Farhy v Commissioner Case – Introduction
On 3 April 2023, the United States Tax Court ruled in Farhy v Commissioner, preventing the IRS from assessing and collecting penalties for failure to file Form 5471, the Information Return of US Persons With Respect to Certain Foreign Corporations.
This form is used to report an individual’s control over a foreign corporation.
Under US Internal Revenue Code (IRC) section 6038(b), failing to provide this information incurs a penalty ranging from $10,000 to $50,000.
Case Background
In June 2021, Alon Farhy challenged the penalties imposed on him for not filing Form 5471.
The Tax Court ruled in his favor, stating that the IRS did not have the authority to assess these penalties under section 6038(b).
However, it noted that the IRS could pursue civil action to collect the penalties.
The IRS appealed this decision to the United States Court of Appeals for the District of Columbia Circuit (DC Circuit), which on 3 May 2024, reversed the Tax Court’s decision, affirming the IRS’s authority to assess and collect these penalties.
Key Points of the Case
Background Details
From 2003 to 2010, Farhy owned two corporations in Belize—Katumba Capital Inc. and Morningstar Ventures, Inc.
Despite knowing his obligation to file Form 5471, he willfully chose not to. After notifying Farhy of his failure, the IRS assessed penalties and issued a final notice of intent to levy when he did not respond.
Farhy requested a collection due process hearing, but the IRS upheld the penalties, leading him to petition the Tax Court, which initially ruled in his favor.
IRS and Taxpayer Arguments
Both parties referenced IRC section 6201(a). The IRS argued that this section granted them broad authority to assess penalties as taxes.
Conversely, Farhy contended that penalties must be explicitly labeled as “tax” or “assessable” in the Code to fall under the IRS’s authority. Farhy outlined four classes of assessable penalties, arguing that section 6038(b) did not fit any of these categories.
DC Circuit’s Analysis
The DC Circuit did not fully align with either party’s arguments but concluded that Congress intended section 6038(b) penalties to be assessable, citing:
- The amendment of section 6038 to include section 6038(b) for easier penalty collection.
- Coordination of penalties under sections 6038(b) and 6038(c).
- The Secretary of Treasury’s authority to determine taxpayer defenses against these penalties.
Key Aspects of the Decision
Ease of Collection
Congress amended section 6038 to simplify the penalty collection process, countering Farhy’s argument that penalties should be nonassessable to limit IRS’s collection powers.
Coordination of Penalties
Sections 6038(b) and 6038(c) penalties work together, and making 6038(b) penalties nonassessable would complicate the process intended by Congress.
Reasonable Cause Exception
The reasonable cause exception for late filing, determined by the Secretary of Treasury, indicates that section 6038(b) penalties fall under the IRS’s assessment authority.
Duplicative Court Proceedings
Farhy’s interpretation would necessitate separate proceedings for sections 6038(b) and 6038(c) penalties, potentially leading to conflicting judgments, which the DC Circuit found impractical.
Farhy v Commissioner Case – Conclusion
The DC Circuit’s decision reversed the Tax Court’s ruling, affirming the IRS’s authority to assess penalties under section 6038(b).
Following this decision, Farhy petitioned for a rehearing, which was denied on 13 June 2024.
As of now, Farhy has not appealed to the United States Supreme Court, but given the ongoing litigation surrounding these penalties, further appeals are likely.
This case underscores the complexities of tax compliance and the importance of adhering to filing requirements for foreign assets. It also highlights the evolving legal interpretations of the IRS’s authority, which may have significant implications for taxpayers with international interests.
Final thoughts
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