The Tax Court’s recent decision in Farhy v. Commissioner held that the IRS does not have statutory authority to use the IRC’s procedures to assess or collect penalties under IRC Section 6038(b) against a taxpayer who failed to file Form 5471, “Information Return of U.S. Persons With Respect to Certain Foreign Corporations.” Instead, the government must file a civil suit in federal court to collect Section 6038(b) penalties. While the case does not impair the IRS’ ability to assert the penalty, it concluded that the way the IRS has been assessing and collecting it is improper.
This decision could apply to other forms required to be filed under Chapter 61 of the IRC, including Form 5472, “Information Return of a 25% Foreign-Owned U.S. Corporation or a Foreign Corporation Engaged in a U.S. Trade or Business”; Form 926, “Return by a U.S. Transferor of Property to a Foreign Corporation”; Form 8865, “Return of U.S. Persons With Respect to Certain Foreign Partnerships”; Form 8858, “Information Return of U.S. Persons With Respect to Foreign Disregarded Entities (FDEs) and Foreign Branches (FBs)”; or Form 8938, “Consent to Extend the Time to Assess Tax Under Section 367 – Gain Recognition Agreement.” However, the rules are complex, and a single form can be used to meet different reporting obligations under the IRC. As a result, in certain cases, the penalty imposed for failure to timely and properly file some of these forms is a penalty under IRC Section 6677 or IRC Section 6679, which explicitly authorize a penalty to be assessed and collected as a tax. Therefore, if the penalty is imposed under IRC Section 6677 or IRC Section 6679, the analysis the Tax Court used in Farhy would not apply.
The analysis the Tax Court used in Farhy generally does not apply to Form 3520, “Annual Return to Report Transactions With Foreign Trusts and Receipt of Certain Foreign Gifts,” and Form 3520-A, “Annual Information Return of Foreign Trust With a U.S. Owner,” though there are narrow situations involving foreign gifts where it could apply.
In the meantime, taxpayers that paid penalties for failure to timely file Forms 5471, 5472, 926, 8865, 8858, or 8938 should consider whether they are eligible to file refund claims for the penalty payments based on the reasoning in Farhy and, if so, whether they want to. While it is unclear what rules might apply to such refund claims, it is possible that taxpayers might have only two years from the date they paid the penalty to file such a claim.
Taxpayers that receive notices asserting penalties assessed under Section 6038(b) should evaluate their options in light of Farhy before paying or challenging the penalty. Taxpayers might be able to request abatement of the penalty based on the decision in Farhy, which could be made in addition to a request for abatement of the penalty based on reasonable cause where applicable.
Many uncertainties remain. The decision is new, and the government almost certainly will file an appeal, so the ramifications and ultimate resolution of the matter is far from clear and likely far off. The IRS also might attempt to offset penalties against amounts owed to the taxpayer. Therefore, it is very possible that taxpayers that paid these penalties will never receive a refund.
It is unclear how the IRS will be handling abatement requests for the penalties and whether systemically generated penalty notices will continue to be issued.
The Farhy decision is still fresh, and it will take time to see how the IRC Section 6038(b) penalty issue ultimately will be resolved. It is possible that the decision could be overruled on appeal or that Congress will enact legislation allowing the IRS to assess and collect the penalty without having to sue in federal court. However, as the IRS National Taxpayer Advocate noted in recent blog posts, the decision is a clear win for taxpayers who have been subject to unfair immediate assessment of the penalty without a meaningful preassessment opportunity to challenge its applicability. Taxpayers considering refund claims or that recently have been assessed the penalty should consult with their tax adviser to consider their best course of action.
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