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International information return penalties are often thought of as primarily affecting rich people or multinational corporations with significant overseas assets. This is not true. Taxpayers – many of whom are lower- and middle-income individuals, small and midsize business owners, and immigrants – face significant and potentially life-changing penalties, even when they voluntarily comply, for failing to meet obscure and complex foreign information reporting requirements.
As I have discussed in prior blogs and my Annual Report to Congress, these penalties overwhelmingly impact lower- and middle-income individuals and small and midsize businesses who voluntarily come forward. For example, the IRS assesses 71 percent of individual IRC § 6038 penalties against lower- and middle-income taxpayers (those reporting under $400,000 in income). Likewise, it assesses 83 percent of systemic business IRC §§ 6038 and 6038A penalties against small and midsize businesses. These penalties can be huge. For instance, in the foreign gift context, the average penalty for 2018-2021 was more than $235,000 for taxpayers who reported $400,000 or less in income. Many of these penalties bear no relation to any underlying taxable income or liability.
Courts continue to litigate whether IRC § 6038(b) gives the IRS the authority to assess foreign information penalties and whether it can take administrative collection actions against taxpayers. These issues will take time to resolve with finality. (See Farhy v. Commissioner (Tax Court opinion and D.C. Circuit Court of Appeals opinion) and Mukhi v. Commissioner).
The IRS and Congress can and should act now to fix the unfair, draconian penalty regime taxpayers experience with these international information returns. I continue to advocate for the IRS and Congress to apply these penalties in a fair manner by providing taxpayers their rights prior to assessment of the penalties.
U.S. persons who receive money from abroad or who have foreign financial interests or cross-border activities are potentially subject to a range of U.S. reporting requirements. But these taxpayers commonly do not know they are subject to international information reporting requirements and if they do, they do not have the resources to hire tax professionals to help navigate the process. Typically, upon learning of their filing obligation, they voluntarily file the missing information returns – albeit late – only to have their compliance rewarded with a harsh penalty. This is because the IRS has decided to systemically assess many of these penalties, meaning its computer system automatically assesses the penalty upon receipt of a late international information reporting return without any review or action from IRS personnel.
To make matters worse, although the IRS can waive these penalties if taxpayers show they had reasonable cause for the failure to file, it often does not immediately consider requests for reasonable cause relief for international information reporting penalties. Furthermore, the IRS may tell taxpayers they can submit requests for relief, but then it doesn’t consider them and assesses taxpayers the penalty. The result is that taxpayers have to resubmit any defenses later in the process.
The IRS’s cavalier approach is unfair to taxpayers and inefficient for our tax system. By systemically assessing penalties when taxpayers willingly come forward and file their late returns, the IRS discourages voluntary compliance. When taxpayers know that voluntarily filing is going to result in a crushing penalty that is going to be difficult and costly to challenge, how many taxpayers decide not to file and hope the IRS doesn’t find them?
The inefficiency of the existing process is evident because the IRS ultimately abates many of these penalties, often because the agency determines that granting reasonable cause relief is appropriate. The abatement statistics are eye-popping. In the 2023 Annual Report to Congress, TAS found that for the most frequently assessed international information return penalties (IRC §§ 6038 and 6038A), averaged across 2018-2021, the abatement percentage as measured by number of penalties was 74 percent and by dollar value was 84 percent. These high abatement rates indicate there are flawed IRS policies causing overassessment of these penalties. Taxpayers and the IRS expend significant time, energy, and money addressing penalties that the IRS should not have assessed in the first place.
Though the IRS abates so many penalties, taxpayers still experience great financial cost and emotional toll fighting them. Imagine the stress from opening a collection notice from the IRS demanding payment when you believe your reasonable cause statement provided the information necessary to establish that the IRS should not assert the penalty. Imagine the frustration to learn the IRS did not even read your reasonable cause letter, and you are left in limbo wondering whether it will grant relief. And if you happen to live abroad, imagine the challenges created by having to dispute these penalties through administrative procedures and perhaps even in court while residing in a country that may be thousands of miles away, in a different time zone, and in a language that may not be your own.
