By Anthony Diosdi
The law permits the Internal Revenue Service or “IRS” to proceed with enforced collection actions on individuals or business entities that have outstanding legally assessed taxes or penalties. Enforced collection actions often include the filing of tax liens, the seizure income, bank accounts, and property to secure the payment of an outstanding federal tax liability. The IRS’s authority to proceed with enforced collect actions has its limitations. It must have statutory authority to assess and collect the tax or penalty at issue.
The IRS has been aggressively automatically assessing penalties against individuals and businesses for failing to timely file Forms 3520, 5471, and 5472. The IRS’s legal authority to assess and collect these penalties have been questioned by the IRS Taxpayer Advocate and a number of nationally recognized tax attorneys. The IRS’s ability to assess and collect these penalties is currently being litigated before the United States Tax Court. See Farhy v. Commissioner (Docket No. 10647-21L). This article will discuss whether individuals subject to IRS enforced collection action associated with the assessment of a Section 3520, 5471, or 5472 penalty (hereinafter referred to as “international penalties”) are entitled to seek damages from the IRS under Section 7432 and/or Section 7433.
An Overview of International Penalties
Chapter 61 of the Internal Revenue Code contains countless reporting requirements regarding foreign information filing obligations. Many of the sections under Chapter 61 impose significant penalties for the failure to comply with the reporting requirements. The more well known reporting requirements and penalties are found in Chapter 61 and are as follows:
The Internal Revenue Code 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 and schedules are used to satisfy the reporting requirements of Internal Revenue Code Section 6038 and 6046 along with the applicable regulations. Substantively, Form 5471 backstops various international provisions of the Internal Revenue Code such as Sections 901/904 (Foreign Tax Credit), Section 951(a) (Subpart F and Section 956), Section 951A (GILTI), Section 965 (transition Tax), Section 163(j) (interest deduction limitation), and Section 482 (transfer pricing). International information returns that often are associated with Form 5471s include Form 926 (Return by a U.S. Transferor of Property to a Foreign Corporation), Form 5713 (International Boycott Report), Form 8621 (PFIC), Form 8990 (Limitation on Business Interest Expense), and Forms 1116/1118 (Foreign Tax Credit).
In the Form 5471, at a minimum, as per Treasury Regulation Section 1.6038-2(f) and (g), the reporting agent must provide the following information regarding a foreign corporation:
i) Stock ownership, including current year acquisition and dispositions,
ii) The names of U.S. shareholders,
iii) GAAP income statement and balance sheet,
iv) An accounting of foreign taxes accrued and paid,
v) Current and accumulated earnings and profits, including any actual dividend distributions during the corporation’s taxable year,
vi) An accounting of each U.S. shareholder’s pro rata share of GILTI and Subpart F income, and
vii) Disclosure of any transactions between the foreign corporation and its shareholders or related persons.
The Form 5471 is ordinarily attached to a U.S. person’s federal income tax return. See Treas. Reg. Section 1.6038-2(i). 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, as well as a reduction in the taxpayer’s foreign tax credit. See Treas. Reg. Section 1.6038A-2(a). 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. A separate Form 5472 is filed for each foreign or domestic related party with which the reporting entity engaged in reportable transactions during the year. See VI.B.1 of Notice 97-34. The practical importance of the Form 5472 is that the IRS often uses this form as a starting point for beginning transfer pricing audits. See IRM, International Audit Guidelines Handbook, April 1, 2022, 4.61.3. Any reporting corporation or limited liability company that fails to file Form 5472 may be subject to a penalty of $25,000. See IRC Section 6038A(d); Treas. Reg. Section 1.6038A-4(a). If the failure continues for more than 90 days after notification by the IRS, there is an additional penalty of $25,000 for each 30 day period or fraction. There is no upper limit on this penalty.
Another well known provision in Chapter 61 is Section 6039F. Section 1905 of the 1996 Tax Act created new reporting requirements under Section 6039F for U.S. persons (other than certain exempt organizations) that receive large gifts (including bequests) from foreign persons. The information reporting provisions require U.S. donees to provide information concerning the receipt of large amounts that the donees treat as foreign gifts, giving the IRS an opportunity to review the characterization of these payments and determine whether they are properly treated as gifts. Donees are currently required to report certain information about such foreign gifts on Part IV of Form 3520.
Section 6039F(b) generally defines the term foreign gift as any amount received from a person other than a U.S. person that the recipient treats as a gift or bequest. However, a foreign gift does not include a qualified transfer (within the meaning of Section 2503(e)(2)) or any distribution from a foreign trust. A distribution from a foreign trust must be reported as a distribution under Section 6048(c)(discussed below) and not as a gift under Section 6039F.
