Six Weeks, Three International Information Reporting Decisions

In the space of just over six weeks, courts made three key judicial decisions. Those decisions helped clarify the requirements of individuals and the limitations on the powers of the IRS in assessing international information reporting penalties:

• title 31 penalties for foreign bank account reports;

• title 26 international information reporting penalties specific to reporting of ownership interests in foreign companies (and trusts¹); and

• how the federal statutory regimes of titles 31 and 26 cross over into international law as set forth in U.S. income tax treaties.

The three cases are interconnected and have significance for U.S. taxpayers with global lives, global assets, multinational family members, and businesses or accounts in different parts of the world.

Aroeste v. United States

First, on February 13 the U.S. District Court for the Southern District of California ruled on a joint discovery motion in Aroeste.² The district court concluded that the IRS and the Department of Justice Tax Division could not ignore the Mexico-U.S. income tax treaty and its application to a Mexican national who has resided all of his life in Mexico City and has maintained a green card for immigration purposes in the United States. It is a non-willful FBAR case. The district court applied the interconnected statutes and regulations of titles 31 and 26 to determine who qualifies as a “United States person,” specifically with reference to international law and obligations set forth in the treaty. The key question that remains to be answered is, who must file FBARs? Must Mr. Aroeste and, by extension, millions of green-card-holding individuals residing outside the United States?³

Bittner v. United States

Second, on February 28 the U.S. Supreme Court found in Bittner⁴ that the applicable non-willful FBAR penalty is not calculated based on every foreign account of the individual, as the IRS has argued for years. That case also dealt with non-willful filing of FBARs. The Court concluded that the IRS cannot impose penalties of $10,000 on each account held; rather, the penalty is per report that was not correctly filed. Hence, the total maximum penalty per year is $10,000. A maximum penalty of $50,000 (10,000 for each of the five years at issue) applied, according to the Court, as opposed to what the IRS had determined: more than $2.7 million.

Farhy v. Commissioner

Last, on April 3 the U.S. Tax Court issued a decision in Farhy,⁵ saying that the IRS does not have statutory authority to assess international information reporting penalties under section 6038(b). This has far-reaching implications regarding how the government will be able to collect international information reporting penalties that the IRS administratively determines are owed.⁶ The national taxpayer advocate’s 2020 report to Congress addressed this issue, calling it one of the most serious problems in international tax.⁷ In the report, the taxpayer advocate identified more than $310 million in penalties for tax year 2014 that the IRS assessed under sections 6038 and 6038A.⁸ We now know that those assessments were invalid.

This article focuses on Farhy, while noting that section 6038(b) penalties (along with other international information reporting penalties determined by the IRS) are at issue in Aroeste as well (for a foreign trust⁹).

Assessments and Assessable Penalties

The Farhy court cited case law that defines an assessment as “the formal recording of a taxpayer’s tax liability” by the IRS.¹⁰ The U.S. Supreme Court has noted that it is “essentially a bookkeeping notation.”¹¹

According to the Farhy court, the term “assessable penalties” is as used in section 6201(a), which includes some, but not all, penalties in the code. In other words, not all penalties are “assessable” penalties. Assessable penalties are those that “must be paid upon notice and demand and assessed and collected in the same manner as taxes.”¹² The court added that “the term ‘assessable penalties’ used in section 6201 does not automatically apply to all penalties in the Code not subject to deficiency procedures.” (Emphasis omitted.) The Tax Court concluded that penalties under section 6038(b) (failure to file Form 5471, “Information Return of U.S. Persons With Respect to Certain Foreign Corporations”) are not assessable penalties.

The Tax Court quoted Ruesch,¹³ in which the court held that section 6038(b) penalties are not subject to deficiency procedures:

After the IRS mails a taxpayer a timely notice of deficiency, this Court has jurisdiction to redetermine deficiencies in income, estate, and gift taxes “imposed by subtitle A or B” and deficiencies in certain excise taxes imposed by “chapter 41, 42, 43, or 44.” Secs. 6212(a), 6213(a). The section 6038 penalties assessed against [the taxpayer] are imposed by subtitle F, chapter 61, and thus lie outside our deficiency jurisdiction.

The Tax Court ruled in a separate proceeding in Aroeste¹⁴ that the Tax Court has no jurisdiction over international information reporting penalties under sections 6038(b) and 6677:

By negative implication, any other taxes — even if imposed in Title 26 — fall outside this Court’s deficiency jurisdiction. Williams v. Commissioner, 131 T.C. 54, 58 (2008). Penalties under section 6038(b) are imposed by respondent under subtitle F, chapter 61, and are thus outside the Court’s deficiency jurisdiction. Ruesch, 154 T.C. at 297. Penalties under section 6677 are imposed by respondent under subtitle F, chapter 68, subchapter B, and are explicitly exempt from the deficiency procedures for income, estate, gift, and certain excise taxes. Section 6677(e); see also Smith v. Commissioner, 133 T.C. 424, 428-29, n.3, 4 (2009).

