Farhy v. Commissioner: 5471 Penalties Are Not Assessable

On April 3, 2023, the United States Tax Court delivered a sweeping win to taxpayers with certain international activity. In the precedent-setting Farhy v. Commissioner, the Tax Court held that the IRS “lacks statutory authority to assess penalties” for failure to file Form 5471.

Form 5471 and Sec. 6038: Who is affected?

Form 5471 is an information return that must be filed by U.S. persons who are invested in (or officers or directors for) certain foreign companies. The intent of the form is to help the IRS better enforce international tax regimes. Most commonly, the form affects U.S. citizens and residents who own more than 10% of a foreign company with majority U.S. owners.

The information reported on Form 5471 also calculates certain income, deductions and credits reported on the tax returns of the foreign company’s U.S. shareholders. The penalty for failure to file Form 5471 starts at $10,000 per year, per foreign corporation.

While Farhy deals specifically with Form 5471, other international tax forms are governed by Sec. 6038 and related sections of the IRC. The Farhy opinion holds that the lack of authority to assess penalties exists because Sec. 6038(b) does not contain a provision that renders the penalties assessable. Therefore, the opinion may be more far-reaching than it first appears. It’s possible that the same reasoning and conclusion would apply to other international forms (e.g., Form 5472 under Sec. 6038A, Form 8938 under Sec. 6038D, etc.)

Assessable is the key word. What does this mean?

It is important to define assessable in order to understand the Tax Court’s opinion on this case. Assessable penalties are immediately payable by the taxpayer to the IRS and can be collected administratively. In other words, the IRS can collect them (a) without involving another agency or government body, and (b) when necessary by way of wage garnishment, lien or levy.

The Tax Court’s holding in Farhy means penalties for failure to file Form 5471 are not assessable under this definition. However, that doesn’t mean the IRS has no means to collect them. The Farhy opinion references Goldston v. United States and notes that when penalties are not assessable, the IRS may still pursue them through civil action. Practically, this would mean deferring to the Department of Justice (DOJ) and suing the taxpayer through that department.

The average taxpayer failing to file Form 5471 would likely be insignificant compared to cases the DOJ usually handles. So it’s considered unlikely the IRS would seek this type of penalty through civil action.

A win for taxpayers now – but what does the future hold?

While Farhy is a big win for taxpayers, it’s not a free pass to ignore Form 5471. First, failure to file Form 5471 stops the statute of limitations from ever starting. This means that, in the event of failure to file, the IRS has an unlimited amount of time to pursue tax on unreported income and related penalties.

For example, in Fairbank v. Commissioner the IRS went back 15 years to collect tax and penalties due to missing international forms. Normally, the IRS only has three years (or seven years for large understatements of income). This exception to the statue of limitations was not changed by the Farhy opinion.

Second, while perhaps improbable, it is still possible for the IRS to pursue penalties through civil action.

Third, it’s unlikely the judicial and legislative circumstances will remain this way for long. The IRS could appeal the Tax Court’s decision, or legislation could be enacted to change the picture. The Taxpayer Advocate Service, for example, has recommended that Sec. 6038 be amended to make international reporting penalties subject to “deficiency procedures.” This would allow the IRS to collect penalties directly, but only after giving taxpayers an opportunity to dispute and resolve them through administrative or judicial process.

What should I do if I’m out of compliance?

For taxpayers with delinquent Forms 5471, the best course of action is to take advantage of the current state of affairs and come into compliance, especially in light of Farhy. Various procedures make this easier by lessening the burden on taxpayers, sometimes reducing the number of years for which past due forms must be filed.

These forms and compliance procedures require a great depth of international tax expertise. As always, consult an international tax advisor to discover your compliance options and gain peace of mind.

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