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In the tax world, the Internal Revenue Service’s (IRS’s) assessment authority for penalties is trending. Earlier this month, the government filed its notice of appeal to a recent and precedential Tax Court decision:Farhy v. Commissioner.1 The Farhy outcome has significant implications, leaving many taxpayers seriously considering how to potentially recoup recently paid penalties connected to IRS Forms 5471, 5472, 8938, or 926. Savvy tax professionals are advising clients to file protective refund claims in some instances. And, it’s been reported that the IRS is projected to concede Internal Revenue Code (IRC) §6038(b) penalties in Collection Due Process (CDP) cases.2 Let’s take a closer look at Farhy and how the court reached its holding that the IRS lacks the authority to assess noncompliance penalties applicable to Form 5471 (category 4 and category 5) filers.3

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Background

Alon Farhy, sole owner of two foreign corporations during tax years 2003 through 2010, failed to report his ownership interests during that time to the IRS as required under Internal Revenue Code (IRC) §6038. More specifically, “for each year at issue, [Farhy] was required to file Form 5471, Information Return of U.S. Persons With Respect to Certain Foreign Corporations, but he did not.”4 As clarified by the Court, each “failure to file Form 5471 was willful and not due to reasonable cause.”5

The IRS assessed the failure to timely file Form 5471, which imposes a civil tax penalty of $10,000 for each year.6 Shortly, thereafter, the IRS assessed continuation penalties totaling $50,000 for each year at issue.7 Ultimately, Farhy petitioned the Tax Court, disputing the IRS’s legal authority to assess IRC §6038 penalties. As the Court phrased it:

Petitioner argues that there is no law giving the IRS authority to assess penalties under section 6038(b) and that while the United States may be able to collect liabilities for these penalties through a civil action, see 28 U.S.C. § 2461(a), the IRS may not assess or administratively collect these penalties.8

Opinion 

The Tax Court ruled that the IRS was not authorized to assess IRC §6038(b) penalties for petitioner’s deliberate failures to file Forms 5471. In reaching this conclusion, the court began by acknowledging that IRC §6038(b)(1) and (2) imposes penalties but stated that “[t]here is no statutory provision, in the Code or otherwise, specifically authorizing assessment of these penalties.”9 The court contrasted this assertion with the fact that “Congress has explicitly authorized assessment with respect to myriad penalty provisions in the Code, but not for section 6038(b) penalties.”10 The court emphasized that it was:

loath to disturb this well-established statutory framework by inferring the power to administratively assess and collect the section 6038(b) penalties when Congress did not see fit to grant that power to the Secretary of the Treasury expressly as it did for other penalties in the Code.11

As explained by the Court, IRC §6201(a) authorizes the Secretary of the Treasury to make assessments of taxes (including assessable penalties); however, the term “assessable penalties” as used in IRC §6201(a) is left undefined, creating uncertainty about which penalties the IRS may assess and ultimately collect through administrative means.”12 Accordingly, the Court did not agree that the IRS could use IRC §6201(a) to assess IRC §6038(b) penalties.13 The Court also emphasized that, without a specified mode of recovery or enforcement for IRC §6038(b) penalties, the IRS would need to file a civil action under Title 28 U.S.C. §2461(a) in order to collect IRC §6038(b) penalties. 

Conclusion

The ruling in Farhy may be an attempt to re-align the overly aggressive and punitive nature of IRC §6038(b) with the principle outlined in the IRS penalty handbook that penalties should be “objectively proportioned to the offense [and] be used as an opportunity to educate taxpayers and encourage their future compliance.”14 Although the ruling is narrowly applied to IRC §6038(b), it has potentially far-reaching implications. Many taxpayers and tax professionals are considering the possibility that other failure to file violations may be open to challenge now, including the failures to file Forms 5472, 8938, and 926. At the very least, it’s fair to anticipate that this ruling will inspire more careful analysis of statutory language and increased arguments that the IRS must act with the scope of what Congress has authorized.

Footnotes

  1. 160 T.C. No. 6 (April 3, 2023).
  2. See Book, L. (2023, July 14). Government Files Notice of Appeal in Farhy. Procedurally Taxing. https://procedurallytaxing.com/government-files-notice-of-appeal-in-farhy/.
  3. Note that this Court’s analysis is not projected to apply to noncompliance penalties associated with: (1) Form 5471 categories 2 and 3 filers; (2) Form 3520-A; or (3) Form 8865 (in certain instances). These penalties are assessable under IRC §§6677(a) and 6679(a). See David Schuster, Tax Court Ruling Against IRS Cracks Open Door to Penalty Refunds, DTR (Apr. 17, 2023).
  4. Farhy, at 2-3.
  5. Id. at 3.
  6. See IRC §6038(b)(1).
  7. See IRC §6038(b)(2).
  8. Farhy, at 6.
  9. Id. at 3.
  10. Id. at 4.
  11. Id. at 8.
  12. Id at 6.
  13. Here the Court noted that “Precedent firmly establishes that taxes and penalties are distinct categories of exactions, at least in the absence of a provision treating them as the same.”
  14. IRM 20.1.1.2.1, Encouraging Voluntary Compliance (Nov. 25, 2011).
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More Penalty Challenges Expected After Tax Court Rules That IRS Lacks Authority to Assess Section 6038(b) Penalties

