Navigating IRS Penalties: The Impact of Farhy v. Commissioner on U.S. Taxpayers

By: Matthew E. Foreman, Esq., LL.M. and James K. Ivanov

Overview

On May 3, 2024, the U.S. Court of Appeals for the D.C. Circuit issued its opinion in Farhy v. Comm'r ("Farhy DC"),[1] reversing the Tax Court,[2] holding that the IRS has authority under I.R.C. section 6038(b) to assess penalties when a taxpayer fails to file IRS Form 5471, Information Return of a U.S. Person With Respect to Certain Foreign Corporations without filing a civil lawsuit. It must be noted that the decision in Farhy DC is only binding on taxpayers subject to jurisdiction in the D.C. Circuit (i.e., those living within Washington, D.C. and those living outside of the U.S.), and the Farhy Tax Court decision is binding on all other taxpayers.

Facts and Tax Court Decision

The facts are straightforward and were largely stipulated. Alon Farhy (“Farhy”), a U.S. citizen, was caught in a scheme to conceal income through two wholly-owned corporations that were incorporated in Belize. Due to his ownership of the foreign corporations, Farhy was required to file Form 5471 for tax years 2003-2010 for each corporation, but he failed to do so, which was willful and not due to reasonable cause. The IRS assessed penalties under I.R.C. section 6038(b) and Farhy filed a petition in the U.S. Tax Court after the IRS refused to abate the penalties.

Under I.R.C. section 6201(a), the IRS is authorized to assess taxes, defined as “interest, additional amounts, additions to the tax, and assessable penalties” imposed by the Code. Code section 6038(b)(1) imposes a $10,000 penalty for each accounting period (commonly each year) that Form 5471 is not filed for each U.S. Shareholder of a Controlled Foreign Corporation. Additionally, after a 90-day notice period, Code section 6038(b)(2) imposes an additional $10,000 penalty for any part of each 30-day period during which the failure to file continues, capped at $50,000. Thus, a taxpayer could potentially face up to $60,000 for each failure to file Form 5471 (i.e., $10,000 for not filing plus $50,000 for the additional 30-day continuation penalties).

Farhy argued that Code section 6038(b) did not authorize the penalties to be assessed through the IRS’s typical enforcement mechanism, a levy, and therefore the IRS would need to commence a civil action to enforce the penalties under section 6038(b). Farhy argued further that Code section 6201(a) uses the phrase “assessable penalties,” but never provided a definition, making it unclear which penalties are assessable penalties.

The IRS disagreed, stating that “assessable penalties” include any penalties in the Code that are not in the deficiency procedures because the term “assessable penalties” is not limited by Code section 6201 or other sections of the Code. Specifically, the IRS argued that the word “taxes” in Code section 6201(a) includes the penalties in Code section 6038. The Tax Court agreed with Farhy, concluding that Congress authorized the IRS to assess penalties in many other instances, but not for Code section 6038(b). The Tax Court further concluded that 28 U.S.C. 2461(a) expressly provides that if no mode of recovery is specified, the amount may be recovered by civil action. Therefore, the default method of collection is via civil action, limiting the IRS’s ability to recover via levy to where it is specifically authorized to do so by Congress. As no method of collection is specified for Code section 6038(b), civil action is the IRS’s sole recourse.

D.C. Circuit Decision to Reverse the Tax Court

The D.C. Circuit reversal of the Tax Court focused on statutory interpretation and Congressional intent, holding that Congress made the section 6038(b) penalty “assessable by implication”.[3] This D.C. Circuit provided three explanations for why the penalties prescribed by section 6038(b) are meant to be assessed by the IRS without requiring a civil lawsuit.

First, the Circuit Court highlighted the process by which section 6038(b) came into fruition. The previous version of section 6038 did not include the fixed dollar penalties now in section 6038(b), instead including a reduction of the taxpayer’s foreign tax credit, a penalty now codified under section 6038(c). Congress was displeased with the difficult process necessary to calculate penalties, and further noting that taxpayers with no foreign income could escape the penalties altogether.[4] As such, the I.R.C. was amended to include section 6038(b) and the penalty reducing foreign tax credit was shifted to section 6038(c), being modified to first take into account any fixed penalty prescribed by section 6038(b) as to avoid duplication of penalties. The D.C. Circuit decision highlighted this change as evidence that Congress intended for section 6038(b) to be assessable by the IRS, thereby streamlining and simplifying the penalty application of section 6038, which would be defeated if the IRS were required to bring a civil case every time they wished to enforce this penalty. Furthermore, the decision focused on section 6038(c)(3) as further evidence that 6038(b) was meant to be assessed without significant delay, as each imposition of the penalty under 6038(c) would need to wait for the penalty under 6038(b) to be assessed before reducing the foreign tax credit accordingly. As such, if 6038(b) was not assessable by the IRS, the penalty now in section 6038(c) in its current form would be more difficult to enforce than prior to the addition of 6038(b).

Second, the Circuit Court focused on section 6038(c)(4)(B) which states that the penalties prescribed by 6038(b) and (c) are subject to a “reasonable cause” affirmative defense which must be “shown to the satisfaction of the Secretary”. The Circuit Court stated that this supported the argument that 6038(b) is assessable without a civil lawsuit, as the IRS was given the statutory authority to abate the penalty if the taxpayer can demonstrate reasonable cause.[5] Thus, it should be the IRS, not a court, that has the authority to assess a penalty under 6038(b), as a court is not permitted to rule on the taxpayer’s reasonable cause arguments prior to assessment.[6] As such, the inclusion of section 6038(c)(4)(B) supports the view that Congress intended 6038(b) to be assessable by the IRS without a civil lawsuit.

