A recent U.S. Tax Court ruling hinders the ability of the IRS to assess and collect certain international information return penalties. In Farhy v. Commissioner, the court ruled that the IRS does not have the authority to assess penalties for a taxpayer’s failure to file Form 5471, Information Return of U.S. Persons With Respect to Certain Foreign Corporations. As a result, the IRS is prevented from using its expansive administrative powers to collect the penalties. The court’s decision also opened the door to future challenges to other similar penalties.
In the case, Alon Farhy willfully failed to file required Form 5471s. Failure to timely file Form 5471 is subject to an initial $10,000 penalty under Internal Revenue Code (Code) Section 6038(b). Additionally, if the taxpayer fails to file within 90 days after the IRS mails a failure to file notice, the taxpayer is subject to an additional penalty of $10,000 for each 30-day period that the failure continues, with a $50,000 maximum. Because of Farhy’s failure to file, the IRS assessed these penalties against him. The IRS then attempted to collect the penalties using a levy.
The issue in the case was whether the IRS had authority to assess penalties under Code Section 6038(b) and to collect the penalties through a levy. The Tax Court ruled that the IRS lacked such authority. While the Code has provisions that allow the IRS to assess certain types of penalties (called “assessable penalties”), the court held that the Code does not have any specific provision that allows the IRS to assess penalties for a failure to file Form 5471. Consequently, the IRS lacked the power to assess and collect the Form 5471 penalties using its expansive administrative powers. Instead, in order to collect the Form 5471 penalties, the IRS would have to resort to a more cumbersome procedure—bringing a civil suit against the taxpayer.
This is a significant taxpayer victory. The IRS has routinely assessed penalties on any late-filed Form 5471 by sending automated penalty notices. This ruling (absent congressional action or a successful court appeal) establishes that this practice is unlawful. According to the opinion, in order to collect penalties, the IRS is forced to pursue the burdensome task of requesting that the Department of Justice sue the taxpayer to collect the penalties. While this case is only applicable to the penalty for failure to timely file Form 5471, the Tax Court’s reasoning may extend to penalties for failure to file certain other foreign reporting forms, including penalties for failure to file Forms 5472, 8865, 8938 and 926.
This ruling also comes on the heels of two other recent taxpayer victories. First, in Bittner v. United States, the U.S. Supreme Court clarified that the $10,000 penalty for non-willful failures to file an FBAR applies per FBAR filed rather than per account reported on the FBAR (as the government had argued). As a result, a taxpayer who non-willfully fails to file a FBAR may have a significantly lower penalty exposure. Second, in Wrzesinksi v. U.S. (the so-called Polish lottery case), the government conceded the case and agreed to refund penalties paid by the taxpayer for late-filed Form 3520s. As a recap, Wrzesinksi involved penalties assessed on the taxpayer’s late filing of Form 3520s to report gifts received from his non-U.S. mother. The taxpayer argued that the penalty should be abated based on reasonable cause, as his accountant told him that he did not need to file any forms with his tax returns to report the gifts. The IRS initially rejected the reasonable cause argument, which led the taxpayer to pay the penalties and sue to get a refund. The IRS’ rejection is emblematic of its high threshold for reasonable cause in these types of cases. Hopefully this case marks a shift in the IRS’ policy and the IRS will acknowledge reasonable cause in more international information reporting cases going forward.
These recent taxpayer-friendly developments highlight the serious issues with the IRS’ policy of automatically assessing certain international information return penalties, and hopefully will bring about change to these policies. Taxpayers with offshore holdings and activity, and those with potential exposure to international information reporting penalties, should consult with their legal advisers to determine how these recent updates may affect them.
For more information, please contact any member of Loeb & Loeb’s International Trust and Estate Planning team.