This raises the question: What other international information reporting penalties are not assessable penalties? The Tax Court order in Aroeste distinguishes between section 6038(b) penalties (chapter 61 of subtitle F) and section 6677 penalties (chapter 68 of subtitle F). Section 6677 penalties are clearly ones that can be assessed. The problem individuals face is the inability to obtain judicial review if they do not agree with the IRS’s determination. In Farhy, the Tax Court said individuals facing section 6038(b) penalties will receive review in a federal district court or court of federal claims after the Department of Justice pursues its civil lawsuit for enforcement within the time required by the statute.

A previously published report provided a summary of international information reporting statutory penalties in two categories: chapter 68 and chapter 61.¹⁵ The statute as reflected in the following tables designates penalties under subchapter B of chapter 68 of subtitle F as assessable.

The Tax Court in Farhy took great care to explain those distinctions and use other statutory examples of when some international information reporting penalties can be subject to an assessment procedure, as explained in footnote 13 of the decision. Specifically, the Tax Court noted that the IRS can assess accuracy-related penalties under section 6662(a), (b)(7), and (j) for “undisclosed foreign financial asset” information that extends to numerous international information reporting requirements.¹⁶ The Farhy court held that the IRS’s power to assess accuracy-related penalties under section 6662 does not, however, give it the power to assess section 6038(b) penalties.

The Farhy court provided a detailed list of penalty provisions that are assessable penalties and explained the statutory framework with reference to chapter 68 of subtitle F, noting that Congress did not expressly authorize section 6038(b) penalties as assessable.¹⁷

Generally, the IRS has broad powers to commence administrative levy proceedings to collect taxes, interest, and penalties (at least those that are assessable) without judicial oversight.

When Is an Assessment Valid?

If all that is required to have an “assessment” is that the IRS record a bookkeeping notation of liability, what makes it a valid assessment? The Farhy court discussed the authority required by the IRS to make an assessment and cited other Tax Court decisions that invalidated assessments or portions of assessments.¹⁸ The Tax Court went through a detailed statutory analysis to conclude that the IRS has no authority to make an assessment of penalties arising under section 6038(b). This does not mean that the IRS cannot make a determination that the individual ultimately owes the specific international information reporting penalties; rather, it means that the IRS cannot use an assessment as a tool to administratively levy and collect the amounts the agency claims the individual owes. An assessment of section 6038(b) penalties would be invalid, full stop.

When Can the IRS Collect?

The Farhy court explained how generally the IRS can collect tax (or a deemed tax, such as additions to tax), assessable penalties, or interest through an administrative levy, provided there has been a valid assessment.¹⁹ If there has not been a valid assessment, the Tax Court explained that the IRS may still be able to collect those liabilities through a civil action, but that the IRS may not assess or administratively collect them.²⁰ The recovery of penalties under title 28 is quite different, though, because it requires the federal government to commence a civil action in either federal district court or the court of federal claims. The IRS lawyers do not bring those cases when the Tax Court does not have jurisdiction over a particular issue; rather, it is the Department of Justice.

Can the IRS administratively collect on international information reporting penalties that are not assessable penalties under its administrative powers to lien and levy assets extrajudicially? The answer, per the Tax Court in Farhy, is “no.” Multiple authors and practitioners have argued that to collect those penalties, which are not subject to the assessment powers, the Department of Justice must sue the taxpayer.²¹ In Farhy, the Tax Court confirmed this conclusion and told the government it must independently pursue a judicial civil action.²²

Conclusion

In the Farhy decision, the Tax Court confirmed the interpretation of many practitioners that the IRS has no power to assess penalties under section 6038. The Tax Court did not conclude (at least not explicitly) that its analysis necessarily extends to numerous other international information reporting penalties that are not identified as assessable penalties (for example, sections 6038A, 6038B, 6038C, 6038D, 6039E, 6039F, et. seq., which were not at issue in Farhy). The authors are of the view that, by inference, the same analysis should apply, and the remedy for the government to collect international information reporting penalties that the IRS alleges are owed is through a judicial civil action.²³

The Tax Court did specify numerous international information reporting penalties that are assessable, including some in subtitle F, chapter 61, which, according to the court, “contain a cross-reference to a provision within chapter 68 of subtitle F [assessable penalties] providing a penalty for their violation.”²⁴ The decision means that the Department of Justice will have to bring a judicial civil action against individuals when the IRS claims those penalties are owed (international information reporting penalties under sections 6038, 6038A, 6038B, 6038C, 6038D, 6039E, and 6039F), thus subjecting those IRS determinations to judicial review.