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D.C. Circuit Overturns Tax Court’s Farhy Decision: What it Means for International Tax Filing Penalties

May 16, 2024

Attention taxpayers…the D.C. Circuit recently reaffirmed the IRS's authority to assess penalties against taxpayers who fail to timely file certain international information returns, overturning the Tax Court’s taxpayer-friendly decision from last year. Here’s what you should know.

On May 3, the United States Court of Appeals for the District of Columbia issued an opinion in Farhy v. Commissioner, overturning the Tax Court’s decision from April of last year in which that court found that the IRS lacked the statutory authority to directly assess the penalties provided for by I.R.C. section 6038(b).

Section 6038(b) establishes an initial $10,000 penalty (plus increased penalties for ongoing non-compliance) for failing to file certain information reporting forms, including Form 5471. What is the impact of this decision? We explore here.

Background – The Farhy Case

Check out our blog, Tax Court Rules that IRS Cannot Assess Penalties for Failure to File Form 5471 regarding last year’s Tax Court decision.

Under the Tax Court’s Farhy decision, the IRS’s ability to pursue and enforce section 6038(b) penalties against taxpayers who fail to timely file Form 5471 was severely limited. Rather than the IRS making a direct assessment against a taxpayer as it has done historically, the Department of Justice would have to obtain a judgment in federal court against each taxpayer upon which it hopes to enforce the penalty.

The resources required to pursue the penalty in this manner would presumably limit the IRS’s ability to enforce it against many taxpayers that might have otherwise been assessed the penalty, resulting in a win for many taxpayers who missed filings.

In reversing the Tax Court’s decision, the Court of Appeals found that the “text, structure, and function of section 6038 demonstrate that Congress authorized assessment of the penalties” provided for by section 6038(b). In support of this finding, the Court of Appeals noted that the IRS has been assessing penalties under section 6038(b) for more than forty years without Congress seeing fit to intervene. Now, in the wake of the Court of Appeals decision in Farhy, the IRS can resume its practice of assessing penalties where taxpayers fail to file Form 5471.

The petitioner taxpayer in Farhy may still pursue an appeal of the DC Circuit’s decision to the Supreme Court. The next procedural step to watch for is whether the Supreme Court grants certiorari should the taxpayer indeed appeal.

What should you do if you missed a Form 5471 filing?

In the meantime, unless and until the Supreme Court steps in to reverse the DC Circuit, there are several options to consider for taxpayers who have missed a Form 5471 filing to limit their penalty exposure:

  1. Certain taxpayers may be eligible to use the Streamlined Offshore Procedures. The Streamlined programs will generally eliminate penalty exposure for missed filings, but Streamline filers residing in the U.S. will be subject to a 5% penalty based on the value of the taxpayer’s foreign assets. (Streamline filers residing outside the U.S. are not subject to this 5% penalty.)
  2. Taxpayers who do not meet the eligibility requirements for the Streamlined program should file the delinquent forms by attaching them to an amended tax return for the year(s) in which the missed filing(s) occurred. Taxpayers using the delinquent filing procedure may seek penalty relief by including a reasonable cause statement explaining why the penalties should not be assessed. (Note that the IRS is now telling taxpayers that it may ignore the reasonable cause statement initially and taxpayers may be assessed a penalty first and then re-submit their reasonable cause statement in order to have the IRS consider rescinding the penalty.)
  3. In addition, some taxpayers may be eligible for a first-time abatement, in which the IRS will abate a penalty for failure to file a Form 5471 if the taxpayer meets certain criteria.

Need help assessing your filing obligations? Contact our International Tax Services Team.

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