A run of good fortune for U.S. taxpayers with foreign corporate ties continues after the Bittner v. United States case, with a recent ruling in the Farhy v. Commissioner case. 

On April 3, 2023, the United States Tax Court released its decision in Farhy v. Commissioner. It indicated the Internal Revenue Service (IRS) lacked the statutory authority to assess and collect the $10,000 penalty on willful delinquent reporting requirements related to Form 5471. Specifically, the Tax Court indicated, IRC Sec. 6038(b) neither includes the appropriate language authorizing the IRS to assess and collect the penalty, nor references another section with the appropriate language authorizing the IRS to assess and collect. Therefore, as of today, any attempt by the IRS to administratively collect Form 5471 penalties is invalid, and in violation of the Tax Court’s order. 

Case Background 

Alon Farhy was the 100% owner of two foreign corporations, both incorporated in Belize, from 2003 through 2010. He did not file a Form 5471 to disclose this. He also participated in an illegal scheme to reduce the amount of income tax owed. After signing an affidavit describing his role in this illegal scheme in 2012, he was granted immunity from prosecution. In 2016, the IRS mailed Farhy notices for failure to file Form 5471, which he still never filed. The Tax Court noted he was willful in his failure. After the IRS assessed the penalties in 2018, Farhy went through the administrative collections process before petitioning the Tax Court in 2021. 

The Tax Court looked at this statute and compared it to other penalty statutes in effect.  

“Congress has explicitly authorized assessment with respect to myriad penalty provisions in the Code, but not for section 6038(b) penalties. Section 6671(a) [for example] provides that the numerous penalties found … in sections 6671 to 6725 … ‘shall be assessed and collected in the same manner as taxes,’ subjecting those penalties to the Secretary’s assessment authority under Section 6201.  Section 6665(a)(1) contains a similar statement. . ..   Code sections outside chapter 68. . . contain their own express provision. . . .  In contrast, section 6038 contains only a cross-reference to a criminal penalty provision. . . .” [Emphasis added] 

The IRS argued the terms in the relevant statutes still encompassed the one found in Section 6038(b) or the term “taxes” (which the IRS can administratively collect) encompassed this penalty as well. The Tax Court remained unpersuaded. 

Section 6038 is not a new statute. So, why did this holding take place now? While the large volume of statutes and regulations makes finding drafting errors like searching for a needle in a haystack, the relatively recent Supreme Court decision in West Virginia v. EPA provided the legal foundation for such a decision. In that 2022 case, the Supreme Court held that agencies have only those powers given to them by Congress. 

What Does This Mean? 

There are three points taxpayers should keep in mind related to these cases:   

1. This case will almost certainly be appealed by the IRS. If it wins on appeal, then this victory will be short-lived, and the status quo restored. However, if it loses on appeal, then it loses the ability to administratively collect penalties on a major international information reporting form. Which is something the IRS can’t fix –  only Congress can.  

Even the National Taxpayer Advocate, Erin M. Collins, questioned the IRS's position in the case, suggesting a legislative change was needed covering a number of penalty provisions for it to be effective. Although Collins's position does not speak for the IRS,  it is not a supportive IRS position.  

2. The Farhy v. Commissioner case only prohibits the IRS from collecting the penalty through administrative action, it does not prevent the IRS from collecting the penalty in a civil action. If the decision stands after the appeal and Congress does not change the statute, the IRS must consider whether to pursue these penalties in court.  

3. This defect is not found everywhere in the Tax Code covering penalty provisions, but it may still impact other international information reporting forms. The statutes that mandate Forms 926, 8938 and 5472, may be similarly vulnerable to the logic in the case. 

How to Respond as A Taxpayer 

If you were required to file a Form 5472, but filed late or haven’t filed it at all, consider your options. In the event you receive(d) a penalty notice from the IRS related to the delinquent filing, speak with your CPA to determine if you should consider challenging it. Penalties for other Forms 926, 8938 and 5472 should also be reviewed. 

Regardless of what the ultimate decisions hold, having your international information reporting forms completed properly is the best defense against IRS penalties. Contact the international tax advisors at Moore Doeren Mayhew if you need help, or have more questions about how the Farhy v. Commissioner decision may impact your unique tax situation.