On April 3, 2023, the U.S. Tax Court, in Farhy v. Commissioner, 160 T.C, No. 6 (April 3, 2023), made a surprising but welcome decision on international form penalties. The Court held that the IRS lacks the statutory authority to assess Form 5471 penalties and therefore could not proceed with the collection of the penalties against the taxpayer.
In this blog, we review the technical reasoning behind the 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.
Scope and Impact of the Form 5471 Penalties Decision
The Farhy decision, overall, should be seen as good news for U.S. expats burdened with the task of reporting on complex international forms, such as the Form 5471.
For those who have been penalized in the past for failure to file, timely file, or properly file the Form 5471, the decision gives the opportunity to request an abatement and refund of the penalty. Similarly, those who are currently contesting a penalty now have the Farhy decision to rely on to resolve the issue.
It should be noted, in this regard, that the Court’s reasoning and analysis would seem to apply equally as well to penalties associated with other international forms, such as Forms 5472, 8938, 926 and, in certain instances, Form 8865. It should seemingly not apply to the noncompliance penalties associated with Form 5471 category 2 and category 3 filers, or Forms 3520 and 3520-A, nor, in certain instances, Form 8865, because these penalties are based in Code provisions.
It remains to be seen whether the IRS will appeal the Tax Court’s decision in Farhy. Alternatively, Congress may be pressured to amend the Code so that the IRS is not hindered from assessing any international form penalties. In the wake of this decision and the recent taxpayer victory on the issue of FBAR penalties, some fear the IRS may become more aggressive in imposing penalties in order to bolster its enforcement potency.