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Tax Court Rules that IRS Cannot Assess Penalties for Failure to File Form 5471

May 22, 2023

Attention taxpayers...have you missed a foreign filing and been assessed a penalty by the IRS? A recent tax court decision may have created refund opportunity. Here is what you should know.

The Internal Revenue Code imposes harsh penalties for U.S. taxpayers who fail to properly report certain ownership interests in foreign entities. However, on April 3, 2023, the United States Tax Court issued a decision in Farhy v. Commissioner (T.C. 160 No. 6), in which it held that the IRS lacked the statutory authority to assess penalties against a taxpayer for failing to file form 5471 under Internal Revenue Code Section 6038(b). Here are the details.

Background - Farhy vs. Commissioner

The United States tax code provides for a penalty for taxpayers who fail to timely file certain informational reporting returns with respect to their interest in foreign entities.

How much is the penalty?

The penalty includes a $10,000 penalty for each instance of failing to timely file the required foreign reporting,[1] and an additional $10,000 penalty for each 30-day period in which the taxpayer fails to file the information return after the taxpayer has been notified by the IRS of its failure to file (capped at $50,000).[2]

What happened in the Farhy case?

The taxpayer in Farhy owned 100% of multiple foreign corporations but failed to file the required Forms 5471 for multiple years. The IRS assessed penalties against the taxpayer for these failures to file form 5471, and the taxpayer challenged the IRS’s authority to do so arguing that the relevant statute did not expressly authorize the IRS to assess the penalty.

The IRS contended that its statutory assessment authority under Internal Revenue Code Section 6201 (as delegated to it by the Secretary of the Treasury) extends to any penalty provided for in the tax code, including the penalty for failure to file a form 5471.

The Court’s Decision

The Tax Court agreed with the taxpayer, finding that the IRS lacked the statutory authority to assess the penalty for failure to file Form 5471. Due to the lack of statutory authority to assess the penalty, the court also held that the IRS could not proceed with the collection of the penalty via levy.

What Happens Next, and What It Means for Taxpayers

The Farhy decision was specifically about the taxpayer’s failure to file Form 5471, but the ruling could apply in cases of failures to file other informational reporting – like Forms 8865, 8858, 926, and potentially others.

Are taxpayers owed refunds?

It remains unclear whether the Tax Court’s decision in Farhy opens the door for taxpayers to pursue a refund of previously assessed (and paid) penalties for failures to file Form 5471, especially where the statute of limitations has run. Further, there is as yet no clarity as to the appropriate procedure through which a taxpayer could pursue such a refund claim.

Do taxpayers still have to include the informational reporting with their tax returns?

The decision does not alleviate taxpayers from the obligation to include the informational reporting with their tax returns – the court ruled that the IRS did not have the statutory authority to assess the penalty, not that the penalty itself was invalid or unenforceable. Rather, the IRS would have to pursue a civil action against a taxpayer in order to collect the penalty.

Could the IRS appeal this decision?

The IRS may choose to appeal the Tax Court’s Farhy decision to the Circuit Court of Appeals, and a Court of Appeals decision could be further appealed by either party to the Supreme Court. The appeals process, if the IRS chooses to pursue it, could take years to resolve. The IRS has 90 days from the date of the Farhy decision to decide whether to appeal.

Stay tuned

We will monitor future developments with the Farhy case and provide updates here as they become available. In the meantime, if you have paid a penalty related to failing to file required foreign reporting, we can assist you in assessing your options and navigating any potential refund claim you might have. We can also help you with any of your foreign reporting obligations, including presenting options if you have late filings that haven’t been addressed.

[1] I.R.C. § 6038(b)(1).

[2] I.R.C. § 6038(b)(2).

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