In 2023, the United States Tax Court issued a ruling in Farhy v. Commissioner stating that the IRS lacked the authority to assess and issue penalties directly for failing to file certain foreign tax information. While penalties could still be issued for failure to file, this decision would have added significant administrative hurdles to get a penalty issued by the IRS court. However, nearly a year later, the Washington, D.C. Circuit Court of Appeals reversed that decision, handing the IRS a significant victory and ushering in sweeping implications for taxpayers.
With this flurry of changes over the past year, it can be challenging to understand how the latest IRS guidance affects taxpayers’ foreign filings. Below, we outline the critical updates from the latest rulings and discuss how taxpayers can effectively navigate these changes.
What is at stake?
Section 6038(a) of the Internal Revenue Code requires that all U.S. persons must file information returns to report their control of any foreign business (Example – Form 5471). If a U.S. person fails to file their informational filing, section 6038(b) of the Internal Revenue Code gives the IRS and the U.S. Government the authority to issue penalties for said missing informational returns. Such penalties start at $10,000 per form per year and can increase to $60,000 per form per year, depending on the length of noncompliance to paying the initial penalties.
This ruling had additional implications for Form 5472, which reports related party transactions; Form 8938, which reports foreign financial assets; and Form 926, which reports property contributions to foreign corporations.
Why was the ruling overturned?
Business owner Alon Farhy established two foreign entities and did not report his ownership to the IRS and thus, was assessed penalties by the IRS. While the IRS argued it has the authority to independently assess Section 6038(b) penalties and issue levies against taxpayers’ personal property, Farhy argued that Section 6038(b) does not clearly say that the IRS can use such methods to collect on these penalties. Rather, the IRS would have to pursue civil action via a lawsuit in federal court under Title 28 of the U.S. Code, causing a much heavier burden on the U.S. Government to collect on these penalties.
The IRS appealed to the Washington, D.C. Circuit Court of Appeals, and the initial decision has now been reversed. The appeals court provided the following explanation: “Based on the statute’s text, structure, and function, that penalties imposed under section 6038(b), like the related penalties under section 6038(c), are assessable. This conclusion is buttressed by more than forty years of congressional acquiescence to the IRS’s practice of assessing section 6038(b) penalties.”
To summarize, the appeals court puts the responsibility of changing the definition of a statute like Section 6038(b) on Congress. Since Congress has not revisited the statute in over four decades, it is implied that there is no objection to the IRS’s interpretation of the law.
What does this mean for U.S. taxpayers?
While there is a chance that Farhy may try to appeal this case to the U.S. Supreme Court, the ruling made by the appeals court is the law of the land for now.
Taxpayers must stay diligent in understanding which foreign reporting forms and returns they are required to file with the IRS regarding their foreign businesses. Since this ruling currently empowers the IRS to levy these penalties directly, ensuring you are compliant and current with all foreign information returns will help you avoid these penalties in the future.
If you have questions or concerns about filing your foreign information return, please contact your RKL tax advisor directly or fill out the form below.
