CSG Law Alert: Tax Court: IRS Cannot Enforce Penalties for Failure to Timely File Form 5471
Last week, the U.S. Tax Court decided Alon Farhy v. Commissioner,1 holding that the IRS lacks the authority to assess penalties when a taxpayer fails to file IRS Form 5471, Information Return of U.S. Persons With Respect To Certain Foreign Corporations. As a result, the IRS cannot collect penalties via levy, and the IRS’s only course of action would be a civil lawsuit.
Alon Farhy (“Farhy”), a U.S. citizen, was caught in a scheme to conceal income through two wholly-owned corporations that were incorporated in Belize. Due to his ownership of the foreign corporations, Farhy was required to file Form 5471 for tax years 2003-2010 for each corporation, but he failed to do so, which was willful and not due to reasonable cause. The IRS assessed penalties under section 6038(b) of the Internal Revenue Code (the “Code”). Farhy filed a petition in the U.S. Tax Court after the IRS refused to abate the penalties.
IRS Form 5471 Filing Requirements
Under Code section 6201(a), the IRS is authorized to assess taxes, defined as “interest, additional amounts, additions to the tax, and assessable penalties” imposed by the Code. Code section 6038(b)(1) imposes a $10,000 penalty for each accounting period (commonly each year) that Form 5471 is not filed for each U.S. Shareholder2 of a Controlled Foreign Corporation.3 Additionally, after a 90-day notice period, Code section 6038(b)(2) imposes an additional $10,000 penalty for any part of each 30-day period during which the failure to file continues, capped at $50,000. Thus, a taxpayer could potentially face up to $60,000 for each failure to file Form 5471 (i.e., $10,000 for not filing plus $50,000 for the additional 30-day continuation penalties).
Farhy argued that Code section 6038(b) did not authorize the penalties to be assessed through the IRS’s typical enforcement mechanism, a levy, and therefore the IRS would need to commence a civil action to enforce the penalties under section 6038(b). Farhy argued further that Code section 6201(a) uses the phrase “assessable penalties,” but never provided a definition, making it unclear which penalties are assessable penalties.
The IRS disagreed, stating that “assessable penalties” include any penalties in the Code that are not in the deficiency procedures because the term “assessable penalties” is not limited by Code section 6201 or other sections of the Code. Specifically, the IRS argued that the word “taxes” in Code section 6201(a) includes the penalties in Code section 6038.
The Tax Court agreed with Farhy, concluding that Congress authorized the IRS to assess penalties in many other instances, but not for Code section 6038(b). The Tax Court further concluded that 28 U.S.C. 2461(a) expressly provides that if no mode of recovery is specified, the amount may be recovered by civil action. Therefore, the default method of collection is via civil action, limiting the IRS’s ability to recover via levy to where it is specifically authorized to do so by Congress. As no method of collection is specified for Code section 6038(b), civil action is the IRS’s sole recourse.
What is Next?
The IRS will almost certainly appeal the Tax Court’s decision to the U.S. Court of Appeals for the D.C. Circuit,4 and will likely continue to assess and enforce penalties under Code section 6038(b) until appeals are extinguished. Further, Congress could act to amend Code section 6201 to include the penalties under Code section 6038, though Congress’s recent inaction makes a legislative fix unlikely.
The IRS could continue to enforce its assessment via civil action, though the lack of a formal mechanism, coupled with the increased time and expense, make the use of a civil action an undesirable enforcement mechanism. The IRS could decide to decline to levy under these limited circumstances, but still assess the penalties to offset refunds elsewhere under Lewis v. Reynolds,5 which permits the IRS to reject a refund claim due to an assessment in another year and/or relating to a different tax. Additionally, the IRS could still revoke passports due to seriously delinquent tax debts. Thus, even though it may be hamstrung in its ability to collect penalties under Code section 6038(b), the IRS may not be without a mechanism to force a taxpayer to pay.
Finally, the Tax Court’s logic could extend to other late or non-filing penalties under other sections of the Code and forms, most notably the penalties under Code section 6039F, imposed for late filings or failures to file Form 3520, Annual Return to Report Transactions With Foreign Trusts and Receipt of Certain Foreign Gifts.
1 160 T.C. No. 6 (April 3, 2023).
2 A U.S. shareholder, with respect to any foreign corporation, is defined as a U.S. person that owns 10% or more of the total combined voting power of all classes of stock entitled to vote of such foreign corporation, or 10% or more of the total value of shares of all classes of stock of the foreign corporation. I.R.C. § 951(b).
3 A controlled foreign corporation, or CFC, is defined as any foreign corporation if more than 50% of: (1) the total combined voting power of all classes of stock of such corporation entitled to vote; or (2) the total value of the stock of such corporation, is owned by U.S. shareholders at any time during the foreign corporation’s taxable year. I.R.C. § 957(a).
4 The Taxpayer resides outside of the U.S.; therefore, his appeal is to the D.C. Circuit.
5 284 U.S. 281 (1932).