Written by: Gautam Chopra, Rita M. Ryan
On April 3, 2023, the U.S. Tax Court issued its opinion in Farhy v. Commissioner ruling that the Internal Revenue Service (IRS) lacked the statutory authority to both assess and collect penalties for the Form 5471 under § 6038(b)(1) or (2) of the Internal Revenue Code (IRC). Because of this ruling, the IRS does not appear to have the statutory authority to either have issued or collected on the thousands of notices issued to countless taxpayers for either the late filing or failure to file Forms 5471. The Court concluded that to assess and collect on these penalties, the IRS must request that the U.S. Justice Department sue taxpayers in federal district court to obtain a judgment for the penalties and collect on it.
This ruling has significant implications for taxpayers who received a notice from the IRS or paid penalties in connection with not only the Form 5471, but also Forms 5472, 8938, or 926.
Form 5471 Filing Requirements
Section 6038 of the IRC requires that U.S. taxpayers who have an ownership interest in or control of a foreign corporation (FC) to disclose the interest on a Form 5471. The reporting does not rely on having “control” of the foreign corporation (more than 50% ownership of vote or value of the FC) nor does it rely on whether the FC generated income or had a net profit on its books. The mere existence of the FC and having an ownership interest in it, can and does (in many cases) result in the Form 5471 needing to be included as part of a U.S. tax filing.
Section 6038 Penalties
Should a U.S. taxpayer fail to furnish the required information filings, Section 6038(b)(1) states that such person shall pay a penalty of $10,000 for each annual accounting period with respect to which such failure exists. If the Secretary of the Treasury mails a notice of such failure to the U.S. Taxpayer, § 6038(b)(2) states such person shall be liable to an additional penalty of $10,000 for each 30-day period during which such failure continues. Said additional penalty shall not exceed $50,000.
Criminal penalties under Sections 7203, 7206, and 7207 may also apply.
Typical § 6038 Penalty Defenses
The IRS allows taxpayers to argue against the assessment of the above referenced penalties by asserting that reasonable cause existed which prevented them from meeting their informational return filing requirements. The Internal Revenue Manual (IRM) states that the penalty for a failure relating to an information reporting requirement can be waived if there are significant mitigating factors with respect to the failure, and the failure arose from events beyond the filer’s control. The taxpayer must further establish they acted in a responsible manner both before and after the failure. Generally, this means the taxpayer and/or their representative must gather factors to show compliance history, lack of prior filings like this, acting to rectify the failure as promptly as possible, in addition to many other facts and circumstances.
Until recently, the IRS did not allow the abatement of Form 5471 penalties under the First-Time Abatement (FTA) procedures – this changed in December 2022. The IRS updated the IRM to allow for FTA consideration for systematically assessed Form 5471 and 5472 penalties because the forms are attached to late-filed Form 1120 and 1065. If the underlying Form 1120 or Form 1065 penalties are abated by the FTA, the Form 5471 and 5472 penalties may also be abated.
If you could neither make a reasonable cause argument nor fall under the FTA procedures for Form 1120 or Forms 1065 your choices for relief were next to non-existent. Many taxpayers found themselves in that tight spot and simply paid the penalties to get off the IRS radar and move forward.
Enter Farhy v. Commissioner
The taxpayer petitioner in Farhy owned 100% of a foreign corporation in Belize and failed to report the same on Form 5471 for tax years 2005 through 2010. The IRS mailed the petitioner a notice of this failure to file, but the petitioner never remedied the situation by filing the forms. The IRS subsequently assessed a Section 6038(b)(1) penalty of $10,000 for each year at issue and an additional failure penalty under § 6038(b)(2) for the continued noncompliance which totaled $50,000 for each year at issue.
The Court found that the petitioner’s failure to file Form 5471 was willful and not due to reasonable cause. Further, the Court even noted that petitioner participated in an illegal scheme to reduce the amount of income tax that he owed and signed an affidavit describing his role in that illegal regime. This means the Taxpayer had zero chance of a reasonable cause argument. Why is this good, though? The statutory arguments in the case and resulting ruling do NOT hinge on a finding of reasonable cause.
Lack of Authority to Assess
The petitioner’s main argument was that the IRS did not have the statutory authority to assess Section 6038(b) penalties. The Court broke that argument down, however, and we will review each Section as the analysis has much more far-reaching implications than just the Form 5471.
