In April 2023, taxpayers and tax professionals were elated by news that the U.S. Tax Court had ruled in favor of businessman Alon Farhy in his suit against the IRS. Farhy asserted that the IRS had no authorization to assess and impose penalties for failure to file foreign information returns. Their collective joy was tempered a year later when in May 2024, the U.S. Court of Appeals for the D.C Circuit reversed the Tax Court’s initial ruling.
Farhy failed to report his ownership in two foreign entities in Belize and was assessed hefty Section 6038(b) penalties. The penalty scale for infringements under Section 6038(b) includes initial penalties of $10,000 for each annual accounting period, for every foreign entity for which the required information is not provided. Additional penalties include $10,000 for each 30-day period that the infraction occurs, up to a maximum of $50,000.
Farhy’s argument to the courts was unique; he did not deny his lack of compliance. Rather, he challenged the IRS’ authority to independently assess and issue Section 6038(b) penalties directly, for failing to file certain foreign tax information. If the IRS sought to collect penalties, he contended, it would have to pursue civil action by filing a lawsuit in federal court under Title 28 of the U.S. Code. In its surprising ruling, the Tax Court agreed with Farhy’s position, and acknowledged that Section 6038(b), unlike other penalty sections, does not include a provision authorizing assessment of penalties.
Farhy’s victory didn’t last long. A year later, the Washington, D.C. Circuit Court of Appeals reversed the decision, based on context and history. “… penalties imposed under section 6038(b) … are assessable. This conclusion is buttressed by more than forty years of congressional acquiescence to the IRS’s practice of assessing section 6038(b) penalties.”
Apparently, silence is acquiescence. The court decided that the responsibility to clarify, change, or reinterpret a statute falls upon Congress. If Congress hasn’t revisited this statute in forty years, it must have no objection to its interpretation. The Court of Appeals utilized the “tools of statutory interpretation” and looked “to contextual clues” to assess whether this specific penalty provision could be challenged. It concluded that that Congress meant for Section 6038(b) penalties to be assessable, “Read in light of its text, structure, and function, section 6038 itself is best interpreted to render assessable the fixed-dollar monetary penalties subsection (b) authorizes.” On June 4, 2024, Farhy filed a petition for a rehearing, but it was denied.
While Farhy v Commissioner was on appeal, the ruling was successfully applied in Raju J. Mukhi v. Commissioner. Mukhi racked up $11 million of foreign reporting penalties and brought several claims to court, a fraction of which were Section 6038(b) penalties. In regard to those penalties, the Tax Court reaffirmed its decision in Farhy, finding that the IRS lacked authority to assess the penalties under Section 6038(b). Farhy was heard in U.S. Tax Court and deals with tax law interpretation, while Mukhi was heard by the U.S. Court of Appeals for the Second Circuit and involves immigration law. The overlap between the two cases highlights how rulings in one area can simultaneously impact decisions in other areas, influencing both IRS enforcement practices and federal law.
Litigation revolving around the IRS’ assessment authority for Section 6038(b) is likely to continue; but until there is a conclusive decision by the Supreme Court, taxpayers and practitioners can and should challenge IRS authority to assess these penalties in US Tax Court cases, where they fall outside of the D.C. Circuit. Ultimately, regardless of the courts’ decisions, the requirement to file still remains. Serious players in the international business space must be scrupulous in their tax compliance and stay mindful and aware of changing judicial interpretations of tax law.
This material has been prepared for informational purposes only, and is not intended to provide or be relied upon for legal or tax advice. If you have any specific legal or tax questions regarding this content or related issues, please consult with your professional legal or tax advisor.
