The US Tax Court in Farhy v. Commissioner, 160 T.C. No. 6 (April 3, 2023), ruled that the IRS lacked statutory authority to assess Section 6038(b) penalties against an individual taxpayer for failure to file Forms 5471, Information Return of U.S. Persons With Respect to Certain Foreign Corporations, with respect to his Belize foreign corporations. The Court also held that the IRS could not proceed with the collection of the penalties via its proposed levy against the taxpayer. The IRS has not yet indicated whether it will appeal the decision.
Action item: Taxpayers should review whether they have paid any penalties with respect to the Form 5471 information reporting returns at issue in the Tax Court decision as it is anticipated that the IRS will issue guidance indicating its position on the current process around these penalty assessments as well as the review of any pending and future requests for abatements.
During his 2003 through 2010 tax years, Alon Farhy (Farhy) owned 100% of Katumba Capital, Inc. (Katumba), a foreign corporation incorporated in Belize. During his tax years 2005 through 2010, Fahry also owned 100% of Morningstar Ventures, Inc. (Morningstar), a foreign corporation also incorporated in Belize.
For the tax years at issue, Farhy had a reporting requirement under Section 6038(a) to report on Forms 5471 his ownership interests in both Katumba and Morningstar. For each tax year at issue, Farhy failed to file the required Forms 5471 with respect to these foreign corporations. Farhy’s failure to file the Forms 5471 was willful and not due to reasonable cause, the Tax Court noted.
In response to the taxpayer’s failure to file Forms 5471, the IRS imposed $10,000 per year in initial penalties under Section 6038(b) and $50,000 per year in continuation penalties for the tax years 2003 through 2010.
The IRS issued a levy notice to Farhy seeking to collect the Section 6038(b) penalties it had assessed for the tax years at issue. Farhy timely requested a collection due process hearing, arguing that the assessment was unlawful because the IRS lacked the legal authority to assess the penalties as Section 6038(b) has no provision authorizing assessment.
The IRS issued Farhy a Notice of Determination regarding his liabilities for unpaid Section 6038(b) penalties and sustaining its proposed collection action. Farhy filed a petition with the US Tax Court for a review of the determination.
Because the parties stipulated that the standards for the penalty were met, the only issue before the Tax Court was whether the IRS had statutory authority to assess penalties under Section 6038(b). The court decided the issue in favor of Farhy and held that the IRS lacked statutory authority to administratively assess the penalties under that provision and could not proceed with collection of the assessed penalties via the proposed levy.
In so holding, the Tax Court agreed with Farhy’s contention that Section 6038(b), unlike many other penalty sections, does not include a provision authorizing assessment of the penalty and found that the Section 6038(b) penalty is not an assessable penalty. The court 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.”
The IRS argued that the term “assessable penalties” includes any penalties found in the Code that are not subject to the Code’s deficiency procedures. The Tax Court rejected the IRS’s argument that Section 6038(b) penalties are necessarily assessable penalties because they are not subject to deficiency procedures. The court explained that “the mere fact that a penalty is not subject to deficiency procedures does not automatically give rise to the conclusion that it is an assessable penalty, such as where, as here, Congress has not given the Commissioner the authority to assess the penalty.”
The court also rejected 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), stating that “taxes and penalties are distinct categories of exactions…” and declining to “substitute the Commissioner’s judgment for Congress’ decision not to deem the Section 6038(b) penalties ‘taxes’ for assessment and collection purposes.”
Observation: For a number of years, the IRS computer system has been programmed to systematically assess penalties under Section 6038(b) when the IRS receives Forms 5471 attached to delinquent income tax returns. The Tax Court opinion raises questions as to the validity of that program and assessments made under that program.
Observation: The IRS systematically also assesses civil penalties for delinquent Forms 5472, Information Return of a 25% Foreign-Owned U.S. Corporation or a Foreign Corporation Engaged in a U.S. Trade or Business, relying on the same authority as for systematically assessing Form 5471 delinquency penalties. Since domestic disregarded entities that are wholly owned by a single foreign person now must file pro forma Forms 1120, U.S. Corporation Income Tax Return, to transmit Forms 5472 to report reportable transactions between the domestic disregarded entity and its sole foreign owner, Form 5472 delinquency penalties have been systematically assessed, as well. Based on the Tax Court’s decision, these penalties also are in question.