IRS lacks statutory authority to assess penalties under section 6038(b) for willful failure to file Form 5471
On April 3, 2023, the United States Tax Court ruled in Alon Farhy v. Commissioner, 160 T.C. No. 6 that the Internal Revenue Service (IRS) did not have authority to assess penalties under Internal Revenue Code (IRC) section 6038(b) against a taxpayer who willfully failed to file Form 5471, Information Return of US Persons With Respect to Certain Foreign Corporations. As a result, the IRS could not proceed with collecting such penalties from the taxpayer via a proposed levy.
Generally, Form 5471 is required to be filed with the IRS by certain US taxpayers that own an interest in a foreign corporation that is treated for US tax purposes as a controlled foreign corporation (CFC). A CFC is a foreign corporation in which US shareholders own:
- More than 50 percent of the combined total voting power of all classes of stock of the foreign corporation entitled to vote
- Or, more than 50 percent of the total value of shares of all classes of stock of the foreign corporation
For these purposes, a US shareholder is a US person who:
- Owns 10 percent or more of the total combined voting power of all classes of stock of the foreign corporation entitled to vote
- Or, 10 percent or more of the total value of shares of all classes of stock of the foreign corporation.
In the case of failure to timely file Form 5471, IRC section 6038(b)(1) imposes a $10,000 penalty for each annual accounting period for which such failure exists. Furthermore, if the failure described in IRC 6038(b)(1) continues for more than 90 days after notification, IRC section 6038(b)(2) imposes an additional penalty (i.e., continuation penalty) of $10,000 for each 30-day period for which such failure continues to exist, up to a maximum additional penalty of $50,000.
There is no statutory provision specifically authorizing the assessment of these penalties. However, IRC section 6201(a) authorizes the Secretary of the Treasury to assess taxes (including interest, and assessable penalties). The Secretary of the Treasury has delegated these duties to the Commissioner of the IRS, who, in turn, has delegated them to other IRS officials.
Facts of the case
During the taxable years relevant to the case (i.e., 2003 through 2010), Alon Farhy (the Taxpayer) wholly owned a foreign corporation incorporated in Belize (Belize Co 1). From the taxable year 2005 through the taxable year 2010, the Taxpayer also wholly owned another foreign corporation incorporated in Belize (Belize Co 2). As the result of the Taxpayer’s ownership in Belize Co 1 and Belize Co 2, he had a US reporting obligation with respect to both corporations for the years of ownership in each under IRC 6038(a). More specifically, for each of the years, the Taxpayer was required to file Form 5471 and failed to fulfill this reporting obligation. The Taxpayer’s failure to file Form 5471 was willful and not due to reasonable cause.
On February 9, 2016, the IRS notified the taxpayer of their failure to file Form 5471. On November 5, 2018, the IRS assessed an initial penalty of $10,000 for each year at issue, under section 6038(b)(1). On November 12, 2018, the IRS assessed an additional penalty of $50,000 for each year at issue, under section 6038(b)(2). On January 30, 2019, the IRS issued the Taxpayer Letter 1058, Final Notice of Intent to Levy and Notice of Your Right to a Hearing. Subsequently, the Taxpayer requested a hearing with the United States Tax Court and disputed whether the IRS had the legal authority to assess section 6038 penalties described above.
Summary of the Arguments
The Taxpayer argued that IRC section 6038(b), unlike a number of other penalty sections contained in the Internal Revenue Code, includes no provision authorizing the assessment of the penalty it provides. For example, IRC section 6671(a) provides that the numerous penalties this section applies to “shall be assessed and collected in the same manner as taxes”, which gives the Secretary of the Treasury the authority to assess these penalties under IRC section 6201. Unlike section 6671, IRC section 6038(b) provides for no such explicit assessment authority. Accordingly, the Taxpayer argued that the IRC section 6038(b) penalty is not an assessable penalty, noting that it may still be collected through a civil action. In turn, the IRS argued that the term “assessable penalties” includes any penalties found in the Internal Revenue Code that are not subject to its deficiency procedures.
Tax Court Decision
The United States Tax Court agreed with the Taxpayer’s reading of the Code. The court found the IRS lacked statutory authority to assess penalties under IRC section 6038(b) against the Taxpayer. Accordingly, it could not proceed with the collection of those penalties from the Taxpayer via the proposed levy. More specifically, the court stated it was “loath to disturb this well-established statutory framework by inferring the power to administratively assess and collect the section 6038(b) penalties when Congress did not see fit to grant that power to the Secretary of the Treasury expressly as it did for other penalties in the Code.”
Impact of Decision
Based on the decision, it would appear that the IRS can no longer automatically assess penalties on Forms 5471 that are not filed in a timely manner.
This case presents what will most likely be the first “shot” at this issue. Will the IRS appeal? If so, what will the Appellate Court hold? And how with the other appellate courts view this issue in the future?
There is also the issue of how this decision will impact automatic penalty assessments by the IRS for the late filing of the numerous international informational returns required for foreign trust, foreign gifts, Passive Foreign Investment Company (PFIC) forms to name just a few.
Note: many of these forms form a part of the individual’s income tax return. Thus, if the appropriate forms are not filed, the income tax return will not have been technically filed, so the “statute of limitations” will not begin to run…in other words the tax year will remain open until all the required forms have been filed.
For those taxpayers who have paid the Form 5471 penalties consideration should be given to whether to file for a refund.
For taxpayers with a penalty notice for the late filing of other foreign informational returns you will want to consider whether the result in this case will impact those penalties.
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