Case Background
Mr. Farhy owned a 100 percent interest in two Belize corporations between 2003 and 2010. In 2016, the IRS issued a notice to Mr. Farhy indicating that he had failed to file Forms 5471 for the respective tax years reporting these ownership interests. It should be noted that Mr. Farhy participated in an illegal scheme to evade tax during these years and willfully failed to file Forms 5471 with respect to the two corporations, which he admitted via signed affidavit.
The IRS mailed Mr. Farhy a notice proposing the assessment of penalties pursuant to Section 6038(b) for his failure to file Forms 5471 for the tax years at issue. This included the initial Section 6038 penalty of $10,000 for each corporation for each year at issue, as well as the continuation penalties under Section 6038(b)(2). In total, $50,000 per tax year was assessed. In January 2019, the IRS issued to Mr. Farhy an intent to levy notice.
For each tax year at issue, the taxpayer was required under Section 6038(a) to file Form 5471 for the respective corporations, but he did not, and his failure to file the Forms 5471 was willful and not due to reasonable cause, facts acknowledged by the Tax Court. Nevertheless, Mr. Farhy submitted a timely request for a due process hearing, disputing the IRS’s right to assess penalties under Section 6038(b). A Notice of Determination for the unpaid Section 6038(b) penalties was then issued by the IRS in June 2021.
Mr. Farhy timely filed a petition with the U.S. Tax Court for a review of the IRS determination. The authority of the IRS to assess these penalties was the only issue entertained by the Tax Court.
U.S. Tax Court Decision
The taxpayer argued that Section 6038(b), unlike a multitude of other penalty sections in the Code, contains no provision authorizing assessment of the penalty for which it provides. The taxpayer’s contention was that if the IRS does not have authority to assess Section 6038(b) penalties, it would not have the right to collection by levy. The court decided the issue in favor of Mr. Farhy and held that the IRS lacked statutory authority to assess the penalties administratively under Section 6038(b) and could not proceed with collection of the assessed penalties via the proposed levy. Because the underlying assessment by the IRS was invalid, the court ruled that the IRS could not avail itself of its administrative collection powers.
Accordingly, the attempt to levy Mr. Farhy’s assets to collect the improperly assessed penalties was invalid. The court noted, however, that the government does not wholly lack a method for collecting such penalties, as 28 U.S.C. § 2461(a) provides a specific method (a civil action) for collecting penalties where the mode of recovery is not otherwise specified in the Code. Thus, while a Section 6038(b) penalty is not an assessable penalty, it may be collected through a civil action.
In addition, the IRS’s argument that the term “taxes” in Section 6201(a) encompasses the Section 6038(b) penalties (even if they are not assessable penalties) was rejected by the Tax Court, which stated that “taxes and penalties are distinct categories of exactions…” Further, the Tax Court declined to “substitute the Commissioner’s judgment for the Congressional decision not to deem the Section 6038(b) penalties ‘taxes’ for assessment and collection purposes.”
Ruling's Implications
The IRS has relied on its “machines” to auto-generate and mail penalty notices for missed or late Form 5471 filings to taxpayers for many years. These “machines” were programmed to identify a missed or late filed Form 5471 (among other international centric forms) and auto-assess penalties under Section 6038. The Tax Court’s ruling challenges the validity of the auto-assessments, not only to Form 5471, but other international tax forms as well (e.g., Forms 5472, 8865, 8858).
Further, those who have paid these assessments may now seek recourse depending on the statute of limitations. It would not be surprising to see taxpayers facing such penalties argue, based on the reasoning in this ruling, that the Commissioner has no authority to collect the penalty without first filing a lawsuit. Thus, while the liability is not being absolved in the case, it would appear that the Tax Court is indicating that the IRS must take civil action and seek a resulting judgement to secure an amount a taxpayer owes.
IRS to Respond
How the IRS responds to the Tax Court’s ruling is yet to be seen. The IRS may appeal or ask for reconsideration with the Tax Court. An appeal would be heard by the Circuit Court of Appeals for the District of Columbia. Alternatively, the IRS could file a Decision of Nonacquiescence concerning the ruling, indicating that it does not agree with the Tax Court’s decision but will not pursue an appeal. The IRS could also let the ruling stand and seek a cure by way of Congressional intervention, something the IRS has had to do previously when a Tax Court case does not go its way. The legislative fix would likely have to include an amendment to Section 6038 or to some other statute that would expressly grant the IRS the authority to assess and collect the penalties in Section 6038(b) or in all of Subpart A. Any decisions made by the Commissioner will be in published guidance.
For additional information regarding an open or paid assessment under Section 6038(b), as well as analysis of whether or not other penalties assessed under similar statutes regarding other international tax form filings could be in scope of the Tax Court’s opinion, please contact a member of FGMK’s International Tax team.
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