In Information Return Penalty Assessment Fight Coming to a Head [$] Andrew Velarde highlights a major tax procedure issue before the Tax Court. It concerns allegedly improper IRS procedures with respect to the assessment of penalties associated with the delinquent or erroneous filing of information returns. As Velarde notes, in Farhy v Commissioner, the IRS assessed significant penalties under Section 6038 stemming from the taxpayer’s failure to File 5471 “Information Return of U.S. Persons With Respect to Certain Foreign Corporations,” for his Belize foreign corporations. The stakes of the case are high, with the potential for upending the IRS’s longstanding practice for imposing civil penalties for the failure to file certain information based returns.
Farhy, a CDP case, squarely focuses on whether the IRS was entitled to use its summary assessment procedures with respect to the taxpayer’s failure to file the required Form 5471 for a number of years. A side question in the case is whether in a CDP case the IRS’s assessment authority with respect to the penalty is part of the requirement that the court verify that the IRS followed all applicable laws or a challenge to the underlying liability. Liability challenges are not properly before the court if the taxpayer has had a prior opportunity to challenge the determination. The government in Farhy has conceded that the taxpayer did not have a prior opportunity to dispute the penalty so that allows the Tax Court to proceed to the substantive legal issue.
Back to the heart of the matter, and some context, simplified for purposes of this blog. The IRC provides that some tax penalties are subject to the deficiency procedures, requiring that the IRS assert the penalties in a stat notice or in pleadings in Tax Court for a case that is otherwise before the Tax Court. Other civil penalties are explicitly identified in the Code as “assessable penalties” provided in Subtitle F, Chapter 68, Subchapter B. These are found within §§ 6671-6725 and are not subject to the Code’s deficiency regime. IRC 6665(a) provides a similar statutory hook for penalties found within Subchapter A of Chapter 68.
For penalties in Chapter 68 the IRS is entitled to use its summary assessment powers, meaning that the IRS can assess those penalties immediately upon receipt of the taxpayer’s return.
What makes this case interesting and important is that the Section 6038 penalty is not found within Chapter 68 and is also not (at least explicitly) subject to the deficiency procedures.
The taxpayer in Farhy asserts in its opening brief that for decades the IRS has been acting ultra vires by using its summary assessment powers when the proper course is to refer the 6038 penalties to the Department of Justice “for collection like other tax judgments.” While Farhy involves an assessment with respect to Section 6038 and the failure to file Form 5471, as the brief notes the same issue presents itself with other penalties that are located outside Chapter 68, including:
- Section 6038A: Information returns required for certain foreign-owned U.S. corporations (Form 5472); the associated penalty is in the text of section 6038A all in Chapter 61 all in Chapter 61 (Information and Returns (§§ 6001 to 6117);
- Section 6038B: information returns required for certain transfers to foreign persons (Forms 926 and 8865); the associated penalty is in the text of section 6038B all in Chapter 61 (Information and Returns (§§ 6001 to 6117);
- Section 6038C: Information returns required for certain foreign corporations engaged in U.S. business (Form 5472); the associated penalty is in the text of sections 6038C all in Chapter 61 (Information and Returns (§§ 6001 to 6117);
- Section 6038D: Information returns regarding foreign financial assets (Form 8938); the associated penalty is in the text of section 6038D all in Chapter 61 (Information and Returns (§§ 6001 to 6117);
Prior to this case, a number of commentators and practitioners have written that collection of the Section 6038 penalty and similar non Chapter 68 penalties can only be accomplished via referral to the Justice Department and litigation. See for example Robert Horwitz, Can the IRS Assess or Collect Foreign Information Reporting Penalties? TAX NOTES TODAY (Jan. 31, 2019) 301-305. Others, including Frank Agostino and co-authors Phil Colasanto and Inhyuk Yoo, have concluded that the assessments are improper and have claimed that the Section 6038 penalty should be considered an “additional amount” under Section 6214(a) and subject to deficiency procedures. A nice summary of the critical commentary can be found on pages 123 and 124 of the 2020 NTA Annual Report to Congress; NTA Erin Collins, prior to her appointment, was one of the first to highlight the issue in a 2018 Tax Notes article she wrote with Garrett Hahn.