Section 6039F(c) provides that if a U.S. person fails, without reasonable cause, to report a foreign gift as required by Section 6039F, then (i) the tax consequences of the receipt of the gift will be determined by the Secretary and ii) the U.S. person will be subject to a penalty equal to 5 percent of the amount for the gift for each month the failure to report the foreign gift continues, with the total penalty not to exceed 25 percent of such amount. Under Sections 6039F(a) and (b), reporting is required for aggregate foreign gifts in excess of $100,000 during a taxable year. Once the $100,000 threshold has been met, the U.S. donee is required to file a Form 3520 with the IRS.
Originally, penalties associated with Form 5471, Form 5472, and Form 3520 (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. Several years ago the IRS began a systemic assessment of international penalties associated with the late filing of these returns. The systemic assessment of international penalties is controversial. Many taxpayers are unaware of their international reporting obligations and learn of their filing obligations after the due date of the filing obligation has already passed. Many of these same taxpayers often try to comply with their international filing obligations by filing an international informational return (i.e. Form 5471, Form 5472, and Form 3520) late. The IRS typically rewards these same taxpayers “trying to do the right thing” by automatically assessing international penalties against them. These penalties can range from a minimum of $10,000 to several million dollars. The policy of automatically assessing international penalties discourages compliance. Not only does the summary assessment procedure for international penalties discourage compliance, for reasons discussed below, the summary assessment and collection of international penalties probably exceeds the IRS’s statutory authority.
Does the IRS Have the Legal Authority to Assess and Collect International Penalties?
The IRS treats international penalties as summarily assessable, as they are not subject to deficiency procedures, wherein taxpayers receive a notice of deficiency alerting them of the potential assessment and explaining the taxpayer’s options for contesting or complying with the penalty assessment. The notice of deficiency also informs taxpayers of the last day to petition the United States Tax Court for pre-assessment and prepayment judicial review. Many penalties related to income tax filings are not summarily assessable (that is, they are generally subject to deficiency procedures). For example, deficiency procedures typically apply when the IRS determines noncompliance of a taxpayer resulted in an underpayment of some type of tax. Common penalties associated with the issuance of a notice of deficiency include an accuracy or negligence penalty under Section 6662 of the Internal Revenue Code. In other words, typically the IRS is required to issue a taxpayer a notice of deficiency and permit the taxpayer the ability to challenge an assessment before initiating collection actions.
Summarily assessable penalties are primarily found in Internal Revenue Code Section 6671 through 6720C. Chapter 68, Subchapter B, titled “Assessable Penalties,” authorizes the IRS to assess and collect penalties “in the same manner as taxes” without first sending a notice of deficiency. Summary assessments are made without the issuance of a notice of deficiency and “shall be paid upon notice and demand and collected in the same manner as taxes.” Most of these “penalties” are included in Chapter 68 of the Internal Revenue Code. Chapter 68, Subchapter A, titled “Additions to the Tax and Additional Amounts,” which allows the IRS to impose penalties for failure to file or pay tax, understatements or underpayments of tax, and penalties for fraud. However, Chapter 61 penalties are not located in Chapter 68 of the Internal Revenue Code and are not therefore assessable penalties.
The IRS believes it has a grant of authority to assess international penalties under Internal Revenue Code Section 6201(a). This provision of the Internal Revenue Code permits the IRS to assess tax as well as interest and penalties. In NFIB v. Sebelius, 567 U.S. 519 (2012), 546, the United States Supreme Court agreed that the plain language of Section 6201 places assessable penalties within the definition of a tax for purposes of granting the IRS the authority to assess those penalties. As a result, the IRS has taken the position that NFIB v. Sebelius authorized it to summarily assess and collect international penalties found in Chapter 61 of the Internal Revenue Code without the issuance of a notice of deficiency.
This interpretation is overbroad and misplaced. The IRS’s ability to assess a penalty and collect an assessment are two distinct matters. See Erin Collins and Garrett Hahn, Foreign Information Reporting Penalties: Assessable or Not? Tax Notes Today (July 9, 2018) 211-213. Section 6201 authorizes the collection of assessable penalties found in Chapter 68, Subchapter B. Section 6201 does not provide the IRS with the authority to assess and collect international penalties authorized in Chapter 61 of the Internal Revenue Code. The IRS also does not have the authority to assess or collect international penalties found in Chapter 61 of the Internal Revenue Code because these penalties cannot be classified as a tax. Since international penalties cannot be characterized as a tax, these penalties cannot be assessed or collected in the same way as a tax. See Robert Horwitz, Can the IRS Assess or Collect Foreign Information Reporting Penalties? Tax Notes Today (Jan 31, 2019) 301-305. This not only means that the IRS does not have the authority to collect international penalties found in Chapter 61, the IRS does not have the authority to file corresponding liens or levies in connection with an international penalty assessment. This also means that the collection due process procedures in connection with an international penalty assessment are not valid. See Id.
