Updates on the Shocking Farhy vs. Commission Case

For decades, the IRS has assessed penalties under Section 6038 when a taxpayer fails to file a Form 5471. The initial penalty for such failure is $10,000. If the taxpayer fails to furnish information after being notified, additional fines of up to $50,000 may be assessed.

Alon in Wonderland

As my colleague Jason Rauhe wrote in his blog, U.S. Tax Court: Farhy vs. Commissioner Case Ruling, on April 3, 2023, the Tax Court ruled in favor of Mr. Alon Farhy regarding the collections of penalties under Section 6038. To briefly recap, Farhy established two wholly-owned Belize entities. The entities were part of an illegal scheme Farhy used and admitted to, avoiding taxes. Farhy willfully did not file Form 5471 to report the activities of these entities. In due course, the IRS issued a $10,000 penalty for each year under Section 6038(b)(1) for both entities. The IRS also issued notices, letters, and assessments under Section 6038(b)(2) for the entire $50,000. However, to this point, the IRS has not yet issued a notice of deficiency.

Frozen…In Tax Court

Farhy timely requested a Collection Due Process or equivalent hearing. He asserted that “the IRS did not have authority to assess Section 6038 penalties.” The IRS did not quite agree with Farhy and upheld the penalties. Farhy petitioned the Tax Court.

In a somewhat shocking decision, the Tax Court sided with Farhy. In summary, they reasoned that Congress had not provided Treasury with authority to assess penalties under Section 6038. They specifically noted that Congress has given such authority (via Treasury) for specific penalties (cf. Title 26, Chapter 68), but not Section 6038. The case ultimately hinged on the words “assessable penalties” under Section 6201(a), which is not defined.

Has the Golden Goose Been Killed?

While the Farhy case specifically addressed penalties under Section 6038, the reasoning could be extrapolated to other forms, such as Form 5472 and 3520. Indeed, the Tax Court may have hindered, in a very real way, the IRS’ primary tool to ensure taxpayers provided important information regarding offshore entities and activities. While the IRS still has recourse under civil action to collect penalties, it seems that the Tax Court, temporarily at least, has killed an important “goose that laid the golden eggs.”

Going to See the Wizard (of D.C., that is)

Of course, the story does not end there. On July 12, 2023, the IRS filed notice of its intention to appeal the Tax Court’s ruling. As the taxpayer resided in Israel at the time of the petition’s filing, the venue is with the D.C. Circuit Court of Appeals.

On November 13, 2023, the Department of Justice filed a lengthy brief laying out in great and quite technical detail why the Tax Court was wrong. The brief leads off bluntly, stating, “The Tax Court erred in holding the Section 6201 does not authorize assessment of the Section 6038(b) penalty.” The brief listed 22 cases as precedents and numerous statutes, public laws, rules, and legislative history. In the brief, the DOJ appealed to the concept of tax assessments being “critical to tax administration and collection.”

On February 14, 2014, oral arguments were presented. The judges rigorously questioned both the Justice Department and Farhy’s legal counsel on Section 6201(a) and related relevant statutes, such as Section 6038(b). At the heart of the matter is the wording “assessable penalties” and its application to penalties not identified in a specific code section (which both parties have agreed does not exist). For example, Section 6698(a) identifies a particular penalty for failure to comply with Section 6031 reporting. No such law exists for Section 6038.

So, it seems that the appellate court will need to determine if the parenthetical language in Section 6201 is to be taken broadly, or narrowly. Only time will tell when the curtain is pulled back to see what “the Wizard of D.C.” really thinks.

Contact McGuire Sponsel’s Global Business Services team for more details on the Farhy case or any other international tax issue.