The argument that the collection of penalties is required to be accomplished via DOJ referral turns in large part on the placement of the information reporting penalties outside Chapter 68 of the Code. It seems that the key assumption for that argument is that immediately assessable penalties are limited to those explicitly identified in Chapter 68.
I confess to not having given the issue my full attention, in part because my assumption has been that absent a specific Congressional requirement the IRS has discretion to summarily assess and in effect use whatever process it chooses, subject to very weak procedural due process limitations that would allow for a taxpayer, following full payment, to bring a post payment refund suit. (As an aside: the procedural due process treatment of taxpayers is a separate issue and one which I have written about and discussed most recently here, where I presented on the issue at the 2021 Center for Taxpayer Rights International Conference on Taxpayer Rights; Keith has also discussed the procedural due process issue in tax penalties in Assessable Penalties Do Not Violate Due Process).
My prior statutory take on this issue is that the default, absent special Congressional direction, is the summary assessment procedure that IRS has been using. To be sure, Congress has occasionally spoken and required additional process prior to assessment. For example a century ago Congress injected the deficiency notice and pre-assessment review procedures, and in 1998 Congress (albeit sloppily) provided that no assessment for some Title 26 penalties is valid unless there was adequate written supervisory approval.
All of this focuses attention on Section 6201, which provides the IRS broad authority to assess taxes, providing that the IRS via delegation “is authorized and required to make the inquiries, determinations, and assessments of all taxes (including interest, additional amounts, additions to the tax, and assessable penalties) imposed by this title…”
As Professor Bryan Camp shared with me via email, the wording of Section 6201 supports the Service view that it can use its summary assessment power with respect to the non-Chapter 68 information reporting penalties:
In looking at 6201, the word “including” is the important word to the analysis. The parenthetical instructs us that the word “taxes” is to be broadly construed to mean liabilities other than taxes. Examples of such liabilities are given in the parenthetical, but the word “including” tells us that what is listed in the parenthetical is not to be read as the exclusive set of liabilities that count as “taxes” within the scope of 6201.
In its opening brief the government makes a similar argument:
The parenthetical reference in section 6201(a) to taxes “including . . . assessable penalties” includes the section 6038(b) penalty. As recently recognized by this Court, whether a penalty falls within the meaning of the term “taxes” as used in section 6201(a) is dependent on context. Grajales v. Commissioner, 156 T.C. 55, 61 (2021). Rather than limit the definition of “taxes,” the parenthetical reference in section 6201(a) includes “interest, additional amounts, additions to the tax, and assessable penalties,” which demonstrates that Congress intended to use “taxes” in an expansive sense rather than a narrow one. The modifier “all” preceding “taxes” also reflects that Congress intended to define the “taxes” to be interpreted under the broadest construction. The only limitation to respondent’s broad assessment authority under section 6201(a) is to limit that authority to assessments imposed under Title 26.
The dispute at issue highlights the labyrinth of the statutory authority to assess taxes and penalties. For example, Section 6202 addresses the process “mode or time for the assessment of any internal revenue tax (including interest, additional amounts, additions to the tax, and assessable penalties).” 6202 notes that the IRS “may” (but is not required) to establish a process for assessment if it is not otherwise mandated.
So IRS and Treasury could and should mandate additional procedural protections in connection with Section 6038 and similar penalties. Practitioners and the NTA have flagged the difficulties with the information penalty process, including what appears to be the IRS’s disregarding of apparent claims of reasonable cause and a high abatement rate for the penalties. These are serious problems that impinge on taxpayer rights and merit legislative attention. In fact the NTA has recommended that Congress extend deficiency procedures for these penalties, and others (including Keith), have highlighted how Congress needs to modify the Flora rule, which effectively keeps some taxpayers from ever getting the chance to get court review of potentially crippling penalties.
In any event, now that this issue is teed up in a case, we can expect to see the Tax Court’s take on what is looming to be one of the biggest issues in tax procedure and tax administration in 2023.