Defenses to Section 6038 IRS Penalties
Administratively, the IRS continues to devote significant resources to catching taxpayers who have failed to properly file international information returns (e.g., Forms 5471, Forms 8865, Forms 3520, etc.). Don’t believe me? Just look at the uptick in federal court cases associated with these information returns and the IRS’ attempts to assess civil penalties against taxpayers who have not timely filed.
For example, the Western District of Texas only months ago issued its decision in Colliot v. U.S., No. 1:19-cv-212-LY (W.D. Tex. Mar. 24, 2021). In that case, the IRS sought to impose over $400,000 of civil penalties against a taxpayer for his failure to file Forms 5471 and Forms 8865 for 6 years under section 6038 of the Code. Only months later, the United States Tax Court issued its memorandum opinion in Kelly v. Comm’r, T.C. Memo. 2021-76, which also involved a taxpayer’s non-failure of Forms 5471 under section 6038. However, in that case, the IRS was not attempting to impose civil penalties against the taxpayer—rather, the IRS was attempting to utilize section 6501(c)(8) and its extension of the general three-year statute of limitations period for assessment indefinitely until a taxpayer files the Form 5471.
Not only do these two decisions provide support that section 6038 issues are here to stay, they also offer some lessons and insights to taxpayers who are attempting to defend against civil penalties under section 6038. Accordingly, these two decisions are discussed in more detail below.
Before going into the facts and issues of Colliot and Kelly, it is important to have a good understanding of section 6038 itself. Under that provision, if a taxpayer fails to file a Form 5471 (for his or her reportable interests in a foreign corporation) or Form 8865 (for his or her reportable interests in a foreign partnership), the taxpayer may be liable for civil penalties of $10,000 per failure to timely file. See I.R.C. § 6038(b)(1). By way of example, if a taxpayer failed to file Form 5471 for 2017, 2018, and 2019, the IRS could assess $30,000 of cumulative civil penalties against the taxpayer, or $10,000 per year, per failure to timely file.
The Colliot Decision.
In Colliot, the IRS had assessed $410,000 of section 6038 civil penalties against Mr. Colliot for his failure to timely file Forms 5471 and Forms 8865. After the IRS assessed the penalties and Mr. Colliot made full payment to the IRS of the civil penalty amounts, he filed an IRS Form 843, Claim for Refund and Request for Abatement, which sought a full refund of the civil penalties from the IRS. The IRS failed to respond to his claim for refund, and Mr. Colliot filed a lawsuit against the United States.
In his complaint, Mr. Colliot contended, among other things, that the IRS failed to comply with section 6751(b) of the Code. That provision requires IRS managers to approve of certain civil penalties prior to notifying the taxpayer of the civil penalty determination. After the conclusion of discovery, Mr. Colliot and the IRS both moved for summary judgment on the section 6751(b) claim.
The federal district court held in favor of the United States on the grounds that Mr. Colliot’s claim was barred by the doctrine of variance. Under that doctrine, federal courts lack jurisdiction over refund claims unless the taxpayer strictly complies with the requirements and procedures to timely file administrative claims for refund with the IRS. And, under these governing provisions, the taxpayer must raise all arguments or contentions first during the administrative refund claim process. See, e.g., Mallette Bros. Constr. Co. Inc. v. U.S., 695 F.2d 145, 155 (5th Cir. 1983). Here, Mr. Colliot’s administrative claim provided that
to the extent the IRS is unable to satisfy its burden of production for showing that the approval requirement of Section 6751(b) has been satisfied with respect to penalties assessed under Section 6038(b) for the year in question, the taxpayer reserves and asserts his right to a refund of such amounts.
Although Mr. Colliot apparently sought to preserve his section 6751(b) argument as part of his refund claim, the federal district court concluded that the above language was not sufficient in that “Colliot’s administrative refund claims each fail to specifically identify which of the Entities or years that Colliot alleges the IRS failed to provide notices of the penalties.”