It appears that the IRS’s only recourse to collect an international penalty residing with Chapter 61 would be to ask the Department of Justice to sue the individual or entity assessed an internal penalty. This would involve bringing suit in a United States district court with property venue and asking the court to liquidate the penalty assessment into a judgment.
An Introduction to Sections 7432 and 7433
Although the IRS’s legal authority to assess and collect international penalties is questionable at best, this has not stopped the IRS from proceeding with enforced collection actions to collect international penalties it has automatically assessed. The IRS regularly files tax liens and threatens taxpayers assessed international penalties with enforced collection actions. An IRS lien can harm one’s finances, credit, and can even put a business in jeopardy. IRS enforced collection actions can also cause an individual to suffer irreparable harm. Enforced collection actions include the seizure of income, wages, bank accounts, and property to satisfy an international penalty assessment.
For reasons discussed below, Individuals or businesses assessed an international penalty that are subject to a lien or enforced collection actions in connection to the assessment of an international penalty may potentially recover damages under Section 7432 and/or Section 7433. Typically, the doctrine of sovereign immunity bars actions to recover damages from the misconduct of an officer or employee of the United States. Under this doctrine, the United States or its agencies such as the IRS cannot be sued except where a federal statute has expressly authorized such an action. Although the Federal Tort Claims Act provides jurisdiction to the United States district courts for common law torts committed by a federal employee within the normal course of employment, that statute expressly excludes any claim “arising in respect of the assessment or collection of any tax.” See 28 U.S.C. Section 2680(c). This exclusion has been construed to be intended to insulate the IRS from tort liability stemming from any of its revenue-raising activities. It is with this background that Congress enacted Internal Revenue Code Section 7432 and Section 7433 to permit tort-type actions against the IRS with respect to damages arising from a lien and improper collection actions.
Action Under Section 7432 for Failure to Release a Lien
The United States district courts have exclusive jurisdiction under Section 7432 to hear a cause of action by a taxpayer for damages arising from the knowing or negligent failure of the IRS to release a notice of tax lien as required under Section 6325. Section 6325 establishes a procedure for the release of a tax lien that was appropriate when originally filed, but which has become unenforceable. In general, Section 6325 requires the release of a lien when an assessment is paid or the liability at issue becomes legally unenforceable.
The Internal Revenue Code does not authorize the IRS to assess and collect international penalties. This means that any liens filed in connection with an international penalty is illegal and is legally unenforceable. Does this mean that taxpayers assessed a lien in connection with an international penalty have immediate standing to bring an action in court for damages suffered? Possibly, but first the taxpayer must exhaust its administrative remedies with the IRS. This requires the filing of a written claim or request to release the lien. The claim must be filed with the IRS District Director where the lien was filed. The claim must state in “reasonable detail” the reason the lien should be released, e.g., the lien is not enforceable because the IRS does not have the authority to assess or collect international penalties found in Chapter 61 of the Internal Revenue Code.
The claim must also carefully describe the injuries suffered as the result of the lien. Describing the harm a lien caused is complicated. Section 7432 authorizes a taxpayer to recover “actual, direct economic damages” sustained as a result of the wrongful lien, plus the costs of the action. The term actual, direct economic damages is defined for this purpose as actual pecuniary damages (it must have something to do with money) that would not have been sustained “but for” the actions of the IRS. The statutory “but for” test should be contrasted with the “as a proximate result” language used for damages recoverable under Section 7433 for improper collection actions of the IRS. In general, the damages under Section 7432 include inconvenience, emotional distress, and loss of reputation. A description of these injuries associated with the lien should be clearly stated on the claim. The claim should include any substantiating documentation or evidence providing evidence of the harm the lien caused. The claimant should also provide a dollar amount for the injuries suffered on the claim. This amount should be broken down to include damages incurred and reasonably foreseeable damages.
The IRS must be given at least 30 days to respond to the administrative claim after it has been filed. If the IRS declines the administrative claim or fails to render a decision on the merits of the administrative claim within 30 days after it has been filed, an action can be filed in the appropriate United States district court with proper venue.
Anyone considering filing a Section 7432 claim must understand there are time limitations to filing such a claim. An action under Section 7432 must be commenced within two years after the right of such an action accrues. See IRC Section 7432; Treas. Reg. Section 301.7432-1(i)(1).
Action Under Section 7433 for Improper Collection Actions
If the IRS attempts to proceed with enforced collection to collect an international penalty against an individual or entity to collect an international penalty, the taxpayer may seek damages under Section 7433. The United States district courts have jurisdiction under Section 7433 to hear a cause of action by a taxpayer for damages arising from the reckless or intentional disregard of the Internal Revenue Code or regulations in connection with the collection of a federal tax.
