Tax Court: IRS Had No Authority to Assess Penalties on Certain International Tax Filings

In a recent US Tax Court decision, Farhy v. Commissioner, 160 T.C. No. 6 (April 3, 2023), the Tax Court found that the IRS had no statutory authority to assess certain penalties on an individual taxpayer related to his failure to file required Forms 5471, Information Return of U.S. Persons With Respect to Certain Foreign Corporations.  The penalties were assessed under Internal Revenue Code (IRC) Section 6038(b) for the tax years 2003-2010 with respect to the taxpayer’s ownership of two foreign corporations incorporated in Belize. 

Section 6038(b)(1) imposes a penalty of $10,000, with respect to each annual accounting period for which a failure exists, if any person fails to timely furnish certain required information about any foreign business entity.  Section 6038(b)(2) imposes a continuation penalty of $10,000 for each 30-day period (or fraction thereof) during which such failure continues for any annual accounting period after an initial 90-day notice period, subject to a maximum of $50,000. 

Under the facts of Farhy, the IRS had assessed a penalty under Section 6038(b)(1) of $10,000 per corporation for each year at issue and a continuation penalty under Section 6038(b)(2) totaling $50,000 per corporation per year at issue.  The Tax Court observed that the taxpayer’s failure to file Forms 5471 was willful and not due to reasonable cause.  The IRS followed up its assessment with collection actions, including a levy. 

For many years, the IRS has been automatically assessing Section 6038(b) penalties for failure to file Form 5471.  Similarly, the IRS has been assessing penalties on taxpayers for not filing Form 5472, Information Return for of a 25% Foreign-Owned U.S. Corporation or a Foreign Corporation Engaged in a U.S. Trade or Business.  Penalties for failure to file Form 5472 are imposed under IRC Section 6038A(d) where the penalty is $25,000 for each failure to file and the continuation penalty is $25,000.  Often these failures to file are not willful, but rather due to a simple oversight, a lack of familiarity with US tax filing requirements, or some other reasonable cause.  Frequently this occurs when a Form 5471 (or 5472) is attached to a late-filed income tax return.  The only recourse for taxpayers charged penalties in these situations has been to request relief from the IRS in an abatement request, which may or may not be granted. 

The Tax Court in Farhy observed there is no statutory provision, in the IRC or otherwise, specifically authorizing assessment of the penalties in Section 6038(b).  In their decision, the Tax Court discussed at length the situations in which the IRS could assess a penalty without having to first go through the usual deficiency process.  The Tax Court noted that in many other penalty provisions, there was specific language authorizing assessment of the penalty, which was not present in Section 6038(b).  The conclusion of the Tax Court is that while Section 6038(b) provides for penalties, it does not provide for assessable penalties.  Collection of any penalties would have to be done by civil action in the courts.

Application to Other Penalties

The Tax Court’sdecision dealt only with the penalties in Section 6038(b).  Therefore, relief would not apply to all categories of 5471 filers but, rather, would exclude Form 5471 “Category 2” and “Category 3” filers.  Forms 5471 required for those filers is subject to different code sections that do have specific language allowing assessments for penalties.  However, the Tax Court’s reasoning in Farhy may extend to penalties for failure to file certain other foreign reporting forms, including penalties for failure to file Forms 5472, 8865, 8938 and 926, though perhaps not in all cases. 

Next Steps

The Farhy decision is a significant victory for taxpayers in challenging IRS imposed penalties for international information returns.  Taxpayers may want to review their records to determine if they have paid any penalties for failure to timely file Form 5471 with facts similar to the ruling. 

There has been some debate as to whether taxpayers who have paid these penalties in the past should file for a refund of those penalties.  At this point, it seems doubtful that such a refund claim would be productive as the IRS could assert that it is not required to return an overpayment of such penalties, unlike with the overpayment of an income tax.  The taxpayer would instead likely have to sue for the penalty refund.  At this point, the IRS has not indicated whether it will appeal the Tax Court’s decision, but we expect there will be some sort of guidance coming from the IRS in the near future on its position. 

Please contact your Elliott Davis tax advisor if you have any questions about how this Tax Court decision affects you.

The information provided in this communication is of a general nature and should not be considered professional advice. You should not act upon the information provided without obtaining specific professional advice. The information above is subject to change.