The Internal Revenue Service (IRS) was sucker-punched by the Tax Court on April 3, 2023 in the case of Farhy v. Commissioner, 160 T.C. No. 6 (2023). In that case, the Tax Court held that the IRS does not have the authority to assess and collect penalties asserted under Internal Revenue Code Section 6038(b), in the Farhy case, Form 5471 penalties. This is a sweeping win for taxpayers who have not been filing Form 5471 as well as some other forms relevant to foreign assets and transactions. I do not think the taxpayer euphoria will last very long, so taxpayers who have issues should make hay while the sun shines and get those forms filed while the IRS is essentially powerless to hit them with penalties. Let’s look at what happened in Farhy and what this all means.
This is not an easy topic, but it is a very important one. If reading is too onerous for you today, you can listen to my podcast with attorney John Richardson.
Under Section 6038(a), a taxpayer such as Mr. Farhy, with certain interests in a foreign corporation during the taxable year is required to file a Form 5471 with his income tax return. Failure to timely file Form 5471 can result in penalties pursuant to Section 6038(b). Under that section, the IRS may impose a $10,000 penalty per year and an additional penalty of $10,000 every 30-days (up to $50,000) if the form is not filed after IRS notifies the taxpayer. What is important to note about the penalties under Section 6038, is that unlike many other penalty provisions in the tax law, penalties under Section 6038 are not treated as a tax or “assessed and collected in the same manner as taxes.” We will discuss later why this difference is so significant.
Magic Language
Certain sections of the Code tell us when a penalty is an assessable penalty by providing a listing of penalties that are “assessable”. If the penalty is not on the list, one must dig deeper, find the Code section imposing the specific penalty and look there for the magic language to make a determination if the penalty is assessable.
Code section 6671(a) for example, contains the rules for application of “assessable penalties” and provides the magic language:
” (a) Penalty assessed as tax. The penalties and liabilities provided by this subchapter shall be paid upon notice and demand by the Secretary, and shall be assessed and collected in the same manner as taxes…..”
Reference to the “subchapter” is to Subchapter B—Assessable Penalties (§§ 6671 – 6725) The listing of assessable penalties includes, for example, penalties for failure to file information returns with respect to foreign trusts. This is an assessable penalty contained in the listing and is found in Section 6677.
Section 6671, however, is not the exclusive section for assessable penalties. Section 6665(a)(1) contains similar language that the additions to tax, additional amounts, and penalties provided in chapter 68 of subtitle F (i.e., in sections 6651–6751) “shall be assessed, collected, and paid in the same manner as taxes.” If the penalty in question is not found on such a list, then one must look to the Code section imposing the particular penalty to see if it specifies the treatment of penalties or other amounts as a tax or an assessable penalty. For example, the penalty for the failure to file the required information return to report receipt of certain foreign gifts or bequests is found in Section 6039F. This section is not contained on a “list” of assessable penalties, but the magic language is contained in Section 6039F(c)(1)(B) : “[s]uch United States person shall pay (upon notice and demand by the Secretary and in the same manner as tax)…” .
(Confused yet? Whoever said tax law was easy?)
Assessable Penalties – What are they?
When the IRS advises a taxpayer that he owes taxes and penalties, this is called an “assessment”. When a penalty is an “assessable” penalty, it must be paid upon notice and demand and assessed and collected in the same manner as taxes. An assessable penalty can be imposed on a taxpayer by the IRS without the need for any further administrative or judicial action. The IRS can simply assess a penalty without going through any additional procedures. The IRS has various methods to collect the amounts owed if the taxpayer does not pay up. The collection remedies include placing a lien on the taxpayer’s property (e.g., a residence, bank account, brokerage account); the IRS may also garnish the taxpayer’s wages.
Deficiency Procedures – What are they?
On the other hand, a penalty requiring so-called “deficiency procedures” is a penalty that can only be imposed on a taxpayer after a formal deficiency notice has been issued. Once the deficiency notice is issued the taxpayer has an opportunity to dispute the proposed deficiency (without having to immediately pay up) and have the matter resolved through administrative or judicial proceedings.
In summary, the main difference between an assessable penalty and a penalty requiring deficiency procedures is that the former can be imposed (and collected through an arsenal of collection devices such as wage garnishment and levy) without any further action. The latter requires a formal deficiency notice and subsequent proceedings to be resolved.
The Taxpayer Advocate Service just responded to Farhy on April 17th, a mere 3 days ago. In its National Taxpayer Advocate blog, it again recommended that Congress amend the tax law to allow deficiency procedures for all Chapter 61 (dealing with information and returns) penalties, including the Code Section 6038 and 6038A penalties. In doing this, taxpayers would be able to contest penalties before being forced to pay them and can present their case to Tax Court judges who are familiar with tax law.
The Farhy Case
The taxpayer was the sole owner of 2 Belize corporations for a number of years. Even though the taxpayer knew of his Form 5471 reporting obligation under Section 6038, he decided he would not file the form for any of the relevant tax years. The IRS notified Mr. Farhy about his failure to file Form 5471 but he failed to respond. As a result, the IRS assessed penalties and tried to collect the penalties through a levy. The taxpayer submitted a request for a collection due process hearing which was conducted. After the hearing, the IRS sent Mr. Farhy a Notice of Determination upholding the collection of the penalties previously assessed. Mr. Farhy petitioned the Tax Court to determine whether the IRS had the authority to assess penalties under section 6038(b). It not, the IRS could not levy his assets to collect the penalties.
The Tax Court held in favor of the taxpayer and determined that Congress had expressly authorized the assessment of other penalties in the Internal Revenue Code, but it had not done so for penalties imposed by Section 6038(b). In Farhy, this meant that the penalty assessment was invalid and therefore, so was the levy. The court noted that when a penalty is not assessable, the IRS must use a civil action procedure to collect the penalties.
Civil Action – What Does that Mean for the IRS?
Simply put, what it means is that the IRS has a time consuming and burdensome task to collect the penalties under Section 6038(b). IRS must refer the penalty case to the Department of Justice (DOJ), which must then sue the taxpayer in federal court to collect the penalties. The DOJ has bigger fish to fry than suing taxpayers for a $10,000 Form 5471 penalty. The penalties for not filing the Form 5471 can skyrocket when multiple corporations and tax years are involved. However, for the average taxpayer with an interest in a foreign corporation who failed to file the form, chances are the IRS will not refer such cases to the DOJ. Lawyers at DOJ will not be interested in pursuing the typical Form 5471 penalty case.
Take Corrective Action Now
It is highly doubtful the IRS is sitting idly by nursing its wounds over its big loss in Farhy. Trust me, this is a BIG loss. Not only does the loss implicate penalties for failing to file Form 5471, but IRS can now be challenged with respect to other penalties that are similarly not treated as a tax. The tax statutes do not contain the magic language (“assessed and collected in the same manner as taxes”) for penalties imposed for the failure to file other forms in the foreign/international arena including Forms 8865, 8938, and 926. See IRC Sections 6038B and 6038D.
IRS may appeal Farhy. Better yet, it may ask for Congressional intervention to over-rule the case by statutory enactment, as repeatedly recommended by the Taxpayer Advocate Service.
I doubt whether the Farhy case can help taxpayers obtain a refund if they have already paid penalties with respect to those forms. This is especially so pending a likely appeal of Farhy by the IRS and its undisputed ability to pursue the penalties through a civil action.
Taxpayers having international forms that are late, however, should take advantage of this opportunity. There is no time like the present to take corrective action. The IRS has its hands tied now, but it will not be terribly long before the scene changes. Let me know if you need guidance on how to get this matter corrected.
Posted April 20, 2023
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