Since 2020, I have repeatedly recommended a legislative change under which Congress would make foreign information return penalties and assessable penalties subject to deficiency procedures for the benefit of both the IRS and taxpayers. This change would provide taxpayers with a more efficient, less costly, and more equitable regime governing the initial imposition of these penalties, as well as the mechanisms by which they can be challenged by taxpayers.
This blog specifically addresses information reporting penalties in Chapter 61, Subchapter A, Part III, Subpart A (hereafter referred to as Chapter 61 for brevity’s sake).
Taxpayers who receive foreign gifts or control certain foreign corporations and partnerships and fail to file required information returns are subject to penalties under IRC §§ 6038 and 6039 (which are in Chapter 61 of the IRC). IRC § 6038 is one of several code sections that require similar filings and provide for similar penalties for taxpayers with various types of foreign corporations, partnerships, assets, and accounts. These Chapter 61 penalties are peculiar in that each section specifically imposes the penalties but provides no authority to assess and collect the penalties. I raised this concern in my 2020 Annual Report to Congress and recommended that the IRS take steps to protect the government fisc and also taxpayer rights by maximizing taxpayers’ access to administrative and judicial review.
The ability of the IRS to assess a Chapter 61 penalty was recently challenged before the U.S. Tax Court in Farhy v. Commissioner and, in a precedential decision, the court held that the IRS lacks statutory authority to assess and collect penalties under IRC § 6038(b).
In Farhy, the taxpayer had a reporting requirement under IRC § 6038(a) to report his ownership interests in two foreign corporations but failed to file required Form 5471, Information Return of U.S. Persons With Respect to Certain Foreign Corporations, for multiple tax years. The IRS assessed an initial penalty under IRC § 6038(b)(1) for each year and continuation penalties under IRC § 6038(b)(2). The IRS sought to collect the penalties via levy, and the taxpayer timely filed a petition with the Tax Court challenging the IRS’s authority to assess and attempt to collect via levy.
The taxpayer put forth a simple argument: that, unlike many other penalty provisions in the Internal Revenue Code, IRC § 6038 has no language authorizing assessment of the penalty it imposes. Essentially, the taxpayer argued, because this code section falls outside of the sections in Subchapter B of Chapter 68 of Subtitle F, entitled “Assessable Penalties,” and because it has no language linking its penalty provision to any other authorization to assess and collect penalties, the IRS does not have authority to assess and collect this penalty.
The IRS raised several arguments in favor of its contrary position. The primary contention was that the term “assessable penalties” refers to any penalty in the IRC not subject to deficiency procedures and that no code section limits the term “assessable penalties” to those found within Subchapter B of Chapter 68. Otherwise put, because the penalties were not subject to deficiency procedures, then, by definition, they had to be assessable, an argument that, if sustained, would have been decisive. The IRS also contended that the definition of “taxes,” which includes “assessable penalties,” in IRC § 6201 is broad enough to encompass IRC § 6038(b) penalties. The Tax Court, however, was unimpressed by this analysis.
Rather, the court found the taxpayer’s arguments persuasive, holding that the IRS did not have authority to assess and collect penalties under IRC § 6038. Among other reasons, the court noted that other assessable penalties outside of Subchapter B of Chapter 68 typically contain language authorizing their penalties or cross-referencing the authorizing statute, or else they are explicitly covered by the list of assessable penalties in Chapter 68.
In my opinion, given that Chapter 61 penalties are not currently subject to deficiency proceedings, and given that, under the court’s ruling, the IRS lacks the statutory authority to treat them as assessable penalties, the IRS cannot itself directly assess and collect them. Instead, collection activities would need to be undertaken by the Department of Justice, but that would add to the burden on taxpayers, tax administration, the government, and the court system. This holding impacts a significant number of IRC § 6038 cases open within the IRS.
