The U.S. Tax Court has affirmed its earlier decision that the IRS lacks authority to assess certain foreign information penalties. The latest decision in Mukhi v. Commissioner came after a flurry of activity involving the IRS’ ability to assess the penalty.
Background
In Mukhi, the taxpayer established three entities: a foreign corporation and two foreign trusts that held foreign brokerage accounts. That means he was required to file information returns, including Form 3520, Form 3520-A, and Form 5471.
In 2014, the taxpayer pleaded guilty to one count of filing false U.S. individual income tax returns and one count of failure to file an FBAR.
(As part of the Bank Secrecy Act (31 USC §5314), every U.S. person with a financial interest in, or signature or other authority over, one or more foreign financial accounts with an aggregate value of more than $10,000 must annually report the account to the Treasury Department. You do this by filing a Report of Foreign Bank and Financial Accounts, commonly known as an FBAR.)
After the guilty plea, the IRS began looking at the taxpayer’s records to determine whether he also owed civil tax penalties. The IRS then billed Mukhi for millions, citing his failure to timely file Form 3520 (section 6677) for tax years 2005 through 2008, failure to timely file Form 3520–A (section 6677) for tax years 2005 through 2010, and failure to timely file Form 5471 (section 6038(b)) for tax years 2002 through 2013.
Mukhi filed a protest with the IRS Office of Appeals, which concluded that there was no basis for relief. The IRS then moved to collect, and the taxpayer requested a Collection Due Process (CDP) Hearing, challenging the underlying liabilities and suggesting that he wanted to consider collections alternatives, including an installment agreement and an offer in compromise. After Mukhi could not reach a satisfactory result at the administrative level, he moved the matter to the Tax Court where he made several arguments, including that the international information return penalties were unconstitutional. Specifically, he contended that the penalties imposed under sections 6038(b) and 6677 violated the Eighth Amendment’s excessive fines clause.
The Court found that an analysis of the penalties under section 6038(b) wasn’t necessary, referring to a decision the Court had reached earlier in a case called Farhy.
Farhy Ruling
In Farhy, the taxpayer was required to report his ownership interests in foreign corporations. Specifically, he was required to file Form 5471, Information Return of U.S. Persons With Respect to Certain Foreign Corporations—failure to do so can result in significant penalties until section 6038(b). Farhy did not timely report, and the IRS assessed penalties under section 6038(b)(1) of $10,000 each year. The IRS also assessed continuation penalties under section 6038(b)(2) totaling $50,000 for each year at issue. The continuation penalty is $10,000 for each 30 days the taxpayer doesn’t comply after an initial 90-day notice period, subject to a maximum of $50,000.
Farhy didn’t dispute that he did not file nor that he had not paid. Instead, he challenged whether the IRS had the legal authority to assess section 6038 penalties.
Here’s where words matter. The IRS contended that the term “assessable penalties” includes any penalties found in the Code that are not subject to the Code’s deficiency procedures. The IRS also argued that “taxes” in section 6201(a)—which authorizes and requires the Secretary of Treasury to make assessments of all taxes, including interest, additional amounts, additions to tax, and assessable penalties—is broad enough to include section 6038 penalties. They further claimed that the legislative history supported this position.
The Court disagreed.
It’s important to understand the distinction at play here. When a tax—including an additional amount, addition to tax, assessable penalty, or interest—is assessed, the IRS may take certain actions to collect the tax administratively—that’s clear from the statute. That can include levies, as was attempted here.
Ultimately, the question then wasn’t whether the penalties were included in the statute (they are) but whether the IRS can assess and collect those penalties by administrative means. The Tax Court didn’t buy the IRS’ argument that it has the authority to levy those penalties systematically, nor that the agency didn’t need to take additional steps, such as civil litigation, to collect. “Simply put,” the Court wrote, “while section 6038(b) provides for penalties, it does not provide for assessable penalties.”
That was a huge finding for the taxpayer and raised questions about other kinds of assessable penalties—precisely the issue raised in Mukhi.
Initial Mukhi Findings
By the time Mukhi rolled around, the IRS recognized that Farhy could prove to be a problem—and it was. Referencing stare decisis—a Latin phrase meaning “to stand by things decided”—the Court decided not to delve too deeply into the merits, signaling that it would follow its decision in Farhy.
The Court did examine and reject Mukhi’s Eighth Amendment arguments. Notably, it ruled that section 6677 penalties were not fines, having “consistently found that the purpose of civil tax penalties and additions to tax is to encourage voluntary compliance, and therefore they are not punitive.” (The Court referred back to the U.S. Court of Appeals for the First Circuit, which found that penalties for failure to file an FBAR with the IRS are not fines.)
The Court then held that section 6677 penalties (not fine) were not excessive because they “have consistently held that similar penalties are not disproportionate to the fraud on the government and harm caused on the public fisc.” So, even if the section 6677 penalties were to be considered fines, the Court ruled they do not violate the Excessive Fines Clause.
Farhy Appeals
Farhy’s story did not end in Tax Court. The case eventually moved to the U.S. Court of Appeals for the D.C. Circuit, which reversed the Tax Court’s decision. The IRS then filed a motion for reconsideration in Mukhi, hoping for a different result. The Tax Court did not bite.
In its supplemental opinion issued on November 18, 2024, the Tax Court declared that it didn’t have to follow the D.C. Circuit’s Farhy ruling, writing, “An appeal from this decision would lie in the Eighth Circuit, and therefore, we are not bound… to follow the decision of the D.C. Circuit.”
However, the Court noted that since its original decision in Mukhi was based on Farhy—which was overturned—it would grant the IRS’ motion for reconsideration.
In the opinion, the Court again rejected the idea that section 6201(a) “authorizes the IRS to assess all exactions found in the Code.” The Court went on to note that, in section 6038, “There is no text demanding that the penalty be treated as an assessable penalty, there is no text indicating the penalty should be treated as a tax, and there is no text directing the taxpayer to pay the penalty in a manner like a tax.” The Court found that it was clear that Congress did not grant the IRS authority to assess the section 6038(b)(1) penalty.
The Court also opted to “take this opportunity to address the policy concerns advanced by the D.C. Circuit” in light of the most recent ruling. Notably, the Court took aim at the D.C. Circuit’s suggesting that the Tax Court’s earlier ruling would render the penalty “largely ornamental.” According to the D.C. Circuit, the Department of Justice (DOJ) would not be “incentivized to bring a collection action because of the meager $10,000 penalty.” But, as the Tax Court noted, that fails to account for the accumulation of penalties over several tax years—Mukhi, for example, was hit with penalties over 12 years, resulting in $120,000 in penalties. (Farhy was dinged with eight years of penalties totaling $80,000.)
And the Tax Court pointed out, the $10,000 section 6038(b)(1) penalty is comparable with other DOJ penalties, including those related to FBARs. Failure to timely file an FBAR can result in penalties, as Mukhi well knows, including a $10,000 nonwillful failure to file penalty.
With that, the Tax Court affirmed its holding that the IRS lacks the statutory authority to assess the penalty under section 6038(b)(1). Additionally, the Tax Court held that the IRS could not continue to collect the penalties against Mukhi through a lien or a levy (as initially proposed).
The case is Mukhi v. Commissioner of Internal Revenue (163 T.C. No. 8, November 18, 2024).
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