For four decades, the IRS treated penalties for failing to report foreign corporations the same way it treats most penalties. It assessed them and collected them, with liens and levies if necessary. In 2023 the Tax Court said the IRS had no authority to do that. In Farhy v. Commissioner, the D.C. Circuit said the Tax Court was wrong.
The Facts
Alon Farhy, a U.S. permanent resident, set up a scheme beginning in 2004 to underreport income from exercising stock options. He transferred more than $2 million to a sham foreign entity, which moved the money to an account of a Belize corporation he created. He did not report his control of foreign financial accounts and foreign corporations. In 2012 he signed a non-prosecution agreement with the Justice Department's Tax Division that required him to cooperate and pay applicable taxes, interest and penalties.
On February 9, 2016, the IRS notified him that he had failed to file forms disclosing his ownership of the Belize corporations for 2003 through 2010, as required by IRC § 6038(a). More than two years later, still without the forms, the IRS assessed penalties under § 6038(b) totaling $60,000 per year of noncompliance. Farhy acknowledged he owed nearly $500,000.
The IRS sent a notice of intent to levy. Farhy requested a Collection Due Process hearing, and Appeals sustained the levy. In the Tax Court, he raised one argument: the IRS had no statutory authority to assess § 6038(b) penalties, so it had to sue him in federal district court to collect. The Tax Court agreed.
The Issue
Are penalties under § 6038(b) assessable by the IRS, or must the government file a lawsuit to collect them?
The Holding
Judge Pillard wrote for the court: "We hold that the text, structure, and function of section 6038 demonstrate that Congress authorized assessment of penalties imposed under subsection (b), and so reverse and remand to the Tax Court with instructions to enter decision in favor of the Commissioner."
What the Tax Court had held
The Tax Court reasoned that Congress explicitly authorized assessment for many penalties throughout the Code but did not do so for § 6038(b). That meant, in its view, the IRS could collect these penalties only through a civil action brought by the Department of Justice under 28 U.S.C. § 2461(a), the general statute authorizing suits to recover civil penalties, and not through the administrative collection methods it had used for more than forty years.
The Reasoning
Why assessment matters
The court explained that assessment is "the cornerstone of the government's tax collection authority." It is the official recording of a liability, and it sets in motion the IRS's collection powers, including liens and levies, without judicial process. IRC § 6201(a) authorizes assessment of "all taxes (including interest, additional amounts, additions to the tax, and assessable penalties)."
Subsection (b) was meant to be the easy penalty
Section 6038 originally had only one penalty for failing to file: a reduction of the taxpayer's foreign tax credit, now in subsection (c). Everyone agreed that penalty is assessable. In 1982, Congress added the flat-dollar penalty in subsection (b), now $10,000, increasing with continued failure after notice up to $60,000 per year. Congress did so because the foreign tax credit penalty was complicated and rarely used. Reading subsection (b) to require a lawsuit for every case would make the new penalty harder to enforce than the old one. Farhy's counsel conceded at argument that the Justice Department "wouldn't touch that with a ten-foot pole."
Many penalties are not deficiencies
The court also explained the two paths to prepayment review. If a liability is a "deficiency," the IRS must issue a notice of deficiency and the taxpayer can petition the Tax Court under § 6213(a) before assessment. Many penalties are not deficiencies. The IRS assesses them without waiting for a court, then must give notice and demand for payment within 60 days under § 6303(a). If the taxpayer does not pay, the lien arises under § 6321, and lien and levy notices trigger Collection Due Process rights.
The two penalties are coordinated
Section 6038(c)(3) reduces the subsection (c) penalty by any subsection (b) penalty for the same failure. If (b) penalties required a court judgment first, the IRS could not finish computing the (c) penalty until that lawsuit ended. The court refused to read the statute as having "counterproductively threw sand in the gears" of its own enforcement scheme.
The Secretary decides reasonable cause
Section 6038(c)(4)(B) requires reasonable cause to be shown "to the satisfaction of the Secretary." That only makes sense if the IRS, not a district court, makes the initial penalty decision, which is how an assessable penalty works.
Congress can make a penalty assessable by implication
Farhy argued Congress makes a penalty assessable only in a few standard ways, such as placing it in Chapter 68 of the Code or saying it "shall be assessed." The court rejected that framework. It pointed to § 6038D, which imposes a similar $10,000 penalty for failing to report specified foreign financial assets. Section 6038D(e) sets a presumption that applies "for purposes of assessing the penalties imposed under this section." Without ruling on it, the court said that language would seem to make it "quite plausible" that § 6038D penalties are assessable as well. "Congress can make a penalty assessable by implication, and it did so here."
Forty years of acquiescence
The court added that since 1982, Congress had amended § 6038 seven times without disturbing the IRS's practice of assessing and administratively collecting § 6038(b) penalties.
What It Means for Taxpayers Today
International information penalties are real collection debts
If you own or control a foreign business and fail to file the required information returns, assume the IRS can assess the penalty and collect it with liens and levies, as it did with Farhy. The penalty is per year and stacks quickly.
Your challenge route is CDP and the Tax Court
Because these penalties are assessed without a notice of deficiency, your main prepayment forum is a Collection Due Process hearing after a lien or levy notice, followed by Tax Court review. The court noted that a taxpayer can provide a reasonable cause narrative during the CDP hearing. Request the hearing on time; see Boechler v. Commissioner on the deadline.
The assessment statute may still be open
Do not assume old years are closed. Under IRC § 6501(c)(8), when information required under § 6038 and certain other international reporting provisions is not furnished, the time to assess tax for the related return, event or period does not expire until 3 years after the IRS receives the information. If the failure was due to reasonable cause and not willful neglect, that extension applies only to the related items.
Reasonable cause is the main defense
The IRS's international penalty procedures are in IRM 20.1.9, and the general penalty relief rules are in IRM 20.1.1. Document why the forms were not filed, and file them. Farhy never did, which is why the continuation penalties kept running. If you have unreported foreign accounts as well, see our discussion of foreign account reporting and the FBAR cases in this library.
The Bottom Line
Farhy briefly looked like a loophole for anyone facing international information penalties. The D.C. Circuit closed it. Where that decision applies, the IRS can assess these penalties and collect them like any other tax debt. The better path is the one Farhy never took: file the forms, and make the reasonable cause case early.