In April of this year, the Tax Court ruled in favor of the taxpayer in Farhy v. Commissioner (160 TC No. 6, Dec. 62,191 (2023)), that the Internal Revenue Service did not have the authority under the Internal Revenue Code to assess and collect Form 5471 penalties.
Form 5471 is an information return required to be filed by U.S. persons who are officers, directors or shareholders of certain foreign corporations. However, the Tax Court decision is potentially much broader than penalties with respect to Form 5471.
Form 5471 is designed to implement the foreign reporting requirements under Code Secs. 6038 and 6038A, in Chapter 61 of the IRC. Code Sec. 6201 does authorize assessment authority; however, the court adopted the view of the taxpayer and also the National Taxpayer Advocate that the Code Sec. 6201 assessment authority is limited to penalties in Chapter 68 of the IRC.
Options for the IRS
The IRS has several options available to it in response to Farhy. It can appeal the decision to the Court of Appeals. As of this writing, it does not appear to have yet done so. To appeal it, the IRS must do so by July 2023. The agency can alternatively follow Farhy and turn the Form 5471 cases over to the Department of Justice to pursue collection action. It can ignore Farthy and continue to seek to assess and collect Form 5471 penalties. It can, as recommended by the Taxpayer Advocate, ask Congress to extend its assessment authority beyond Code Sec. 6201.
With courts increasingly looking closely at the statutory language to determine the authority of the IRS, and with its own Taxpayer Advocate questioning the authority of the IRS's assessment authority in this area, the IRS may feel that an appeal might not be successful.
Getting Congress to act quickly on any tax change is problematic; however, the IRS is likely to undertake that effort. Turning the cases over to the Department of Justice for collection would be a time-consuming and burdensome process, with approximately 10,000 Code Sec. 6038 penalties assessed each year.
Options for taxpayers
Any taxpayer currently faced with a Form 5471 assessment proceeding with the IRS will want to consider following Farhy's example and filing a Tax Court action if the IRS decides to ignore Farhy. Taxpayers who have already paid penalties pursuant to an IRS assessment proceeding with respect to Form 5471 should consider filing a protective refund claim before their statute of limitations expires. Pursuing that refund claim in federal court may be met by a countersuit by the IRS for the penalties, which are still owed and can still be pursued by the IRS in a federal court action.
Taxpayers facing assessment proceedings involving other foreign reporting penalties not covered by Code Sec. 6201 may also consider similar action in reliance on the logic of the Farhy decision. These include Form 926, Form 5472, Form 8858, Form 8865 and Form 8938. Taxpayers facing penalties with respect to these forms should also consider Farhy in resisting IRS assessment proceedings and consider filing protective refund claims if they have paid penalties with respect to these forms and the statute of limitations has not yet expired.
Summary
The IRS has been using the assessment proceedings with respect to Form 5471 since at least 2014. For many of those years the IRS Internal Revenue Manual acknowledged the lack of a statute of limitations with respect to these penalties, while failing to acknowledge that that might also indicate a lack of authority for assessment proceedings. The IRS seemed incapable of believing that it did not have assessment authority for all penalties under the code, in spite of the Taxpayer Advocate stating as much as early as 2020, and several other commentators making the same argument.
The IRS could at least during that time have sought "clarification" from Congress of its statutory authority for assessment proceedings. Now, it may be some time before Congress will take up and enact such a provision.
By the time of publication of this column, we should know whether the IRS has opted to appeal Farhy or not. The odds of a successful appeal by the IRS do not appear to be high. In the meantime, taxpayers who follow Farhy and resist assessment proceedings are likely to have success in the Tax Court. Taxpayers who still have open years with respect to which they have paid penalties as a result of assessment proceedings may file protective refund claims; however, the ultimate outcome of those proceedings might be that the taxpayer may eventually still have to pay the penalties in a federal court proceeding.
