Earlier this month, the U.S. Court of Appeals for the District of Columbia Circuit issued a ruling in Farhy against the Commissioner, No. 23-1179 (May 3, 2024), reversing the decision of the Tax Court which held that the Internal Revenue Service could not assess penalties under Internal Revenue Code section 6038(b) for failure to file Form 5471 – Information Return of US Persons regarding with some foreign corporations.

Background

The taxpayer in Farhy owned 100% of a foreign corporation in Belize and failed to report the same on Form 5471 for tax years 2005 through 2010. The IRS sent the petitioner a notice of this filing failure, but the petitioner never corrected the situation by filing the forms . The IRS then assessed a Section 6038(b)(1) penalty of $10,000 for each year in question and an additional failure penalty under Section 6038(b)(2) for continued noncompliance, which amounted to $50,000 per each year in question.

The Tax Court found that the taxpayer's failure to file Form 5471 was willful and not due to reasonable cause. The court further noted that the taxpayer participated in an illegal scheme to reduce the income tax he owed and signed an affidavit describing his role in that illegal scheme. This means that the taxpayer had zero chance of a reasonable argument. Why is this good, though? The statutory arguments in this case and the resulting decision not depends on a finding of reasonable cause.

The taxpayer's main argument was that the IRS lacked the statutory authority to assess Section 6038(b) penalties and that the government should sue him in federal district court to collect these penalties. The taxpayer asserted that while section 6201(a) is broad in granting its authority for “assessable penalties,” it does not include Chapter 61 penalties. Petitioner further contended that the penalties of section 6038(b) contain no provision that authorizes the IRS to assess or collect the same and should not be considered an “assessable penalty.”

The Tax Court found that this argument had merit, noting that Congress expressly authorized assessment with respect to the “numerous punitive provisions of the Code, but not for the penalties of section 6038(b). As such, the Tax Court found that fines are not “taxes” for purposes of characterizing the assessable penalty.

Current decision

In this appeals court decision, the D.C. Circuit made clear that despite the absence of punitive language from Chapter 68 or the absence of a cross-reference to Chapter 68 or clear language directing the penalty, it is not conclusive that the IRS lacks authority legal to assess these penalties. Using a narrower set of conclusions, the court held that when “read in light of its text, structure, and function,” section 6038(b) is best construed to impose the penalties it authorizes.

Despite the lack of reference to legislative history, the D.C. Circuit decision noted that when Congress amended the IRC in 1982, it intended the Section 6038(a) penalty to be assessed in light of the coordination of the earlier Section 6038 penalties and adding a fixed penalty in dollars. These changes to the plain text of the statute demonstrate Congress's intent to make the penalties of subsection (b) assessable.

The court went on to discuss and reject the notion that the statute intended the government to bring suit to recover the $10,000 flat penalty assessed under section 6038(b). It would be “highly anomalous,” the court declared, for Congress to simply apply a penalty and calculation to the IRC amendment in 1982 only to then make enforcement more difficult.

Finally, the court considered provisions of the IRC that excuse taxpayers for conduct otherwise subject to penalty based on a showing of “reasonable cause.” The court noted that section 6038, on its face, empowers the IRS – NO a court – to give or deny that reasonable protection. It would then only be reasonable to assume that given the post-assessment process in place to “demonstrate to the satisfaction of the Secretary” that reasonable cause did not exist, Congress intended the IRS to have this assessment authority.

Ultimately, the court declined to adopt a reading of section 6038(b) that was counterproductive and ineffective for Congress' intent and concluded that the fines imposed by the same were assessable.

What is expected next?

Although a blow to taxpayers, the court's decision is not necessarily the end of the Farhy matter. The taxpayer may request a review of the decision on the bench (on the bench), and ultimately, the taxpayer may petition the Supreme Court for a writ of certiorari.

What should taxpayers do in the meantime?

In the current climate, continue to file Forms 5471 and other international information filings until a final decision is made. As I tell my clients, reporting information costs you nothing other than annual preparer fees. However, the penalties for not submitting these forms are still there LOT higher than a preparer's fee – even if their valuation is questionable.