Farhy v. Commissioner: Does The IRS Have Statutory Authority To Assess Section 6038(b) Penalties?

This week, the U.S. Tax Court held in Farhy v. Commissioner that the IRS does not hold statutory authority under section 6038(b) to assess penalties against a taxpayer who intentionally did not file Form 5471, Information Return of U.S. Persons With Respect to Certain Foreign Corporations, with his tax return for 2003-2010. As a result of this ruling, the IRS was unable to collect penalties from the taxpayer through the proposed levy.

Summary of Farhy v. Commissioner

From 2003-2010, Mr. Farhy, the petitioner and taxpayer, fully owned a corporation that was incorporated in Belize, although he was living in Israel at the time. Additionally, from 2005-2010, Mr. Farhy fully owned a second corporation incorporated in Belize. In February 2012, Mr. Farhy signed an affidavit that admitted his participation from 2003-2010 in an illegal scheme that reduced his income tax obligations. There was no prosecution for his role in the scheme due to immunity that was granted in September 2012 when Mr. Farhy signed a non-prosecution agreement. Under section 6038(a) of the U.S. Tax Code, Mr. Farhy was required to file Form 5471 with his annual income tax returns from 2003-2010, but he intentionally failed to do so each year.

Section 6038 indicates a penalty of $10,000 for each annual accounting period in which there is a failure to file the appropriate form or to furnish required information regarding a foreign business. In addition, there is a continuation penalty of $10,000 for each additional 30-day period, up to $50,000. However, there is no statutory provision that specifically authorizes the IRS to assess these penalties, although section 6201(a) does both authorize and require the Treasury Secretary to make assessments of all taxes that are imposed by the Tax Code. This includes owed taxes, interest, penalties, and other obligations. The IRS is further authorized to take specific actions to collect owed taxes.

When his hidden income from 2003-2010 was discovered and assessed by the IRS, Mr. Farhy argued that section 6038(b) does not authorize the assessment of the specific tax penalties it allows, and therefore is not an assessable penalty except through civil action. The IRS disagreed, stating that “assessable penalties” in section 6201 include any penalties that are described within the U.S. Tax Code, except for those that are subject to deficiency procedures.

Petitioner’s Arguments Upheld

After deliberation, the U.S. Tax Court agreed with the petitioner and found that the IRS had imposed penalties under section 6038(b) without statutory authority to collect them. Therefore, the IRS could not move forward to collect these penalties from Mr. Farhy through the levy they had proposed. It was noted in the decision that Congress explicitly authorizes assessment for many penalties within the Tax Code, but not specifically for section 6038(b). It remains to be seen how this decision may influence future tax cases or whether the U.S. Tax Code may be amended as a result of this precedent.

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