Unlike Section 7432, there is no need to exhaust administrative remedies to file a claim under Section 7433. The assessment and collection of a penalty that is not authorized by law through enforced collection action could be considered improper collection actions for purposes of Section 7433. Under Section 7433, a taxpayer may recover “actual, direct economic damages” sustained, plus the costs of the action, but not in excess of $1 million. See IRC Section 7433(b). Under this standard, injuries such as emotional distress and loss of reputation is compensable only to the extent they result in actual pecuniary (related to money) damages. See Treas. Reg. Section 301.7432-3(b)(1). However, at least one court permitted a Section 7433 claimant to recover punitive damages, even though there were no actual damages. See Mallas v. United States, 993 F.2d 1111 (4th Cir. 1993).
Anyone considering bringing a claim for damages under Section 7433 in connection with an international penalty must understand that there are three limitations that must be satisfied before litigation can commence. First, recovery is not available in a Section 7433 case for negligence or carelessness on the part of an IRS Revenue Officer or an IRS collections employee. Thus, a Section 7433 claimant must be prepared to allege specific acts of recklessness or the intentional disregard of the law. Detailed written communication should be forwarded to any revenue officers or collections employee specifically stating the reasons as to why the IRS does not have the legal authority to assess and collect the international penalty at issue. Logs should also be kept of any communications with IRS collection agents and their managers. In other words, any IRS employee involved in the collection of an international penalty should be put on notice that it is wrongfully assessed and the collection of the international penalty is procedurally incorrect. When it comes time to file a complaint in district court to recover damages under Section 7433, the complaint can provide specific evidence that the IRS employees or officers were put on notice that the international penalty assessment was defective and the collection of the penalty amounts to reckless or the intentional disregard of the Internal Revenue Code.
Second, the action must be based on a violation of the Internal Revenue Code or its regulations. As discussed above in detail, the IRS does not have the authority to assess or collect international penalties found in Chapter 61 of the Internal Revenue Code. Since in theory the IRS does not have the authority to assess or collect international penalties, arguably, attempting to collect an international penalty through enforced collection acts will support a Section 7433 action for damages.
The third, and potentially the most problematic criteria for a district court to secure jurisdiction under Section 7433 is the requirement that the damages arise in connection with the collection of a tax. The IRS believes it has a grant of authority to assess international penalties under Internal Revenue Code Section 6201(a). This provision of the Internal Revenue Code permits the IRS to assess tax as well as interest and penalties. The Supreme Court has agreed that the plain language of Section 6201 places assessable penalties within the definition of a tax for purposes of granting the IRS the authority to assess those penalties. The IRS has taken the position that it is authorized to summarily assess and collect international penalties found in Chapter 61 of the Internal Revenue Code, international penalties should be defined as a tax for purposes of a Section 7433 claim. Whether or not an international penalty is a tax for purposes of a Section 7433 claim is an open question that must be decided by the courts.
Another issue that falls under the third category of a Section 7433 is legislative history of this provision. The legislative history to Section 7433 provides that a claim for intentional or reckless disregard of a Code or regulation provision cannot be based on the determination or assessment of a tax. See HR Conf. Rep. No. 1104, 100th Cong., 2d Sess 229 (1988). Consequently, the IRS may claim that a Section 7433 damage suit is not proper when procedurally correct collection methods are utilized to collect a wrongfully assessed penalty. A number of courts have rejected this type of argument on the grounds that Section 7433 encompasses the disregard of any Internal Revenue Code provision that is connected to the collection of taxes. See Miller v. United States, 763 F. Supp. 1534 (ND Cal. 1991).
Demanding damages from the IRS in a collections case is highly unusual. However, the automatic assessment of international penalties and collection of these penalties are also highly unusual. This may potentially open the door to suits against the IRS airing from the improper collection of international penalty assessments. Anyone considering such an action must understand there are time limitations to bringing such a claim.
An action under Section 7433 must be brought within two years after the right of action accrues. A cause of action accrues when an individual has had a reasonable opportunity to discover all essential elements of a possible cause of action.
Sections 7432 and 7433 provides judicial relief to individuals and businesses that have been harmed for the IRS’s failure to remove a lien and improper collection actions.
Sections 7432 and 7433 potentially permits taxpayers to recover damages in connection with wrongfully assessed international penalties. Requesting damages from the IRS in connection with the collection of an international penalty is no simple task. If you are involved in a controversy involving an international penalty with the IRS, you should consult with a tax attorney well versed in international tax and tax litigation.
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 firstname.lastname@example.org.
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.