On April 3, 2023, the US Tax Court issued its opinion in Farhy v. Commissioner, ruling that the Internal Revenue Service (IRS) could neither assess tax penalties under Internal Revenue Code (Code) Section 6038(b) against Alon Farhy nor collect those penalties via a levy.
This is a significant development because the IRS automatically assesses these penalties on any late-filed Form 5471, Information Return of US Persons with Respect to Certain Foreign Corporations. This practice will presumably be immediately ceased. Moreover, any taxpayer who was assessed and paid a penalty on a late-filed Form 5471 may be able to obtain a refund on the penalty paid.
Farhy had failed to file Form 5471 with his US federal income tax return. Failure to timely file Form 5471 comes with a civil tax penalty of $10,000 for each year. (See IRC Section 6038(b)(1).) If the IRS sends the taxpayer notice of its failure to file Form 5471, the taxpayer has 90 days after the notice is mailed to comply with the filing requirement. Failure to comply within the 90-day period subjects the taxpayer to an additional penalty of $10,000 for each 30-day period, with a $50,000 maximum. (See IRC Section 6038(b)(2).)
Code Section 6201(a) permits the IRS to “assess” taxes and assessable penalties. Assessment is the act of formally recording a tax liability on the IRS’s records for a taxpayer. After assessment and failure to pay, the IRS can enforce the collection of tax, penalties and interest by asserting a lien on property or by levying (taking) property.
The Code provides statutes that permit the IRS to assess taxes (including interest, additional amounts and additions to tax) and certain types of penalties (assessable penalties). In Farhy, the Tax Court held that the Code does not contain any statute that permits the IRS to assess the penalty provided in Code Section 6038(b). As such, although the IRS correctly determined that Farhy should be penalized for failing to file Form 5471 with his return, the IRS lacked the statutory ability under the Code to assess and collect the penalty under traditional assessment and collection procedures that they use for other penalties (essentially treated similar to deemed taxes).
The Tax Court did note that the government had other tools at its disposal to collect the penalties, for example, 28 U.S.C. § 2461(a): “Whenever a civil fine, penalty or pecuniary forfeiture is prescribed for the violation of an Act of Congress without specifying the mode of recovery or enforcement thereof, it may be recovered in a civil action.”
Practice Point: Farhy is a major taxpayer victory and demonstrates that a technical deficiency in the Code can have substantial ramifications for the administration of our tax laws and the potential collection of penalties relating to violations thereof. Clearly, Congress intended to permit the IRS the ability to collect the penalties determined under the Code but failing to connect Code Section 6038(b) with the statutory provisions to assess tax and penalties makes the IRS unable to practically and efficiently collect said penalties. We expect (and are optimistic) that in the wake of this ruling, the IRS will cease all collection activities of Code Section 6038(b) penalties and seek Congress’s assistance in remedying this technical foot fault. Another major takeaway from this ruling is that other penalties for failure to file certain international information returns (e.g., Form 3520 for reporting gifts received from foreign persons pursuant to Section 6039F) are also likely not assessable penalties, which means assessment and collection of those penalties could practically cease as well.