Background
On April 3, 2023, the U.S. Tax Court held that in Farhy v. Commissioner, 160 T.C, No. 6 (April 3, 2023), the IRS did not have the statutory authority to assess and collect penalties from taxpayers under Internal Revenue Code (IRC) Sections 6038(b)(1) and (2) for failure to file Form 5471, Information Return of U.S. Persons With Respect to Certain Foreign Corporations.
During the taxpayer’s 2003 through 2010 taxable years (years at issue), Mr. Farhy owned 100% of Katumba Capital, Inc., a foreign corporation incorporated in Belize. From around 2005 through 2010, the taxpayer also owned 100% of Morningstar Ventures, Inc., a second foreign corporation incorporated in Belize. During the years at issue, the taxpayer participated in an illegal scheme to reduce the amount of income tax that he owed, and on February 14, 2012, he signed an affidavit describing his role in that illegal scheme. The taxpayer was granted immunity from prosecution in a nonprosecution agreement that was signed on September 20, 2012. For the years at issue, the taxpayer had a reporting requirement under §6038(a) to report his ownership interests in both Katumba Capital and Morningstar Ventures. For each year at issue, petitioner was required but failed to file Forms 5471.
In November 2018, the IRS assessed an initial penalty under §6038(b)(1) of $10,000 for each year at issue and subsequently assessed continuation penalties under §6038(b)(2) totaling $50,000 for each year at issue.
Section 6201(a) authorizes and requires the Treasury Secretary to make assessments of all taxes (including interest, additional amounts, additions to tax, and assessable penalties) imposed by the IRC. The Treasury Secretary has delegated these duties to the IRS commissioner, who has delegated them in turn to other IRS officials. However, the taxpayer argued that, unlike other penalty provisions in the IRC, §6038(b)(1) and §6038(b)(2) are not assessable penalties but can only be imposed and subsequently collected through civil action.
The IRS in turn argued four main points in support of its ability to assess penalties under §6038(b)(1) and §6038(b)(2). First, assessable penalties aren’t limited to penalties found in Subtitle F, Subchapter B, Chapter 68 of the code. Second, taxes in §6201(a) include the §6038(b) penalties even if not explicitly designated as assessable penalties. Third, the Tax Court’s holding in Ruesch v. Commissioner, 154 T.C. 289, 297 (2020), affirmed in part, vacated, and remanded in part, 25 F.4th 67 (2d Cir. 2022). Finally, the IRS argued the legislative history of §6038(b) may suggest the IRS has the ability to assess and collect these penalties.1
Court Decision
The Tax Court concluded that the taxpayer’s analysis of the code was correct and that while the IRS has the statutory authority to assess penalties with respect to numerous other provisions in the code, §6038(b) was not one of them. The Tax Court held that the IRS assessed penalties against Farhy without the statutory authority to do so and that the IRS may not proceed with the collection of these penalties.
Takeaway & Impact on Other Filings
The Tax Court case indicates the IRS lacks authority to assess penalties under §6038(b) for failure to file certain foreign-related information returns, e.g., Form 5471 (note, this only applies to 5471 late-filing penalties for Categories 1, 4, and 5 filers). Interestingly, this case could potentially extend to other international information returns that are regulated by sections similar to §6038(b). For example, §6038(b) for failure to file Forms 8858 and 8865, §6038A(d) for failure to file Form 5472, §6038D(d) for failure to file Form 8938, or §6038B(c) for failure to file Form 926 and Form 8865.
Taxpayers should continue following guidance from the IRS on this matter. If you have any questions or need assistance, please reach out to a professional at FORVIS or submit the Contact Us form below.
- 1For a complete assessment of the IRS’ four main points, please view the U.S. Tax Court’s opinion at app.dawson.ustaxcourt.gov.