Lastly, the Circuit Court highlighted the fact that if 6038(b) were not assessable by the IRS, then a violation that results in both 6038(b) and (c) penalties will result in a dual track judicial proceeding: Federal District Court for the 6038(b) penalty, and Tax Court for the 6038(c) penalty.[7] This would result in duplicative court proceedings on common issues, which increases the potential for inconsistent doctrinal development. The D.C. Circuit declined to accept that Congress intended to create such an ineffective and counterproductive method of penalty enforcement.

In sum, the D.C. Circuit looked at the legislative history of section 6038 to hold that the existing statutory language shows that Congress intended for section 6038(b) penalties to be assessed by the IRS without filing a civil lawsuit.

Implications Beyond 6038(b) Penalties

The D.C. Circuit was very clear that their opinion was not a broad ruling on all penalties residing outside of Chapter 68 of the Internal Revenue Code, but instead was a focused explanation for why the Commissioner’s authority to assess all “assessable penalties” encompasses the authority to assess penalties imposed under section 6038(b).[8] As such, the general arguments of Farhy Tax Court decision may still be applicable to other penalties that do not possess the hallmarks the D.C. Circuit used to support their ruling.

To put this into perspective, we can look to another penalty outside of chapter 68, such as section 6039F(c), which penalizes taxpayers for failures to file Form 3520, Annual Return to Report Transactions with Foreign Trusts and Receipt of Certain Foreign Gifts. Section 6039F(c), similar to section 6038, does not explicitly give the IRS the authority to assess a penalty. If a taxpayer were to challenge this penalty as being non-assessable by the IRS without filing a civil lawsuit, would[9] they prevail? It is our view that if the Tax Court were to follow the D.C. Circuit’s analysis, they will take note that section 6039F(c)(2) includes a reasonable cause defense, although notably missing is the parenthetical found in 6038(c)(4)(B) stating that the reasonable cause defense must be “shown to the satisfaction of the Secretary”. Beyond this factor, no other hallmarks used by the D.C. Circuit to reverse Farhy are found in the statutory text of section 6039F, namely the fact that section 6039F does not include a clearly assessable penalty, such as the one found in 6038(c), and thus would not suffer from the same defects of a single code section containing a mix of assessable and non-assessable penalties for the same violation. As such, it is unclear how a court would rule if presented with this issue; however, the case for 6039F(c) being an assessable penalty appears weaker than of section 6038(b), at least on its face.

What is Next?

In a fascinating turn of events, both sides are likely to keep litigating this issue until either Congressional action or the Supreme Court grants certiorari. Farhy is seeking a rehearing, en banc, in the D.C. Circuit, arguing that the panel that ruled against him assumed Congressional intent and neglected to follow the bare words of the statute.[10] The IRS is likely to ignore the Tax Court decision and challenge this issue in other circuits, raising the possibility of a circuit split. The existence of a circuit split will increase the likelihood of the Supreme Court granting certiorari, as the Supreme Court is generally reluctant to grant certiorari on tax issues without a circuit split or significant time passing from prior decisions and new facts becoming relevant.[11]

As noted above, taxpayers subject to the jurisdiction of the D.C. Circuit will be subject to penalties under section 6038(b) without the requirement of filing a civil lawsuit with regard to IRS Form 5471. However, these taxpayers may still consider bringing challenges to penalties for non- or late-filing of other IRS forms (e.g., 5472, 3520, and 3520-A) that were not the subject of the Farhy DC decision, as it seems to require a court to decide whether Congress made a “penalty assessable by implication” on a statute-by-statute basis. Conversely, taxpayers outside of the D.C. Circuit’s jurisdiction may still rely on the Farhy Tax Court decision, and likewise should consider bring challenges to penalties that are not explicitly assessable.

For personalized guidance, contact FRB’s Taxation Practice Group at (212) 203-3255 or fill out the form below.

DISCLAIMER: This summary is not legal advice and does not create any attorney-client relationship.  This summary does not provide a definitive legal opinion for any factual situation. Before the firm can provide legal advice or opinion to any person or entity, the specific facts at issue must be reviewed by the firm.  Before an attorney-client relationship is formed, the firm must have a signed engagement letter with a client setting forth the Firm’s scope and terms of representation. The information contained herein is based upon the law at the time of publication.

[1] Farhy v. Comm'r of Internal Revenue, 100 F.4th 223 (D.C. Cir. 2024)

[2] Farhy v. Comm'r of Internal Revenue, No. 10647-21L, 2023 WL 2752459 (T.C. Apr. 3, 2023), rev'd and remanded, 100 F.4th 223 (D.C. Cir. 2024)

[3] Farhy v. Comm'r of Internal Revenue, 100 F.4th 223, 236 (D.C. Cir. 2024)

[4] See S. Rep. No. 97-494 , vol. 1, at 299 (1982)

[5] Farhy v. Comm'r of Internal Revenue, 100 F.4th 223, 233 (D.C. Cir. 2024); see also S. Rep. No. 97-494 , vol. 1, at 299 (1982)

[6] See I.R.C. § 6038(c)(4)(B) (requiring reasonable cause to be “shown to the satisfaction of the Secretary”)

[7] Farhy v. Comm'r of Internal Revenue, 100 F.4th 223, 234 (D.C. Cir. 2024)

[8] Farhy v. Comm'r of Internal Revenue, 100 F.4th 223, 231 (D.C. Cir. 2024)

[9] Or perhaps ‘could’ is the correct verb.

[10] https://www.taxnotes.com/research/federal/court-documents/court-petitions-and-briefs/rehearing-sought-appeal-irs-penalty-assessment-authority/7k96r

[11] One recent example of this is South Dakota v. Wayfair, Inc., Overstock.com, Inc., and Newegg, Inc., 585 U.S. ___, 138 S. Ct. 2080; 201 L. Ed. 2d 403 (2018).