Tax Blog/Blawg

I think Rocky is a great film series; especially Part IV four where Rocky fights Ivan Drago. During the fight, we see Rocky taking some pretty impressive punches, falling to the ring hard.  Yet, every time, Rocky gets back up and keeps fighting. Eventually, in the fifteenth round, Rocky lands a series of hard punches that knock Drago out, and Rocky wins the fight.

Imagine if Rocky had to fight Ivan Drago, Clubber Lang and Apollo Creed all at the same time in the same fight. It ain't about how hard you hit; it's about how hard you can get hit and keep moving forward, but let’s face it, it would be an impossible fight to win, regardless of how good Rocky is.

Taxpayers have various international reporting requirements arising from the ownership of assets outside of the United States. These include but are not limited to interest in foreign corporations (Form 5471), foreign partnerships (Form 8865), or certain specified foreign financial assets (Form 8938).

Other international reporting requirements include, for example, domestic corporations whose shares are owned in more than 25 percent by foreign persons, and single member disregarded entities, that have a foreign owners, which are required to report (Form 5472) certain transactions with foreign related parties.

The penalties for failure to comply with these reporting requirements are in Chapter 61 of the Internal Revenue Code. For example, Section 6038(b) provides that failure to report ownership of a foreign business entity gives rise to a $10,000 penalty for each tax year where such failure exists, and that the penalty may be increased by $10,000, and up to $50,000, for every 30-day period if the failure continues for more than 90 days after the IRS puts the Taxpayer on notice.

How does the IRS collects this penalty and in general any other penalty in Chapter 61?
According to taxpayer Alon Farhy, the penalty provisions set forth in Chapter 61, as is the case of the penalty in Section 6038(b), are not designated as “assessable penalties” and because of the lack of any other statutory provisions specifically granting the IRS with assessment authority over these penalties, one most conclude that the Government can only seek collection by filing a civil suit in federal court.

By contrast, an assessable liability gives the IRS authority to exercise its collection powers, which include creating and recording liens, and levying the taxpayer’s property, all without judicial review.

In Farhy v. Commissioner, 160 T.C. No. 6 (2023), the Tax Court agreed with the taxpayer, concluding that the penalty found in Section 6038 was not assessable.

The Government appealed and in an opinion issued on May 3, 2024, the United States Court of Appeals for the District of Columbia Circuit reversed the judgement of the Tax Court and ruled in favor of the Government. Farhy v. Commissioner, No. 23-1179, 2024 BL 152514 (D.C. Cir. May 3, 2024).

The D.C. Circuit explained that the legislative history of Section 6038 indicates that by adding the penalty provision currently found in subsection (b) of Section 6038, Congress clearly intended to ease the enforcement of the filing requirement of United States persons to report ownership of foreign corporations, rather than making its enforcement harder by requiring the Government to sue the taxpayer in federal court in order to collect the penalty at issue.

I agree that the legislative history of Section 6038 suggests that the penalty found in Section 6038(b) was designed to ease, not to complicate enforcement. I doubt, however, that Congress intended to authorize collection of these penalties with limited judicial review, following a collections due process hearing. More on this some other time.

This time, I want to highlight a portion of the DC Circuit’s opinion that in my view ignores the enormous disadvantage between the taxpayers and the IRS. It forces Rocky (i.e., the taxpayer) to fight the same fight against Ivan Drago, Clubber Lang and Apollo Creed (i.e., the IRS’s supercharged collection powers).

Per the D.C. Circuit “…interjecting a federal district court into a penalty process already subject to the IRS administrative determinations reviewable by the Tax Court introduces an inexplicable asymmetry and potential for inconsistent doctrinal development.”
In many cases, whether a taxpayer is liable for a Section 6038 penalty depends on the same legal issues and conclusions.

For example, in residency audits the IRS may conclude that a foreign individual, who let’s assume owned a business outside of the United States in the corporate, was classified as a resident alien for tax purposes because the individual satisfied the substantial presence test, or had been issued a green card sometime in the past.

In that event, the taxpayer would be – at a minimum – responsible for the following taxes and penalties: (i) an income tax deficiency arising from the taxpayer’s unreported income from sources outside of the United States; (ii) a Section 6038 penalty for failure to report the taxpayer’s interest in the foreign corporation; and (iii) penalties under Title 31 for failure to report the taxpayer’s foreign bank accounts in a foreign bank account report (i.e., an FBAR penalty).

In our hypothetical, the taxpayer would be required to fight Ivan Drago, Clubber Lang and Apollo Creed in three different forums:

i. Taxpayer v. Ivan Drago. Where the taxpayer would contest an income tax deficiency in Tax Court via the Tax Court’s deficiency jurisdiction under Section 6213.

ii. Taxpayer v. Apollo Creed. Where, in the first round, the taxpayer would contest a Section 6038 penalty “assessment” before the IRS Independent Office of Appeals in the context of a CDP Hearing under Section 6320 or 6330, followed by limited judicial review in Tax Court, in the second round.

iii. Taxpayer v. Clubber Lang. Where the taxpayer would contest an FBAR penalty determination in federal district court, most likely in response to a civil suit by the Department of Justice.

The DC Circuit Court opinion suggests that Farhy’s reading of the statute would introduce an “inexplicable asymmetry” and cause “potential inconsistent doctrinal development” and labels that as an undesirable result.

Yet, in many cases, that is precisely what happens when the IRS seeks to enforce international reporting requirements through three separate enforcement mechanisms, very few taxpayers have the resources and patience to fight the same fight in three separate forums, resulting in a technical knockout, in a fight of three against one.

A more uniform enforcement framework system seems appropriate. In the meantime, let us remember: “it ain't about how hard you hit; it's about how hard you can get hit and keep moving forward.”