IRS Lacks Authority to Assess Sec. 6038(b)(1) Penalty; Tax Court Reaffirms Prior Decision

(Parker Tax Publishing December 2024)

The Tax Court reaffirmed a prior holding, which was based on a decision that was subsequently overturned by the D.C. Circuit Court, and held that the IRS lacks statutory authority to assess a penalty under Code Sec. 6038(b)(1) for a taxpayer's failure to timely file Forms 5471, Information Return of U.S. Persons With Respect To Certain Foreign Corporations. The court concluded that nothing in the text of Code Sec. 6038(b)(1) expressly authorizes the IRS to assess the Code Sec. 6038(b)(1) penalty; nor does the text set forth a procedure the IRS must use to collect the tax. Mukhi v. Comm'r, 163 T.C. No. 8 (2024).

Background

Between November 2001 and September 2005, for U.S. tax purposes, Raju Mukhi created three foreign entities, including a foreign corporation. For years 2002 through 2013, Mukhi did not timely file Forms 5471, Information Return of U.S. Persons With Respect To Certain Foreign Corporations, to disclose his ownership interest in the foreign corporation. As a result, the IRS assessed penalties under Code Sec. 6038(b)(1) for these failures and then proposed a levy and filed a lien to collect the unpaid penalties. Mukhi requested a hearing under Code Sec. 6320 and Code Sec. 6330 and, after the hearing, the IRS issued Mukhi a notice of determination that sustained the collection actions relating to the Code Sec. 6038(b)(1) penalties.

Code Sec. 6038(b)(1) imposes a penalty of $10,000, with respect to each annual accounting period for which a failure exists, if any person fails timely to furnish certain required information with respect to any foreign business entity. Code Sec. 6038(b)(2) imposes a continuation penalty of $10,000 for each 30-day period (or fraction thereof) during which such failure continues with respect to any annual accounting period after an initial 90-day notice period, subject to a maximum penalty of $50,000.

In April of 2023, in Farhy v. Comm'r, 160 T.C. 399 (2023), the Tax Court held that the IRS did not have the statutory authority to assess penalties under Code Sec. 6038(b) against a taxpayer who failed to file Forms 5471.

Mukhi petitioned the Tax Court and, in Mukhi v. Comm'r, 162 T.C. No. 8 (2024), relying on its decision in Farhy, the Tax Court ruled in Mukhi's favor and held that the IRS lacked the statutory authority to assess the penalties because the Code Sec. 6038(b) penalties are only prescribed for the violation of Code Sec. 6038(a)(1) and (2). In its decision, the Tax Court said that the IRS can collect Code Sec. 6038(b) penalties only through a civil suit filed by the U.S. Department of Justice, not through the administrative collection methods that it had used to enforce the penalties for more than 40 years.

After the Mukhi decision, the D.C. Circuit overturned the Tax Court's decision in Farhy. In Farhy v. Comm'r, 2024 PTC 141 (D.C. Cir. 2024), the D.C. Circuit concluded that the penalties under Code Sec. 6038(b) are assessable based on the text, structure, and function of Code Sec. 6038. The court said that its conclusion was supported by more than 40 years of Congressional acquiescence to the IRS's practice of assessing Code Sec. 6038(b) penalties. The court observed that since adding subsection (b) in 1982, Congress had amended Code Sec. 6038 seven more times. Each time, the court noted, Congress left undisturbed the IRS's practice of assessing and administratively collecting penalties imposed under Code Sec. 6038(b).

The IRS filed a motion for reconsideration of the Tax Court's original holding in its Mukhi decision and the Tax Court agreed to rehear the case. Any appeal of the Tax Court's decision would presumptively lie before the Eighth Circuit, which has not issued a precedential, published opinion as to whether the Code Sec. 6038(b)(1) penalty is assessable.

Analysis

The Tax Court reaffirmed its prior holding and held that (1) the IRS lacks statutory authority to assess the penalty under Code Sec. 6038(b)(1), and (2) the IRS cannot proceed with collection of the Code Sec. 6038(b) penalties from Mukhi via a lien or proposed levy.

The court began by noting that the IRS's authority to assess certain liabilities is derived from Code Sec. 6201(a), which authorizes and requires the IRS to assess "all taxes (including interest, additional amounts, additions to the tax, and assessable penalties)" imposed by the Code. The court rejected the IRS's argument for an expansive reading of Code Sec. 6201(a) that would encompass all exactions in the Code. The court found that, while the IRS was correct that the word "including" typically denotes an illustrative list, it does not therefore follow that the definition becomes inclusive of every exaction in the Code. Such a reading, the court said, would render a portion of the parenthetical in Code Sec. 6201(a) superfluous.

Additionally, the court said, if Congress intended all exactions provided for in the Code, and specifically all penalties, to be assessable by the IRS, the adjective "assessable" would be unnecessary to modify "penalties." The court thus concluded that the use of the word "assessable" denotes that the IRS's assessment authority is more limited than all penalties set forth in the Code. Further, the court said, reading "taxes" as encompassing all exactions would render superfluous the various Code provisions deeming penalties to be taxes for certain purposes. It has been firmly established, the court noted, that taxes and penalties are two distinct categories of exactions.

The court then addressed the text of Code Sec. 6038(b)(1) and noted that nothing in that text expressly authorizes the IRS to assess the Code Sec. 6038(b)(1) penalty; nor does the text set forth the procedure the IRS must use to collect the tax. Instead, the court observed, the text merely states that a taxpayer must pay a penalty for violation of the statute without specifying a mode of recovery.

Finally, the court also highlighted other penalty statutes, such as Code Sec. 6671(a) and Code Sec. 6665(a), to illustrate text that could plausibly indicate that the IRS has authority to assess a penalty and observed that Code Sec. 6038(b)(1) does not contain any text that approaches the assessment text in the other civil penalty statutes. The Tax Court thus concluded that, in reviewing the plain text of Code Sec. 6038(b)(1) and similar civil penalty statutes, Congress did not grant the IRS authority to assess the Code Sec. 6038(b)(1) penalty.

For a discussion of Form 5471 and the information reporting requirements for controlled foreign business entities, see Parker Tax ¶203,120.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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