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Circuit Reverses Farhy on Close Examination of Statute, Context

Posted on May 6, 2024

The D.C. Circuit handed the IRS a significant win, leaning on context clues in reversing a Tax Court decision holding that the agency couldn’t assess international information return penalties.

The D.C. Circuit reversed and remanded the Tax Court in its May 3 decision in Farhy v. Commissioner. It held that the text, structure, and function of section 6038 support the IRS’s assessment authority for those penalties.

“It is hardly anomalous that section 6038(b) penalties are assessable even though the text of section 6038 does not explicitly label them as such. . . . Scattered across the tax code are more than one hundred penalties applicable to diverse forms of noncompliance and set forth in varied ways. Discerning the operation of each penalty is necessarily a context-dependent exercise,” Judge Cornelia Pillard wrote. “The absence of the penalty from Chapter 68 and the lack of either a cross-reference to Chapter 68 or explicit language directing that the penalty ‘shall be assessed’ is not determinative. Congress can make a penalty assessable by implication, and it did so here.”

In April 2023 the Tax Court held for the taxpayer, finding that the IRS couldn't assess penalties under section 6038(b) for failure to file Forms 5471, "Information Return of U.S. Persons With Respect to Certain Foreign Corporations." The Tax Court reasoned that Congress had not explicitly authorized assessment for the section 6038(b) penalties.

Observers have argued that the Tax Court’s decision in Farhy could affect many taxpayers, with its reach stretching far beyond Form 5471 to various other penalties. That could require the IRS to undergo a cumbersome process of asking the Justice Department to bring a civil suit to collect a penalty for which there is no assessment authority or deficiency proceedings.

Section 6201(a) authorizes the IRS to make assessments on taxes and assessable penalties. After assessment and failure to pay, the agency can enforce collection through liens and levies. Section 6212 requires that a notice of deficiency be sent before a liability assessment, and under section 6213, a taxpayer may petition the Tax Court for review. Section 6671 under chapter 68 provides the rules for assessable penalties, which allow for assessment of those penalties without a notice of deficiency. Taxpayers must pay the penalties before judicial review is allowed in a district court or the Court of Federal Claims. Section 6038 is found under chapter 61.

‘Highly Anomalous’

In reversing the Tax Court, the D.C. Circuit held that when Congress amended section 6038 in 1982, it intended the penalties to be assessable. The section originally imposed a penalty only in the form of a foreign tax credit reduction. The court was swayed by Congress's enactment of a fixed-dollar penalty that was simpler and could be collected more consistently, and it noted that the two penalties were coordinated.

“Reading subsection (b) to require the government to sue taxpayers to collect its fixed-dollar penalty, as Farhy does, treats Congress as having enacted a supplemental penalty process that is less streamlined, not more, than the preexisting collection process,” the court said.

The court was wary of overlapping judicial tracks for the two types of penalties under section 6038, noting that it could raise issues of preclusion.

The practical effect of lacking assessment authority also wasn't lost on the D.C. Circuit. The court recognized that it would be unlikely for the government to file suit to collect $10,000 penalties against taxpayers.

“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 wrote.

Reasonable cause determinations that excuse penalties make sense only if the IRS assesses the penalty, the court reasoned. It noted that section 6038(c)(4)(B) explicitly made reasonable cause determinations the responsibility of the IRS.

“It is hard to see what purpose would be served by the statutory requirement that the taxpayer’s reasonable-cause defense be ‘shown to the satisfaction of the Secretary’ if the claim subject to that defense must be decided in the first instance by a district court judge,” the court wrote.

Monte Jackel of Jackel Tax Law said he agreed with the appellate court’s ruling, finding its analysis on the coordination of section 6038(b) and (c) persuasive.

“Although [it was] sloppy drafting by Congress, logic and symmetry should prevail,” Jackel said.

Eric Rietveld of Sullivan & Worcester argued that the holding is based on a close reading of section 6038(b) and doesn't rely on broad, code-wide implications. He noted that the court did not agree with the government that the IRS has the authority to assess any penalty under section 6201(a) unless a penalty is explicitly excluded.

About Reasonable Cause . . .

Rietveld argued that the reasonable cause prong of the court’s analysis could prove helpful to taxpayers in determining if a penalty is assessable.

“If the IRS has the authority to determine whether reasonable cause existed so as to excuse a taxpayer from a penalty, then it is reasonable for the taxpayer (and the IRS) to determine that the IRS has authority to assess said penalty,” Rietveld said.

Daniel N. Price of the Law Offices of Daniel N. Price PLLC was disappointed in the opinion, arguing that it is far less textual and technical than the Tax Court's. He still hopes for a circuit split on the issue based on the Tax Court’s logic.

Price found the D.C. Circuit’s position on reasonable cause disturbing. “Why not view the IRS’s duty to consider reasonable cause as a pre-assessment or pre-collection necessity rather than a post-assessment administrative process?” he asked. “Section 6038’s express authorization of the IRS rather than a district court to evaluate a taxpayer’s defense to penalties imposed under that section reinforces that conclusion.”

Price added that reasonable cause is often litigated in federal courts because the IRS refuses to acknowledge it. “If the IRS did its job and actually considered reasonable cause statements submitted with late returns that include late Forms 5471, then in many cases, penalties would not be assessed. But the IRS fails in following the code and simply assesses 6038 penalties automatically for various classes of taxpayers,” he said.

The D.C. Circuit issued an order on May 3 to withhold issuance of the mandate until one week after disposing of any petition for rehearing or rehearing en banc.

In Farhy v. Commissioner, No. 23-1179, Farhy is represented by Edward M. Robbins Jr. of Hochman Salkin Toscher Perez PC.

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