To illustrate the potential scope of this disruption, one need only glance at data relating to the IRC § 6038 penalties, which are most often imposed systemically at the time of filing a late information return. In these circumstances, collection efforts generally begin before an employee ever reviews the validity of the assessment. Between 2014 and 2022, there were an average of 9,800 IRC § 6038 penalties systemically assessed per year. Of those penalties, the mean abatement rate was 69 percent per year, with a minimum of 58 percent (as of February 2023) and a maximum of 88 percent. These systemic assessments totaled $354 million per year, of which $281 million was abated – an average abatement rate of 80 percent per year by dollars. We note that because of broad penalty relief provided by the IRS with respect to late filing penalties for 2019 and 2020 returns in Notice 2022-36, we cannot differentiate which abatements were due to the broad penalty relief for those tax years, but we believe that the initiative contributed to a higher abatement rate for those years and consequently a higher average abatement rate for the period of 2014-2022. As I discussed in my 2020 Annual Report to Congress, the IRS’s determination over a decade ago to systemically assess foreign information penalties has caused administrative burdens and unnecessary expenses for taxpayers and the government.
In comparison, penalties assessed manually by an IRS employee during the course of an examination occurred much less often than systemic assessments, and most of these manually assessed penalties affect individuals, not businesses. The number of manual assessments averaged only 685 returns per year from 2014-2022, with an average abatement rate of 23 percent per year. In terms of dollars, the average aggregate manual penalty assessment per year was $36 million, of which 19 percent was abated.
As I explained in my 2020 Annual Report to Congress, this was a real concern for taxpayer rights and tax administration even before the Tax Court’s Farhy ruling. As shown by the data presented above, because the IRS views IRC § 6038(b) penalties as assessable, most of those penalties are asserted systemically without any kind of upfront human review. This systemic approach resulted in far more penalties being assessed than are ultimately sustained.
This approach, which causes headaches to all concerned, has now been ruled legally unsupportable, wastes everyone’s resources, and subjects taxpayers to a range of hardships. Thus, taxpayers, and now particularly the government, are between a rock and a hard place. This situation cries out for a congressional fix.
The best means of resolving this dilemma, as I proposed in my 2020 Annual Report to Congress, is to treat Chapter 61 penalties in the same way as tax deficiencies:
To protect taxpayer rights and reduce taxpayer burden, we strongly recommend that Congress amend the IRC to allow deficiency procedures for all Chapter 61 penalties, including the IRC §§ 6038 and 6038A penalties. As one possibility, these IRC sections could be amended to add a cross-reference directing that the penalties be asserted in the same way as other IRC sections subject to deficiency procedures. This approach would allow taxpayers to contest these penalties before Tax Court judges familiar with tax law in a prepayment judicial forum.
Making Chapter 61 subject to deficiency procedures would allow taxpayers the ability for an administrative and judicial review before assessment. This puts judicial review of penalties in the hands of the Tax Court, where it belongs. Due to the tax expertise of its judges, the Tax Court is often better equipped to consider tax controversies than other courts.
Under the IRS’s approach to IRC § 6038, taxpayers assessed a $10,000 penalty must pay the penalty, file a claim for refund, and, if necessary, file a refund suit in the appropriate U.S. district court or the U.S. Court of Federal Claims. As a practical matter, taxpayers make a business decision weighing the cost of representation and legal action in the district court or the U.S. Court of Federal Claims against the cost of conceding and paying the penalty. Such a structure is neither efficient nor equitable for taxpayers and violates their fundamental right to pay no more than the correct amount of tax. This approach is not good for tax administration.
The Tax Court is more accessible, especially to less knowledgeable and unrepresented taxpayers, than other courts because it uses informal procedures, particularly in disputes that do not exceed $50,000 (IRC § 7463). Another benefit is that taxpayers may be offered the option of receiving free legal assistance from a Low Income Taxpayer Clinic or other pro bono representatives. Usually, the Tax Court is by far the least expensive and easiest-to-navigate judicial forum for taxpayers, including low-income taxpayers.
Since 2020, I have repeatedly recommended this legislative change to Congress. Such a step would protect the IRS from the future ramifications of the Farhy decision. More importantly, it would provide taxpayers with a more efficient and equitable regime governing the initial imposition of Chapter 61 penalties and the mechanisms by which they can be challenged by taxpayers while also protecting their rights.
Read Part Two: Chapter 61 Foreign Information Penalties: Taxpayers and Tax Administration Need Finality, Which Requires Legislation.
The views expressed in this blog are solely those of the National Taxpayer Advocate. The National Taxpayer Advocate presents an independent taxpayer perspective that does not necessarily reflect the position of the IRS, the Treasury Department, or the Office of Management and Budget.