In a surprising decision last year, the U.S. Tax Court, in Farhy v. Commissioner, 160 T.C, No. 6 (April 3, 2023), held that the IRS lacks the statutory authority to assess certain Form 5471 penalties, and therefore must collect such penalties through a civil action.
The case was appealed to the D.C. Circuit Court of Appeals, which has now reversed the Farhy decision, much to the dismay of taxpayers living abroad. (Farhy v. Commissioner, No. 23-1179 (D.C. Cir. May 3, 2024).
In this blog, we review the technical reasoning behind the appeals decision and analyze its impact for U.S. expats moving forward.
5471 Penalties – An Introduction
Under Section 6038 of the Internal Revenue Code, several categories of U.S. taxpayers are required to report their interests in foreign corporations on the Form 5471. Section 6038 imposes multiple penalties for failing to timely and properly complete and file the Form 5471.
If a U.S. person fails to furnish required information with respect to a foreign corporation via the Form 5471, the IRS can impose a $10,000 penalty. If the IRS notifies the taxpayer of the failure and the taxpayer fails to correct such failure within 90 days, the IRS can impose a $10,000 continuation penalty for each 30-day period the failure continues (or fraction thereof), up to a maximum of $50,000.
The Farhy Decision on Form 5471 Penalties
In Farhy, the taxpayer owned two foreign corporations. For the 2003 through 2010 tax years, the taxpayer failed to report his interests in the two corporations on Forms 5471. The IRS notified the taxpayer of his failure to file Forms 5471, but the taxpayer never complied. The IRS assessed multiple penalties for each unreported corporation.
After the IRS issued the taxpayer a final notice of intent to levy to collect the Form 5471 penalties, the taxpayer filed a request for a Collection Due Process Hearing in which he contested the IRS’s legal authority to assess the penalties. The IRS issued a Notice of Determination sustaining the IRS’s collection actions, and the taxpayer filed a petition in the U.S. Tax Court.
The Tax Court decided in favor of the taxpayer, concluding that there is no statutory provision, under Section 6038 or otherwise, that specifically authorizes the assessment of the Form 5471 penalties. Therefore, the IRS must collect the penalties through a civil action, a more arduous and costly process.
The impact of the Farhy decision was seen as far-reaching, as it significantly limited the IRS’ penalty assessment capabilities. Further, it was speculated that the Tax Court’s reasoning and analysis would seem to apply equally to penalties associated with other international forms, such as Forms 5472, 8938, 926 and, in certain instances, Form 8865.
Reversing the Farhy Decision
In reversing the Tax Court, the D.C. Circuit Court held that the text, structure, and function of section 6038 of the Internal Code, which contains the provisions regarding international information returns, support the IRS’s assessment authority for those penalties.
The Court reasoned: “It is hardly anomalous that section 6038(b) penalties are assessable even though the text of section 6038 does not explicitly label them as such… Scattered across the tax code are more than one hundred penalties applicable to diverse forms of noncompliance and set forth in varied ways. Discerning the operation of each penalty is necessarily a context-dependent exercise… The absence of the penalty from Chapter 68 and the lack of either a cross-reference to Chapter 68 or explicit language directing that the penalty ‘shall be assessed’ is not determinative. Congress can make a penalty assessable by implication, and it did so here.”
The Court further reasoned that when Congress amended section 6038 of the Code in 1982, it intended the penalties to be assessable. The section originally imposed a penalty only in the form of a foreign tax credit reduction, but was later revised to be a specific dollar amount. The Court stated: “Reading subsection (b) to require the government to sue taxpayers to collect its fixed-dollar penalty, as Farhy does, treats Congress as having enacted a supplemental penalty process that is less streamlined, not more, than the preexisting collection process.”
While it’s unlikely that the Farhy case is taken up by the U.S. Supreme Court, it’s not out of the question. Further, there may be other suits relating to this issue that are appealed to other circuit courts that disagree with the D.C. Circuit Court. For now, however, the IRS should be significantly bolstered by this decision in its ability to assess international information return penalties.
