U.S. Tax Court: Penalties Assessed for Failure to File Form 5471

On May, 3, 2024, the U.S. Court of Appeals for the District of Columbia Circuit issued a decision in Farhy v. Commissioner, No. 23-1179. This reversed the Tax Court’s decision that held that the Internal Revenue Service (IRS) couldn’t assess penalties under Internal Revenue Section 6038(b) for failure to file Form 5471 – Information Return of U.S. Persons with Respect to Certain Foreign Corporations. 

Background of Farhy v. Commissioner

The taxpayer in Farhy owned 100% of a foreign corporation in Belize and failed to report the same on Form 5471 for tax years 2005 through 2010. The IRS mailed the petitioner a notice of this failure to file, but the petitioner never remedied the situation by filing the forms. The IRS subsequently assessed a Section 6038(b)(1) penalty of $10,000 for each year at issue for non-reporting and an additional failure penalty under Section 6038(b)(2) for continued noncompliance, which totaled $50,000 for each year at issue.

The Tax Court found that the taxpayer’s failure to file Form 5471 was willful and not due to reasonable cause. The taxpayer’s main argument against the penalty, however, was that the IRS didn’t have the statutory authority to assess Section 6038(b) penalties since the penalties were not ‘assessable’ and that the government must sue him in federal district court to collect on these penalties.

Understanding Assessable Penalties

“Assessable penalties” can be levied by the IRS without issuing a prior notice of deficiency to the taxpayer. Penalties that are not “assessable” are subject to deficiency procedures, allowing the taxpayer to challenge the penalty even before it is assessed or paid.

The Tax Court found that this argument held merit, noting that Congress explicitly authorized the assessment with respect “to myriad penalty provisions of the Code, but not for Section 6038(b) penalties.” As such, the Tax Court found that penalties aren’t “taxes” for purposes of assessable penalty characterization and the IRS had, therefore, no authority to levy those penalties.

Current Decision

In this appeals court decision, the D.C. Circuit made it clear that despite the absence of penalty language from Chapter 68 or lack of explicit language directing the penalty, it isn’t conclusive that the IRS lacks the statutory authority to assess these penalties.

Despite the lack of reference to legislative history, the D.C. Circuit decision noted that when Congress amended the Internal Revenue Code (IRC) in 1982, it intended the Section 6038(a) penalty to be assessable in light of coordination of the previous Section 6038 penalties and the addition of a fixed-dollar penalty. These changes to the statute’s plain text validate Congress’ intention to make the Subsection (b) penalties assessable.

The court also considered the IRC provisions that excuse taxpayers for conduct otherwise subject to penalty based on a showing of “reasonable cause.” The court noted that Section 6038, on its face, empowers the IRS – not a court – to grant or deny that reasonable cause defense. It would only be reasonable then to assume that given the post-assessment process in place to “show to the satisfaction of the Secretary” that a reasonable cause didn’t exist, Congress intended the IRS to have this assessment authorization.

Due to the preceding reasons, the court concluded that the penalties imposed by the IRS were assessable.

What’s Next & Why File?

Though a blow for taxpayers, the court’s ruling isn’t necessarily the end of the Farhy issue. The taxpayer may request a review of the decision en banc (on the bench), and ultimately, the taxpayer can petition the Supreme Court for a writ of certiorari.

In the current climate, continue to file Forms 5471 and other international information filings until there’s an ultimate decision. As I tell my clients, the information reporting costs you nothing except annual preparer fees. However, the penalties for failure to file these forms are still much higher than a preparer fee — even if their assessability is questionable.

Wolf & Company will continue to monitor whether a review of the decision takes place. If you have questions about your international filing, please reach out to our team today.