Moreover, the federal district court concluded that even if Mr. Colliot had properly raised the section 6751(b) contentions during his claim for refund, his section 6751(b) contentions would nevertheless fail because the United States had offered summary judgment evidence showing that the IRS complied with the requirements of section 6751(b).
The Kelly Decision.
On June 28, 2021, the United States Tax Court issued its memorandum opinion in Kelly v. Comm’r, T.C. Memo. 2021-76. In that case, the IRS issued a notice of deficiency to Mr. Kelly associated with, among others, his 2008 and 2009 tax years. The parties disputed whether the statute of limitations under section 6501 for the assessment of tax remained open for 2008 and 2009. In this regard, the IRS contended that the statute of limitations was open at the time the notice of deficiency was issued because Mr. Kelly had failed to file Forms 5471 for those years until much later in 2019.
Under section 6501, the IRS generally has three years from the date a return is filed to make an additional assessment of tax or penalties. However, there are exceptions to the general three-year rule under section 6501(c). And, under section 6501(c)(8), if a taxpayer fails to file a Form 5471 for any year in which that information return is required, the IRS may assess additional tax against the taxpayer until the Form 5471 is filed and for three years thereafter. If section 6501(c)(8) applies, it applies to all items on the tax return in question—however, the statute of limitations for assessment remains open only to items on the Form 5471 if the failure to file the Form 5471 was due to reasonable cause.
Predictably, Mr. Kelly argued that his failure to timely file the Form 5471 was due to reasonable cause. More specifically, he contended that he had relied on the advice of a tax professional regarding whether he had a Form 5471 filing obligation. After reviewing the facts and law, the Tax Court concluded that Mr. Kelly did have reasonable cause for his failure to file the Form 5471 for both years.
First, the Tax Court noted that taxpayers may show reasonable cause through reliance on the advice of a tax professional if the taxpayer can show: (1) the adviser was a competent tax professional with sufficient expertise; (2) the taxpayer provided necessary and accurate information to the adviser; and (3) the taxpayer relied in good faith on the adviser’s judgment. See also Neonatology Assocs., P.A. v. Comm’r, 115 T.C. 43, 98-99 (2000). As applied to the facts in Kelly, the Tax Court reasoned:
[The tax preparer] has prepared Mr. Kelly’s personal returns since 2000, including Schedules C for his affiliated companies. [The tax preparer] prepared approximately 700 tax returns per year . . . [The tax preparer] had decades of experience with Federal tax return preparation but had no prior knowledge of Form 5471 in 2009. It was reasonable for Mr. Kelly to rely on . . . [the tax preparer. The tax preparer] was adequately advised that Mr. Kelly owned a Cayman Islands entity.
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[The IRS] contends that it was not enough for Mr. Kelly to inform . . . [his tax preparer that the foreign corporation] was a foreign entity, and he implies that Mr. Kelly should have advised . . . [the tax preparer] that Form 5471 was required. The failure to file the Forms 5471 does not present an obvious tax obligation which was negligently omitted from information that a taxpayer provided to the return preparer. Mr. Kelly, through his staff, provided the necessary information to . . . [the tax preparer,] identified . . . [the foreign corporation] as a foreign corporation, and stated that he was unsure of the reporting requirements. Having done this, Mr. Kelly reasonably relied on . . . [the tax preparer] to prepare his returns properly.
Because the Tax Court concluded that Mr. Kelly had reasonable cause for the failure, the Tax Court refused to permit the IRS to go beyond the general three-year period for assessment of additional tax, other than the items that were reported on the late-filed Forms 5471.
The decisions in Colliot and Kelly demonstrate that the IRS will continue to fight for the assessment of civil penalties and additional tax under section 6038. When these issues are front and center, taxpayers should raise all arguments against imposition of the penalties. As Colliot shows, this is particularly important if the taxpayer intends to pay the section 6038 penalties and then seek a refund of those penalties. And, as the decision in Kelly shows, sometimes a plain-vanilla reasonable cause defense can be the best defense of all.