On April 3, 2023, the US Tax Court issued its opinion in Farhy v. Commissioner, holding that the Internal Revenue Service (IRS) lacked the statutory authority to both assess tax penalties under Internal Revenue Code (Code) Section 6038(b) and collect said penalties via a levy against the taxpayer.
The decision in Farhy is significant because the IRS regularly assesses civil tax penalties for the late filing of international information return forms, such as Form 5471, Information Return of US Persons with Respect to Certain Foreign Corporations. Moreover, for any taxpayer who paid a penalty for filing Form 5471 late, arguably the assessment of that penalty was improper, and the taxpayer may be able to seek a refund of the penalty paid.
THE FARHY DECISION
Code Section 6038(b)(1) provides a civil tax penalty of $10,000 for each year a taxpayer fails to timely file Form 5471. If the IRS sends the taxpayer notice of its failure to file, the taxpayer has 90 days after the notice is mailed to comply with the filing requirement. Failure to comply within the 90-day period subjects the taxpayer to an additional penalty of $10,000 for each 30-day period, with a maximum penalty of $50,000. (See Code Section 6038(b)(2).) Farhy had failed to file Form 5471 with his 2003 to 2010 US federal income tax returns, so the IRS assessed penalties. Farhy argued that the IRS did not have the power to assess the penalties under Code Section 6038.
The Tax Court agreed with Farhy and held that the Code does not contain any provision that permits the IRS to assess the penalty provided in Code Section 6038(b). As such, although the IRS correctly determined that Farhy should be penalized for failing to file Form 5471 with his returns, the IRS lacked the statutory ability under the Code to assess and collect the penalty under the assessment and collection procedures.
The Tax Court did note that the IRS had other tools at its disposal to collect the penalties, for example, 28 U.S.C. § 2461(a), which provides:
Whenever a civil fine, penalty or pecuniary forfeiture is prescribed for the violation of an Act of Congress without specifying the mode of recovery or enforcement thereof, it may be recovered in a civil action.
This would mean that the federal government would be required to bring an action against the taxpayer in district court to collect a penalty for failing to file Form 5471. The civil action is a procedure that is not common, thus making the penalty improbable to apply to many taxpayers.
THE IRS’S POWER TO ASSESS AND COLLECT CIVIL TAX PENALTIES
The Code provides specific rules that permit the IRS to assess taxes (including interest and additions to tax) and certain types of civil tax penalties (so-called “assessable penalties”). For example, Code Section 6201(a) permits the IRS to “assess” taxes and assessable penalties. Assessment is the act of formally recording a tax liability on the IRS’s records. After an assessment and the taxpayer’s failure to pay, the IRS can then enforce the collection of tax, penalties and interest by asserting a lien on property or by levying property. (See e.g., Code Sections 6330 and 6331.)
The power to assess, however, is not universally applicable to all civil tax penalties. Indeed, in Farhy, the Tax Court reminded the IRS and taxpayers that, unless a civil tax penalty is specifically enumerated as assessable, the IRS cannot use its power to collect the penalty under Title 26 of the Code. The Court rejected the IRS’s argument that its assessment power in Code Section 6201 covers “all penalties, or virtually any exaction, imposed by the Code simply because it covers taxes and certain other exactions specifically included.” The Court provided examples of the myriad of penalty provisions in the Code, as well as where the IRS’s authority to assess each penalty is found:
OTHER PENALTIES THAT MAY NOT BE ASSESSABLE
The Farhy decision highlights a technical obstacle in the Code with respect to the IRS’s ability to assess other types of civil tax penalties, especially those tied to international information return filings that have been a boon for the IRS in terms of collections in recent years.
Below are some of the other international information returns filing obligations whose penalty provisions fail to include the language “assessed and collected in the same manner as taxes” and thus may not be assessable under the Farhy decision:
Taxpayers that have made payment of these penalties may consider seeking a refund of such amounts paid if the relevant statute of limitations remains open.
Practice Point: Farhy is a noteworthy taxpayer victory and demonstrates that the Code fails to provide the IRS the ability to collect certain civil tax penalties. If the IRS cannot assess a civil tax penalty, then it cannot use its statutory power under the Code to collect non-assessable penalties. This may not be what Congress intended, but in the absence of a statutory fix, the IRS is now powerless to assess and collect numerous civil tax penalties.
It is important to note that the ruling does not automatically vitiate the penalties, but instead prevents the IRS from collecting them in a practicable manner. In the wake of this ruling, we expect that the IRS will cease all collection activities with respect to Code Section 6038(b) penalties and seek Congress’s assistance in providing the necessary statutory basis for the assessment and collection of these penalties. It of course remains important for taxpayers to comply with the various information reporting requirements under the Code, but any taxpayer who was assessed and paid a penalty on a late-filed Form 5471—or any of the other IRS forms discussed above—should consult with their tax advisor about whether to seek a refund of the penalty paid.