To start with the basic threshold assumptions, Section 6201(a) authorizes and requires the Secretary of the Treasury to make assessments of all taxes – including interest, additional amounts, additions to tax, and assessable penalties – imposed under the Code. Under Treas. Reg. § 301.6201-1(a), 301.7601-1, and 301-7701-9, the Secretary of the Treasury has delegated these duties to the Commissioner of the Internal Revenue Service who has in turn, delegated them to the IRS Officials. When a tax is assessed, the IRS may seek to take certain actions to collect those taxes administratively. Section 6201(a)(1) authorized the IRS to immediately assess the tax determined on a taxpayers return as well as certain assessable penalties that are not subject to IRC deficiency procedures.
The key to this part of the argument as to why this is inapplicable to Section 6038(b)(1) or (b) penalties is because the term “assessable penalties” is not defined with regard to Section 6201(a). As such, there is uncertainty about which penalties the IRS may assess and ultimately collect.
The taxpayer asserted that while Section 6201(a) is extensive in its grant of authority on “assessable penalties,” it does not include Chapter 61 penalties. The petitioner further contended that the § 6038(b) penalties contain no provision authorizing the IRS to assess or collect the same so should not be considered an “assessable penalty.”
The Court found that this argument held merit, noting that Congress explicitly authorized the assessment with respect “to myriad penalty provisions of the Code, but not for Section 6038(b) penalties.” This is where the analysis starts to get very intense – so hold on tight as we break it down.
- Section 6671(a) provides that the numerous penalties found in subchapter B of Chapter 68 of subtitle F (i.e., in sections 6671-6725) “shall be assessed and collected in the same manner as taxes,” subjecting those penalties to the Secretary’s assessment authority under Section 6201. In more common terms, they are “summarily assessable.”
- Section 6665(a)(l) contains a similar statement that the additions to tax, additional amounts, and penalties provided in Chapter 68 of subtitle F (i.e., in sections 6651-6751) “shall be assessed, collected, and paid in the same manner as taxes.” Again, meaning they are “summarily assessable.”
The Court noted that Code sections outside of Chapter 68 of subtitle F, whose violations the Code specifically penalizes, all commonly:
- contain their own express provision specifying the treatment of penalties or other amounts as a tax or an assessable penalty for purposes of assessment and collection;
- contain a cross-reference to a provision within Chapter 68 of subtitle F providing a penalty for their violation; or
- are expressly covered by a penalty provision within Chapter 68 of subtitle F.
In contrast, Section 6038 contains only a cross-reference to a criminal penalty provision, Section 7203; i.e. it does not expressly specify the treatment if penalties or other amounts for the purposes of assessment. Further, there is no provision that provides that these penalties must be paid upon notice and demand and assessed and collected in the same manner as any taxes.
So, while Section 6038(b)(1) and (2) allows for a penalty, it fails to provide how it can be assessed or collected.
The Court further noted that because no mode of recovery or enforcement is specified for these penalties, unlike for myriad other penalties in the Code, they were loath to “disturb a well-established statutory framework.”
Summarily Assessable Penalties
The IRS argued, counter to the above, that the term “assessable penalties” as used in Section 6201(a) is applicable to ALL penalties found in Subchapter B of Chapter 68, not subject to deficiency procedures – i.e. those that are “summarily assessable.” The Court was unmoved.
The Court noted that there is no provision in the code that provides that these penalties must be paid upon notice and demand and assessed and collected in the same manner as taxes. As the Court stated, “simply put, while Section 6038(b) provides for penalties it does not provide for assessable penalties.” As such, this argument was found to be baseless.
Taxes vs. Assessable Penalties
Finally, the IRS argued that the term “taxes” in Section 6201(a) encompasses Section 6038(b) penalties, even if they are not assessable penalties. The Court, again unmoved, stated that precedent firmly establishes that taxes and penalties “are distinct categories of exactions, at least in the absence of a provision treating them as the same.” The Court further noted that the IRC has detailed provisions governing the circumstances where amounts are deemed to be a “tax” for assessment; none of these limited inclusions include a fixed dollar information reporting penalty.
As such, the Court found that penalties are not “taxes” for purposes of assessable penalty characterization.
What’s Next and Why File?
This case is a big “win” for the US international tax community and provides a roadmap of sorts for further arguments on this point when dealing with other information reporting penalties; many tax practitioners are already discussing if the same analysis applies to Form 5472 penalties.
The biggest question right now is, “If penalties cannot be assessed, why even file?” Filing should still be done because despite the IRS not having the ability to assess or collect these penalties, the IRS can ask the Department of Justice to bring suit civilly. Granted this will be a big cost to the IRS and they may only pursue the largest cases, but they still could bring suit in all cases should they so choose.
One other item to note – the IRS will most likely appeal this ruling. Wolf & Company will continue to monitor whether an appeal is filed with the Circuit Court of Appeals.
Whatever your international tax needs may be, Wolf & Company is here to help. If you have questions about planning, reporting, analysis, and more, reach out to our team today.