By Anthony Diosdi
Internal Revenue Code Section 6038 requires certain persons to provide the Internal Revenue Service or IRS with information regarding foreign corporations. This information is typically provided on Form 5471, Information Return of U.S. Persons With Respect to Certain Foreign Corporations. The Form 5471 is attached to a U.S. tax return. The penalty for failure to file, or for delinquent, incomplete or materially incorrect filing is a reduction of foreign tax credits by ten percent and a penalty of $10,000. An additional $10,000 continuation penalty may be assessed for each 30 day period that noncompliance continues up to $60,000 per return, per year.
Similarly, Internal Revenue Code Section 6038A requires 25 percent foreign-owned domestic corporations and limited liability companies to report specified information as an attachment to a corporate tax return. This is done on Form 5471, Information Return of a 25% Foreign-Owned U.S. Corporation or a Foreign Corporation Engaged in a U.S. Trade or Business. In filing a Form 5472, the filer must provide information regarding its foreign shareholders, certain other related parties, and the dollar amounts of transactions that it entered into during the taxable year with foreign related parties. The penalty for failing to timely file a Form 5472 is $25,000 for each 30-day period. There is no upper limit on this penalty.
Originally, penalties associated with Form 5471 and Form 5472 (hereinafter “international penalties”) were assessed manually on individuals and entities whose missing filings were discovered during an audit. The IRS is still assessing international penalties during audits. However, recently, the IRS began a systemic assessment of international penalties associated with the late filing of these returns. Penalties associated with Form 5471 and Form 5472 are classified as “assessable penalties” meaning that the IRS can assess and collect these penalties without providing an individual an opportunity for prepayment Tax Court judicial review.
Reasonable Cause Defense
It is common for taxpayers who have been assessed an international penalty to send the IRS a protest letter claiming they acted with “reasonable cause” and request the removal of the penalty. This is easier said than done. In order to obtain an abatement or removal of an international penalty, the individual assessed an international penalty must establish he or she acted with “reasonable cause.” Whether an individual or entity acted with “reasonable cause” is a question of fact. See Treas. Reg. Section 301.6651-1(c)(1). For example, reliance on a professional tax return preparer (such as a CPA or attorney) as to whether or not to file a Form 5471 should constitute “reasonable cause” for purposes of removing an international penalty.
Thus, in theory, if an individual assessed an international penalty can show that he or she exercised reasonable cause, an international penalty should not be assessed. The problem is for purposes of abating or removing an international penalty, for some reason, the IRS has recently taken a very narrow view as to what constitutes “reasonable cause.” In many cases, this has made it is extremely difficult to convince the IRS to remove an international penalty on reasonable cause grounds.
Does the IRS Have the Authority to Assess and Collect an International Penalty?
If a taxpayer disagrees with an international penalty assessment, he or she has the option to pay the international penalty in full, file an administrative refund claim, and sue the government for a refund of the penalty in either a United States district court or Court of Federal Claims. This solution is often easier said than done. In many cases, individuals assessed an international penalty do not have the financial ability to fully pay the penalty. In addition, there is a great deal of uncertainty if the federal courts will more generously apply the “reasonable cause” standard than the IRS for purposes of removing an international penalty.
Fortunately, individuals or entities that have been assessed international penalties may have another option to contest international penalties. That is, in the view of the National Taxpayer Advocate and others, international penalties are not the type that may be systematically assessed by the IRS. To better understand this argument, we will need to take a deeper dive into how the IRS is permitted to assess penalties under the Internal Revenue Code.
The authority to summarily assess a penalty related to international penalties is found in Chapter 68, Subchapter B, of the Internal Revenue Code titled “Assessable Penalties.” Chapter 68 permits the IRS to assess and collect penalties “in the same manner as taxes” without first sending a notice of deficiency to an individual or business assessed a penalty. See IRC Section 6671(a). According to Chapter 68 of the Internal Revenue Code, summary assessments are made without a deficiency determination and “shall be paid upon notice and demand…and collected in the same manner as taxes.” Chapter 68, Subchapter A of the Internal Revenue Code permits the IRS to assess penalties for the failure to file or pay tax, understatements or underpayments of tax, and assess civil fraud penalties. However, in the view of the National Taxpayer Advocate, penalties associated with international information returns are not located in Chapter 68 of the Internal Revenue Code and therefore cannot be assessed and collected by the IRS. See The IRS’s Assessment of International Penalties Under IRC Sections 6038 and 6038A Is Not Supported by Statute, and Systemic Assessments Burden Both Taxpayers and the IRS Taxpayer Advocate Service- 2020 Annual Report to Congress. Since assessment of international penalties are not authorized in Chapter 68 of the Internal Revenue Code, the IRS is not authorized to assess and collect international penalties. If Congress wanted the IRS to have the ability to assess and collect international penalties it certainly would have authorized the IRS to do so in the Internal Revenue Code. But this is not the case.
