Court, arguing that the IRS lacked the authority to impose those penalties.
How the Tax Court Said No to a Higher Court’s Decision
In another case, Fahry v Commissioner, the Tax Court determined that the IRS did not have authority to assess penalties for the failure to file foreign informational returns under Section 6038(b)(1). In an earlier decision in this case, the Tax Court relied on the Fahry decision to summarily dismiss the penalties assessed by the IRS for failure to disclose the foreign corporation (but not the trusts).
Then, the Fahry case was appealed to the Circuit Court for the District of Columbia (DC Circuit), which reversed the decision and reinstated the IRS’s authority to assess those penalties and collect the unpaid balances through lien and tax levy procedures. The IRS asked the Tax Court to reconsider its decision in Mahri based on the DC Circuit’s Fahry decision.
Ordinarily, a district court is required to follow decisions from the circuit court above it. However, because the Tax Court has nationwide authority, the question of when a Circuit Court’s decision is binding on its future decisions is more complicated. The Tax Court has to look at which Circuit Court would address any appeal of its new decision to determine if the older decision is binding or not. The Mahri case will never be appealed to the DC Circuit. Because Mr. Mahri lived in Missouri at the time he filed his petition, the case would be appealed to the Eighth Circuit, which had never addressed the question whether the IRS can assess penalties for failure to file informational returns. Because of this, the Tax Court could reconsider the question and reach its own decision, even though Fahry had been reversed by the DC Circuit Court.
Tax Court Doubles Down on Foreign Informational Return Decision
Granting the IRS’s request for reconsideration, the Tax Court doubled down on its decision in Fahry, saying the IRS can’t assess penalties on foreign informational returns, again. The Tax Court said that agencies like the IRS generally collect civil penalties through a district court lawsuit, unless Congress says otherwise. The Tax Court looked at the language of Section 6308 to determine if Congress had authorized the IRS to assess penalties through its administrative process.
The IRS argued that its authority to immediately assess “assessable penalties” included all exactions in the Code, including all taxes and all penalties. However, the Tax Court disagreed again, just like it had in Fahry. In reevaluating its earlier decision, the Tax Court compared the 1939 tax code with the recodification law Congress passed in 1954. Under the 1939 law, “[t]he Commissioner is authorized and required to make the inquiries, determinations, and assessments of all taxes and penalties imposed by this title.” However, when Congress passed the 1954 law, that language changed, saying the IRS instead “is authorized and required to make inquiries, determinations, and assessments of all taxes (including interest, additional amounts, additions to the tax, and assessable penalties) imposed by this title.” The Tax Court said that the differences in the plain language of these two laws demonstrated a substantive change to the IRS’s assessment authority. By including the word “assessable” before “penalty” Congress must have meant to only grant IRS authority of “all taxes” not “all penalties.” So the key question was whether Section 6038(b)(1) imposed an assessable penalty.
Foreign Informational Return Penalties are Not Assessable Penalties
Section 6038(b)(1) says:
If any person fails to furnish, within the time prescribed under paragraph (2) of subsection (a), any information with respect to any foreign business entity required under paragraph (1) of subsection (a), such person shall pay a penalty of $10,000 for each annual accounting period with respect to which such failure exists.
Unlike other penalty statutes, this section did not include any explicit assessment language or set out any procedure the IRS must use to collect the tax. Instead, it just said the taxpayer shall pay the penalty without any explanation as to how. This means that Section 6038(b)(1) was not an assessable penalty, and the default rule – that the IRS has to sue the taxpayer to collect the penalty – applied. This meant the IRS does not have the authority to assess foreign information return penalties, or collect on those assessed penalties using levies or tax liens.
The Tax Court’s Mahri decision invites the IRS to appeal the decision to the Eighth Circuit. If that Circuit Court agrees with the Tax Court, it would set up a split in the circuits’ application of the law. That will invite the Supreme Court to weigh in and determine the law of the land. This could result in a final answer about whether the IRS can assess penalties for failure to file informational returns disclosing foreign corporate interests, or whether it must file lawsuits to collect those penalties instead.
Attorney Joseph R. Viola is a tax attorney in Philadelphia, Pennsylvania with over 35 years experience. If you have questions about filing foreign informational returns, contact Joe Viola to schedule a free consultation.
