In a holding by the US Tax Court on April 8, 2024, the case of Raju J. Mukhi v. Commissioner of Internal Revenue brought into sharp focus the principle of stare decisis and its implications for tax law. The Tax Court rejected the IRS’ assessment of penalties under Section 6038(b), for failure to file Form 5471 which reports information about certain foreign corporations.
Stare decisis, a Latin term meaning “to stand by things decided,” is a foundational principle in the American legal system. It dictates that courts should adhere to precedent and previous rulings when deciding similar cases. This principle ensures consistency, predictability, and fairness in the application of the law and saved the taxpayer on the Form 5471 penalty (albeit a small dollar number compared to the other international tax reporting penalties he faced).
Central to the Mukhi case was the precedent set by the Tax Court a year ago almost to the date, with its decision in Farhy v. Commissioner, 160 T.C. No. 6 (April 3, 2023). The Farhy decision significantly impacted the interpretation and application of tax penalties and established that the penalty for failure to file Form 5471, was not an “assessable penalty”. It was also not the type of penalty subject to deficiency procedures. Under such circumstances, the only recourse available to the government to recover the penalties is through a civil action. The Tax Court in Mukhi followed its earlier decision in Farhy.
The area of tax penalties can get very confusing. Below are some basics in a nutshell that will help readers understand the importance of the Farhy and Mukhi decisions.
What is an “Assessable Penalty”?
When the IRS advises a taxpayer that he owes taxes and penalties, this is called an “assessment”. When a penalty is an “assessable” penalty, it must be paid upon notice and demand and assessed and collected in the same manner as taxes. An assessable penalty can be imposed on a taxpayer by the IRS without the need for any further administrative or judicial action.
The IRS can simply assess a penalty without going through any additional procedures. Various methods can be used to collect the amounts owed if the taxpayer does not pay. Collection remedies include wage garnishment and placing a lien on the taxpayer’s property (for example, a residence, bank or brokerage account).
Generally, the IRS will send IRS Notice CP15 to notify a taxpayer that a penalty was assessed, explain why it was assessed and demand payment. Various actions can be taken by the taxpayer in response. If the taxpayer wishes to dispute the penalty it must be paid first, and then a claim for refund filed with IRS. If not paid, a Collection Due Process notice will follow upon non-payment of the penalty.
What are Deficiency Procedures?
A penalty requiring “deficiency procedures” is a penalty that can only be imposed on a taxpayer after a formal deficiency notice has been issued advising the potential assessment and detailing the taxpayer’s options. The taxpayer has an opportunity to dispute the proposed deficiency (without having to immediately pay up) and have the matter resolved through administrative or judicial proceedings (for example, petitioning review by the Tax Court).
In summary, the main difference between an assessable penalty and a penalty requiring deficiency procedures is that the former can be imposed (and collected through an arsenal of collection devices such as wage garnishment and levy) without any further action. The latter requires a formal deficiency notice and subsequent proceedings to be resolved.
Civil Action – A Long Road for the IRS
When penalties are not assessable or subject to deficiency procedures, IRS must pursue the penalty collection by going to court. When pursuing penalties through a civil suit, the IRS is faced with a time consuming and burdensome task. IRS must refer the penalty case to the Department of Justice (DOJ), which must then sue the taxpayer in federal court to collect the penalties.
The penalty for failing to file Form 5471 is a $10,000 per annum penalty. The penalties can skyrocket, however, when multiple corporations and tax years are involved and when the taxpayer does not respond to IRS notices. Chances are that the IRS will not refer the smaller cases to DOJ for the average taxpayer with an interest in a foreign corporation who failed to file the form. Given the small amount at stake, DOJ will likely have no interest in pursuing the typical Form 5471 penalty case.
How to Know if a Penalty is “Assessable”?
There is not an easy answer to this question. Various sections of the Internal Revenue Code specify when a penalty is an assessable penalty by providing a listing of penalties that are “assessable”. If the penalty is not on the list, it does not necessarily mean the penalty is not assessable. One must dig deeper and find the Code section that imposes the specific penalty. The language of that section must be carefully examined to determine if it contains certain language rendering the penalty as assessable. My blog post here explains this topic in greater detail.
Posted April 18, 2024
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