Tax Court Rules that IRS Lacks Statutory Authority to Assess Penalties for Failure to File Form 5471
On April 3, 2023, the Tax Court issued a blow to the IRS’s ability to collect certain international information return penalties. In the case Farhy v. Commissioner, 160 T.C. No. 6 (2023), the court held that the IRS lacks statutory authority to assess penalties asserted under Section 6038(b). In doing so, the court barred the IRS from utilizing its traditional, and expansive, administrative collection powers to collect such penalties and opened the Service up to future challenges on similar grounds.
Pursuant to Section 6038(a), taxpayers who have certain interests in foreign corporations during the taxable year are required to file a Form 5471 with their tax return. If a taxpayer fails to timely file Form 5471, pursuant to Section 6038(b), the IRS may impose a $10,000 penalty per year and a continuation penalty of $10,000 every 30-days (up to $50,000) if the form is not filed after notification. Notably, unlike many other penalty provisions of the Code, penalties under Section 6038 are not treated as a tax or “assessed and collected in the same manner as taxes.”
Between 2003 and 2010, Mr. Farhy owned a 100 percent interest in two Belize corporations. In 2016, the IRS issued a notice to the Taxpayer indicating that he had failed to file Forms 5471 reporting these ownership interests. Mr. Farhy declined to file the required Forms 5471 and, in 2018, the IRS assessed penalties under Section 6038(b). In 2019, the IRS attempted to collect the assessed penalties through the use of a levy. The Taxpayer challenged the levy notice through a Collection Due Process (“CDP”) proceeding and ultimately petitioned the Tax Court to review the CDP determination that the levy was proper. The only issue before the court was whether the IRS had authority to assess penalties under Section 6038(b), which is a necessary predicate to collection by levy.
The Tax Court sided with the Taxpayer, finding that, while Congress had expressly authorized the assessment of other penalties in the Internal Revenue Code, it notably had not done so for those imposed by section 6038(b). Because the underlying assessment was invalid, the court ruled that the IRS could not avail itself of its robust administrative collection powers. Accordingly, the attempt to levy Mr. Farhy’s assets to collect the improperly assessed penalties was invalid. The court noted, however, that the government does not wholly lack a method for collecting such penalties, as 28 U.S.C. § 2461(a) provides a specific method (a civil action) for collecting penalties where the mode of recovery is not otherwise specified in the Internal Revenue Code.
Absent Congressional intervention, or a successful appeal to the Court of Appeals for the D.C. Circuit, the IRS will now be forced to undertake the burdensome task of referring Form 5471 penalty cases to the Department of Justice, which must then sue the taxpayer to collect penalties under Section 6038(b). Further, the government is now open to attack with respect to other penalties that are similarly not treated as a tax and whose governing statutes do not contain the “assessed and collected in the same manner as taxes” language – including penalties imposed for failure to file Forms 5472, 8865, 8938, and 926. Taxpayers with offshore holdings and those with potential exposure to penalties under section 6038(b) and similar statutes should consult with their legal advisors to determine whether and how the IRS may impose penalties related to the late or non-filing of international information returns. As part of our broad-based tax controversy practice, attorneys at Caplin and Drysdale have extensive experience representing taxpayers with international profiles in all stages tax controversy, from audit to IRS Appeals, to the U.S. Tax Court and federal district courts, and have defended these cases vigorously.
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