Sadly, the process is onerous and difficult, and it can be expensive to assert your rights in court. The IRC does not allow the IRS to issue a statutory notice of deficiency (commonly referred to as a ticket to Tax Court), which provides a prepayment avenue to challenge assessment of these penalties. This means that taxpayers generally may only challenge the merits of the penalty in a U.S. district court or the U.S. Court of Federal Claims after paying the penalty in full. There are costs and burdens of having to file suit in these courts, and given how these penalties can substantially add up, requiring full payment puts judicial review out of reach for many taxpayers, directly impairing the taxpayer’s right to challenge the IRS’s position and be heard. It is unconscionable to require taxpayers to fully pay a penalty that can be disproportionate to the tax owed without first giving taxpayers an opportunity to obtain independent judicial review of the IRS’s determination.
Taxpayers generally cannot obtain prepayment review of these penalties after assessment through Collection Due Process (CDP) procedures either. Taxpayers have a right to request a CDP hearing with the Independent Office of Appeals (Appeals) when the IRS files a Notice of Federal Tax Lien or proposes a levy, and they can request judicial review of Appeals’ determination in the Tax Court if they disagree with the determination. The Tax Court has jurisdiction to determine the validity of the assessment (i.e., if the IRS followed administrative and legal requirements to properly assess the penalty). However, taxpayers cannot challenge the existence or amount of the underlying liability in a CDP hearing or in Tax Court if they otherwise had a prior opportunity to dispute the liability. The IRS and the courts interpret this restrictively and take the position that a “prior opportunity” to dispute the underlying liability is an invitation (whether accepted or not) to request an Appeals conference either before or after the assessment of the liability, even if the taxpayer had no prior opportunity for Tax Court review of the liability and even if no subsequent Tax Court review is available. The prior opportunity prohibition generally eliminates the ability of taxpayers to challenge the merits of the penalty in a CDP proceeding and before the Tax Court.
The good news is that there is a clear and simple way for the IRS to fix this problem. The IRS needs to stop systemically assessing these penalties now. It must provide taxpayers their rights to be heard and to pay no more than is due before assessing a penalty, which must include review of any reasonable cause relief requests before assessment. Since the IRS began systemically assessing these international information return penalties, it has harmed too many taxpayers. If the IRS wants to meet its stated intention to be transformative in tax administration, this simple change would provide much-needed relief for taxpayers, encourage voluntary compliance, and be consistent with the Taxpayer Bill of Rights.
Additionally, I continue to recommend that Congress amend IRC § 6212 to provide taxpayers the ability to challenge the assessment of international information return penalties in the U.S. Tax Court. Created by Congress as a court of tax experts, Tax Court is typically the least expensive and best forum for lower- and middle-income taxpayers and small businesses to get their day in court. Due to the tax expertise of its judges, Tax Court is often better equipped to consider tax controversies than other courts. It is also more accessible to unrepresented taxpayers because it offers simplified, less formal procedures, particularly for disputes that do not exceed $50,000. Low-income taxpayers representing themselves are generally offered the option of free legal assistance from a Low Income Taxpayer Clinic or pro bono representative.
Congress established the international information return penalty regime primarily to combat tax avoidance and discourage U.S. taxpayers from hiding income and assets abroad. These are worthy and important policy goals, and the IRS should continue to assess and collect these penalties when appropriate.
However, the IRS’s current process is broken. Rather than promoting tax compliance through taxpayer education and support, the IRS has opted to flex its administrative muscle and bring down the enforcement hammer on good–faith taxpayers and bad actors alike. As a result of the IRS’s approach, taxpayers – many of whom are lower- and middle-income individuals, small and midsize businesses, and immigrants – face substantial penalties for failure to meet obscure and complex requirements. Additionally, the inability of taxpayers to obtain judicial review on a preassessment basis and the requirement that taxpayers generally pay the penalties in full to obtain judicial review on a post-assessment basis effectively deprive most taxpayers of the right to judicial review at all, impairing the right to challenge the IRS’s position and be heard.
By taking the simple actions outlined in this blog, the IRS and Congress can make meaningful enhancements to the international information return penalties process that will improve tax administration and protect taxpayer rights without undermining the important policy goals behind the penalty regime.
The international information return penalty process is causing real harm to taxpayers while you’re reading this blog, and an urgent problem calls for an expedited solution. Taxpayers should not have to wait for the courts to iron this out. The IRS and Congress need to act now to prevent further harm to taxpayers.
The views expressed in this blog are solely those of the National Taxpayer Advocate. The National Taxpayer Advocate presents an independent taxpayer perspective that does not necessarily reflect the position of the IRS, the Treasury Department, or the Office of Management and Budget.