Published on
July 21, 2023
More Penalty Challenges Expected After Tax Court Rules That IRS Lacks Authority to Assess Section 6038(b) Penalties
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In the tax world, the Internal Revenue Service’s (IRS’s) assessment authority for penalties is trending. Earlier this month, the government filed its notice of appeal to a recent and precedential Tax Court decision:Farhy v. Commissioner.1 The Farhy outcome has significant implications, leaving many taxpayers seriously considering how to potentially recoup recently paid penalties connected to IRS Forms 5471, 5472, 8938, or 926. Savvy tax professionals are advising clients to file protective refund claims in some instances. And, it’s been reported that the IRS is projected to concede Internal Revenue Code (IRC) §6038(b) penalties in Collection Due Process (CDP) cases.2 Let’s take a closer look at Farhy and how the court reached its holding that the IRS lacks the authority to assess noncompliance penalties applicable to Form 5471 (category 4 and category 5) filers.3

Have Questions? Call Our Team Today.

Background

Alon Farhy, sole owner of two foreign corporations during tax years 2003 through 2010, failed to report his ownership interests during that time to the IRS as required under Internal Revenue Code (IRC) §6038. More specifically, “for each year at issue, [Farhy] was required to file Form 5471, Information Return of U.S. Persons With Respect to Certain Foreign Corporations, but he did not.”4 As clarified by the Court, each “failure to file Form 5471 was willful and not due to reasonable cause.”5

The IRS assessed the failure to timely file Form 5471, which imposes a civil tax penalty of $10,000 for each year.6 Shortly, thereafter, the IRS assessed continuation penalties totaling $50,000 for each year at issue.7 Ultimately, Farhy petitioned the Tax Court, disputing the IRS’s legal authority to assess IRC §6038 penalties. As the Court phrased it:

Petitioner argues that there is no law giving the IRS authority to assess penalties under section 6038(b) and that while the United States may be able to collect liabilities for these penalties through a civil action, see 28 U.S.C. § 2461(a), the IRS may not assess or administratively collect these penalties.8

Opinion 

The Tax Court ruled that the IRS was not authorized to assess IRC §6038(b) penalties for petitioner’s deliberate failures to file Forms 5471. In reaching this conclusion, the court began by acknowledging that IRC §6038(b)(1) and (2) imposes penalties but stated that “[t]here is no statutory provision, in the Code or otherwise, specifically authorizing assessment of these penalties.”9 The court contrasted this assertion with the fact that “Congress has explicitly authorized assessment with respect to myriad penalty provisions in the Code, but not for section 6038(b) penalties.”10 The court emphasized that it was:

loath to disturb this well-established statutory framework by inferring the power to administratively assess and collect the section 6038(b) penalties when Congress did not see fit to grant that power to the Secretary of the Treasury expressly as it did for other penalties in the Code.11

As explained by the Court, IRC §6201(a) authorizes the Secretary of the Treasury to make assessments of taxes (including assessable penalties); however, the term “assessable penalties” as used in IRC §6201(a) is left undefined, creating uncertainty about which penalties the IRS may assess and ultimately collect through administrative means.”12 Accordingly, the Court did not agree that the IRS could use IRC §6201(a) to assess IRC §6038(b) penalties.13 The Court also emphasized that, without a specified mode of recovery or enforcement for IRC §6038(b) penalties, the IRS would need to file a civil action under Title 28 U.S.C. §2461(a) in order to collect IRC §6038(b) penalties. 

Conclusion

The ruling in Farhy may be an attempt to re-align the overly aggressive and punitive nature of IRC §6038(b) with the principle outlined in the IRS penalty handbook that penalties should be “objectively proportioned to the offense [and] be used as an opportunity to educate taxpayers and encourage their future compliance.”14 Although the ruling is narrowly applied to IRC §6038(b), it has potentially far-reaching implications. Many taxpayers and tax professionals are considering the possibility that other failure to file violations may be open to challenge now, including the failures to file Forms 5472, 8938, and 926. At the very least, it’s fair to anticipate that this ruling will inspire more careful analysis of statutory language and increased arguments that the IRS must act with the scope of what Congress has authorized.

Footnotes

  1. 160 T.C. No. 6 (April 3, 2023).
  2. See Book, L. (2023, July 14). Government Files Notice of Appeal in Farhy. Procedurally Taxing. https://procedurallytaxing.com/government-files-notice-of-appeal-in-farhy/.
  3. Note that this Court’s analysis is not projected to apply to noncompliance penalties associated with: (1) Form 5471 categories 2 and 3 filers; (2) Form 3520-A; or (3) Form 8865 (in certain instances). These penalties are assessable under IRC §§6677(a) and 6679(a). See David Schuster, Tax Court Ruling Against IRS Cracks Open Door to Penalty Refunds, DTR (Apr. 17, 2023).
  4. Farhy, at 2-3.
  5. Id. at 3.
  6. See IRC §6038(b)(1).
  7. See IRC §6038(b)(2).
  8. Farhy, at 6.
  9. Id. at 3.
  10. Id. at 4.
  11. Id. at 8.
  12. Id at 6.
  13. Here the Court noted that “Precedent firmly establishes that taxes and penalties are distinct categories of exactions, at least in the absence of a provision treating them as the same.”
  14. IRM 20.1.1.2.1, Encouraging Voluntary Compliance (Nov. 25, 2011).