Earlier this month, the U.S. Court of Appeals for the District of Columbia Circuit issued a decision in Farhy v. Commissioner, No. 23-1179 (May 3, 2024), reversing the Tax Court’s decision that held that the Internal Revenue Service 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
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 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. Further, the court noted that the taxpayer participated in an illegal scheme to reduce the income tax he owed and signed an affidavit describing his role in that illegal regime. This means the taxpayer had zero chance of a reasonable cause argument. Why is this good, though? The statutory arguments in the case and resulting ruling don’t hinge on a finding of reasonable cause.
The taxpayer’s main argument was that the IRS didn’t have the statutory authority to assess Section 6038(b) penalties and that the government must sue him in federal district court to collect on these penalties. The taxpayer asserted that while Section 6201(a) is extensive in its grant of authority on “assessable penalties,” it doesn’t include Chapter 61 penalties. The petitioner further contended that the Section 6038(b) penalties contain no provision authorizing the IRS to assess or collect the same and shouldn’t be considered an “assessable penalty.”
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.
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 the lack of either a cross-reference to Chapter 68 or explicit language directing the penalty, it isn’t conclusive that the IRS lacks the statutory authority to assess these penalties. Using a narrower set of inferences, the court determined that when “read in light of its text, structure, and function,” section 6038(b) is best interpreted to render the penalties it authorizes.
Despite the lack of reference to legislative history, the D.C. Circuit decision noted that when Congress amended the 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 went on to discuss and dismiss the idea that the statute intended that the government file lawsuits to recover the flat $10,000 penalty assessable under Section 6038(b). It would be “highly anomalous,” the court stated, for Congress to simply a penalty application and calculation in the amendment of the IRC in 1982 to only then make it harder to enforce.
Finally, the court 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.
Ultimately, the court declined to adopt a reading of Section 6038(b) that was counterproductive and ineffective to Congressional intent and concluded that the penalties imposed by the same were assessable.
What’s Next?
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.
What should taxpayers do in the meantime?
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.