A number of highly respected legal commentators have questioned the IRS’s assessment and collection of international penalties. For example, on July 9, 2018, Tax Notes, published an article by Erin Collins and Garrett Hahn. See Collins and Hahn, “Foreign Information Reporting Penalties: Assessable or Not?” Tax Notes, July 9, 2018, p. 211. In their view, the IRS does not have the authority to collect international penalties discussed in Internal Revenue Code Sections 6038 and 6038A. The only way that the IRS can collect a foreign information reporting penalty is by authorizing the United States Department of Justice to sue an individual or entity to collect the penalty in a district court. Collins and Han also raise the possibility that the ten year assessment period is legally dubious and subject to challenge.
In November 2018, Frank Agostino and Phillip J. Colasanto published an article suggesting that international penalties should be subject to the deficiency procedures. See Agostino and Colasanto, “The International Information Reporting Penalties: Is the IRS’s Failure to Embrace a One-Stop Shopping Paradigm Inefficient and Statutorily Deficient? Agostino & Associates (Nov. 2018). Agostino and Colasanto essentially take the position that since a Form 5471 and Form 5472 is attached to a tax return, the deficiency procedures for these penalties. In other words, an individual assessed a penalty associated with a Form 5471 or Form 5472 should have the right to petition the Tax Court and challenge these penalties before the IRS can collect an international penalty.
On January 31, 2019, Tax Notes published an article by Robert Horwitz arguing that the IRS that international penalties are not a tax and are not therefore collected in the same way as a tax. Thus, the IRS is not authorized to assess international penalties and the IRS cannot file tax liens or collect them through a levy. See Robert Horwitz, Can the IRS Assess or Collect Information Reporting Penalties? Tax Notes Today (Jan. 31, 2019) 301-305.
Although each of these legal commentators follow slightly different analytical paths, they all arrive at the same conclusion- the IRS lacks the legal authority to assess and collect most if not all international penalties. See The IRS’s Assessment of International Penalties Under IRC Sections 6038 and 6038A Is Not Supported by Statute, and Systemic Assessments Burden Both Taxpayers and the IRS Taxpayer Advocate Service- 2020 Annual Report to Congress. “ To sum it up, the argument is very simple to these types of penalties, “if it ain’t in the [Internal Revenue Code], it doesn’t exist.” Consequently, it appears that the IRS has been illegally using its collection powers for quite some time to automatically assess a penalty that has not been granted to it by the Internal Revenue Code. See Information Return Penalty Assessment Fight Coming to a Head, Tax Notes, November 28, 2022. The fact that the IRS has been illegally using its powers to assess and collect international penalties provides taxpayers assessed these penalties a very real possibility to challenge these assessments.
Unfortunately, challenging the IRS’s legal authority to assess an international penalty cannot probably be done through a simple protest letter. Taxpayers facing an international penalty will probably either need to challenge these penalties through an administrative hearing (such as an appeals conference or a Collection Due Process Hearing) or may need to litigate these penalties in court. In some cases, this may impose an unreasonable burden on taxpayers. The only “good news” – if you want to call it good news- is that in many cases taxpayers assessed an international penalty will not need to pay the penalty in full before challenging the IRS’s legal authority to contest the penalty.
The IRS has recently begun to automatically assess penalties associated with not timely filing a Form 5471 or Form 5472. These penalties are stiff and can range from a few thousand dollars to several million dollars. For many, paying these penalties is not an option. In certain cases, individuals and entities can attempt to challenge the IRS’s legal authority to assess international penalties in a federal court. Anyone considering petitioning a federal court to contest an international penalty should begin preparing right after the penalty is assessed. Preparation should include investigating any possible defenses to the international penalty.
We have substantial experience advising clients ranging from small entrepreneurs to major multinational corporations in foreign tax planning and compliance. We have also provided assistance to many accounting and law firms (both large and small) in all areas of international taxation.
Anthony Diosdi is one of several tax attorneys and international tax attorneys at Diosdi Ching & Liu, LLP. Anthony focuses his practice on domestic and international tax planning for multinational companies, closely held businesses, and individuals. Anthony has written numerous articles on international tax planning and frequently provides continuing educational programs to other tax professionals.
He has assisted companies with a number of international tax issues, including Subpart F, GILTI, and FDII planning, foreign tax credit planning, and tax-efficient cash repatriation strategies. Anthony also regularly advises foreign individuals on tax efficient mechanisms for doing business in the United States, investing in U.S. real estate, and pre-immigration planning. Anthony is a member of the California and Florida bars. He can be reached at 415-318-3990 or email@example.com.
This article is not legal or tax advice. If you are in need of legal or tax advice, you should immediately consult a licensed attorney.
By Anthony Diosdi