Reversal of Farhy Ruling

On May 3, 2024, the D.C. Circuit Court reversed the Tax Court’s decision on the Farhy case. The Circuit Court ruled that the IRS has legal authority to assess and collect penalties related to Form 5471 under Section 6038.

Background

In Alon Farhy vs. Commissioner (160 T.C. No. 6.), the Tax Court ruled that the IRS lacked the authority to assess penalties under Section 6038 for failure to file Form 5471. The court instead ruled that these penalties must be recovered under civil action (i.e., by the DOJ).

Discussion

In their opinion, the Tax Court provided that Congress has given authority to IRS via Treasury to assess specific penalties, but not penalties under Section 6038(b). Specifically, the Tax Court noted that Section 6201(a), which grants the Treasury authority to assess “all taxes (including interest, additional amounts, additions to the tax, and assessable penalties)”, does not encompass the penalties under Section 6038(b).

The Circuit Court believed that the history of Section 6038 reveals the intention of the 1982 amendment is for subsection (b) to be assessable. Prior to the amendment, violation of Section 6038 resulted in a percentage-based reduction of the taxpayer’s foreign tax credit. This rule was retained as subsection (c). In response to difficulties in applying the original penalty, the 1982 amendment added subsection (b), a fixed-dollar penalty, to streamline the calculation and collection process.

Farhy’s claim that the IRS cannot collect Section 6038(b) penalties without civil action is the opposite of Congress’s intention for the 1982 amendment. In addition, the amendment required the two penalties to be coordinated, as provided for in Section 6038(c)(3). In the Circuit Court’s opinion, this demonstrates Congress’ intent to impose Section 6038 penalties concurrently. If the Section 6038(b) penalty is not assessable by the IRS, imposing both at the same time would create undue complexity, which was not Congress’ intent. The District Court noted there is no argument on the IRS’s authority to assess subsection (c) penalties. Accordingly, their interpretation is that it is illogical to argue subsection (b) cannot be assessed using the same procedure as subsection (c).

Furthermore, the process of defense to the penalties imposed by Section 6038 shows that the IRS has such authority. Like many penalties imposed in the tax code, penalties under Section 6038(b) can be alleviated under a “reasonable cause” defense. Section 6038(c)(4)(B) requires reasonable cause to be “shown to the satisfaction of the Secretary”.

Therefore, it expressly grants the IRS the authority to grant or deny that defense. If the IRS cannot assess Section 6038(b) penalties, it would not have the authority to conduct the post-assessment administrative process of allowing a taxpayer to establish reasonable cause. According to Farhy’s interpretation, it would be a district court’s responsibility, which would render Section 6038(c)(4)(B) purposeless.

The court concluded that, based on the statute’s text, structure, and function, penalties imposed under section 6038(b), like the related penalties under section 6038(c), are assessable.

Impact

The original decision was regarded as both a prospective and, potentially, a retroactive win for taxpayers, allowing previously assessed penalties to be refunded. Some believed the same reasoning could also be used to challenge the IRS’ authority on assessing penalties related to other reporting forms such as Forms 5472, 926, 8865, 3520, etc. This appellate ruling seems to have eliminated the possibility of taxpayer refunds and the ambiguity around the penalties for other forms.

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