Tax Court Rules IRS Lacks Authority to Assess §6038(b) Failure-to-File Penalties

On April 3, 2023, the United States Tax Court ruled that the IRS lacks statutory authority to assess penalties for failure to file information returns imposed by IRC §6038(b) in Farhy vs. Commissioner (Farhy, 160 TC No. 6). While §6038 governs the requirements for information reporting with respect to certain foreign corporations and partnerships (i.e., Forms 5471 and 8865), §6038(b) specifies and establishes dollar penalties for non-filing of such information reports. In his defense, Alon Farhy argued that there is no law giving the IRS the authority to assess those penalties.

Background

Alon Farhy failed to file required Forms 5471, Information Return of U.S. Persons With Respect to Certain Foreign Corporations, to report his controlling interest in two foreign corporations located in Belize. It was willful and not due to reasonable cause. In fact, it was part of a scheme to hide income from the IRS. Not surprisingly, the IRS assessed penalties for each year he failed to file. Farhy did not pay the penalties, and the IRS proposed to collect the unpaid penalties by levy. The IRS Office of Appeals sustained the levy, and Farhy filed a Tax Court petition.

In its ruling, the Tax Court asserted that:

• §6038(b)(1) imposes a $10,000 penalty for each failure to file Form 5471 and §6038(b)(2) imposes $10,000 for each 30-day period that such a failure continues, up to a $50,000 maximum. However, “no mode of recovery or enforcement is specified for these penalties,” and the court didn’t want to disturb a well-established framework “by inferring the IRS had the power to administratively assess and collect the §6038(b) penalties when Congress did not see fit to grant that power”;
• that the mere fact that the penalty is not subject to deficiency procedures does not automatically make the penalty an assessable penalty if Congress hasn’t given the IRS the authority to assess the penalty; and
• that the legislative history cited by the IRS said nothing about how the IRS should collect the §6038(b) penalties.

While the IRS could not collect the penalties via levy, it could file a civil collection suite under 28 USC §2461(a), which provides that when 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 is an important case challenging IRS’s authority to assess such penalties, in particular its ability to assess penalties with respect to Form 5471. As of this writing, the IRS has not responded to the ruling. We await further developments.

Our team is trained in addressing these types of issues. If you have questions, please reach out to an HBK Tax Advisor.