Farhy v. Commissioner and International Information Reporting Penalties

HOST: BROOKS NELSON: Welcome to the Cherry Bekaert Tax Beat, a conversation about tax that matters.

HOST: BROOKS NELSON: Today we are talking about a recent U.S. Tax Court case, Fari v. Commissioner. The ruling addresses penalties assessed against taxpayers who must report international tax activities.

HOST: BROOKS NELSON: Joining today's conversation is Brian Dill, the national leader of our firm's international tax practice. How are you doing, Brian?

BRIAN DILL: Great pleasure to be here.

HOST: BROOKS NELSON: And as always, joining me is Sarah McGregor from Greenville, South Carolina. How's it going today?

SARAH MCGREGOR: Today is great and it's sunny in Greenville, South Carolina. We're actually after multiple days of rain, so it's nice to have a bit of sunshine for a change.

HOST: BROOKS NELSON: I'm Brooks Nelson. I've been in Washington, D.C., the last couple days and it has been surprisingly cool, much cooler than many of us visiting were expecting.

HOST: BROOKS NELSON: Just a little background: taxpayers who own or control certain foreign corporations, partnerships, disregarded entities, trusts, and similar entities are subject to penalties under the Internal Revenue Code if they don't meet required reporting each year. Typically this reporting is done with a tax return; sometimes it's done separately; sometimes it's both.

HOST: BROOKS NELSON: Common reporting includes Forms 5471, 5472, 8858, 3520, and others, but those are the big ones most people encounter. Penalties can start at $10,000 or $25,000 and increase from there. The central question in the Fari case was whether the IRS has the authority to assess and collect these penalties.

HOST: BROOKS NELSON: Brian, give us your breakdown of the Fari case and the taxpayer's challenge.

BRIAN DILL: Before we jump into the facts, let's talk about the two major types of penalty procedures under the Internal Revenue Code, because that's the core issue.

BRIAN DILL: Some penalties are subject to deficiency procedures, which broadly means taxpayers can access administrative and judicial review before assessment. Taxpayers can go to the Tax Court without paying the penalty before judicial review occurs.

BRIAN DILL: The other category is where the Internal Revenue Code gives the IRS the right to assess penalties without deficiency procedures. In those cases, if you are assessed a penalty you must first pay the penalty and then seek judicial review in district court or the Court of Federal Claims, not the Tax Court.

BRIAN DILL: That background frames the specifics of the case.

BRIAN DILL: Fari involved the failure to timely file Form 5471 for his foreign corporations. He was assessed $60,000 per year for 2003 through 2010, totaling about half a million dollars in penalties.

BRIAN DILL: Section 6038 of the Internal Revenue Code provides 5471 penalties and, historically, those penalties have been treated as assessable penalties, meaning the taxpayer must pay before seeking Tax Court review.

BRIAN DILL: Fari raised the issue of assessability of Form 5471 penalties before the Tax Court, so the case reached the Tax Court solely on that procedural issue.

BRIAN DILL: Amazingly, Fari did not argue that 5471 penalties were subject to deficiency procedures. Instead, he argued that 5471 penalties were subject neither to deficiency procedures nor to assessable penalties. In other words, he argued the IRS could not administratively assess and collect these penalties; the IRS would instead have to go to the Department of Justice to obtain a judgment for collection.

HOST: BROOKS NELSON: So the IRS could impose the penalty, but the taxpayer argued the IRS could not assess it administratively and would have to use the Department of Justice to collect?

BRIAN DILL: Correct. That mirrors some procedures for FBAR penalties, which are unusual.

HOST: BROOKS NELSON: What did the Tax Court decide?

BRIAN DILL: The government argued these were assessable penalties. Historically, practitioners recognized Section 6038 as a problematic section that never got a legislative fix. The government relied on Code section 6201 and other provisions to argue for assessment authority.

BRIAN DILL: The Tax Court, however, rejected the government's view. Judge Marvel noted that Congress had been specific about assessments in other contexts. He wrote that the court is loath to disturb the well-established statutory framework by inferring the power to administratively assess and collect section 6038(b) penalties—i.e., Form 5471 penalties—when Congress did not grant that power to the Secretary of the Treasury as it did for other penalties of the Internal Revenue Code.

BRIAN DILL: The Tax Court therefore ruled against the government on that point.

HOST: BROOKS NELSON: Is this a technical glitch that people have been overlooking, or has the IRS been operating under an assumption for a long time?

BRIAN DILL: It's the latter. Practitioners and Treasury have discussed this issue for over a decade. It was a known gap that never got fixed legislatively. Now the Tax Court has confronted it.

HOST: BROOKS NELSON: Procedurally, does this mean the penalties are nullified for Fari?

BRIAN DILL: From a technical perspective, not necessarily. The IRS has not issued formal guidance. For cases pending before IRS Appeals, we have heard informally that Fari will not be viewed as controlling law at Appeals, and the IRS has not acquiesced. The IRS is expected to appeal the case.

BRIAN DILL: I expect Form 5471 penalties will continue to be assessed, and there will be substantial litigation because thousands of taxpayers are affected and the penalties involved are significant.

BRIAN DILL: The government may continue collection efforts using its normal procedures and may also consider using the Department of Justice when necessary, but much depends on appeals and potential legislative fixes.

SARAH MCGREGOR: The Taxpayer Advocate has flagged this issue and asked Congress to fix the code section. The Advocate also raised a related issue about the need for a clear statute of limitations on these penalties. Brian, can you explain that?

BRIAN DILL: The statute of limitations here is messy. If you've been affected, talk to your attorneys about filing a protective claim for refund because there is a two-year statute of limitations on some refund claims.

BRIAN DILL: Regarding penalties already paid, taxpayers might argue they were illegally collected because the IRS did not follow the correct collection procedure. The IRS might argue the claim is not valid because the underlying penalty applies.

BRIAN DILL: If a taxpayer files suit, the government may counterclaim for the penalty. Title 28 U.S.C. § 2462 provides a general statute of limitations for suits to enforce penalties, requiring commencement within five years from the date the claim accrued. That could affect the government's ability to bring suits to collect penalties that were allegedly illegally assessed.

BRIAN DILL: Many of these penalties have been in IRS Appeals for longer than five years, so clarifying when the claim accrued and whether the five-year statute runs will be important. That issue was not part of the Fari case and will likely spawn further litigation.

HOST: BROOKS NELSON: Litigation is expensive. Taxpayers will need to weigh whether to pay a $25,000 penalty or litigate, which could cost much more.

BRIAN DILL: Exactly. This affects many forms beyond Form 5471. Form 5472 applies to 25% foreign-owned U.S. corporations and foreign corporations doing business in the U.S., with $25,000 penalties. Form 8938 for specified foreign financial assets can expose individual taxpayers to $10,000 penalties. Form 926 can carry penalties up to $100,000 for certain transfers of property to foreign corporations. Form 8858 applies to foreign branches or disregarded entities of U.S. businesses. Form 8854 applies for expatriation. Some practitioners believe this decision might also affect Form 3520, but I have not researched that specifically.

BRIAN DILL: These potential exposures create a difficult situation for taxpayers in the interim. Someone might, by technicality, avoid a penalty now, but the long-term resolution could involve legislative or appellate fixes.

SARAH MCGREGOR: The headlines are framing this as relief for taxpayers, but it is not necessarily a long-term win. If the government must use the Department of Justice without a legislative fix, that could be burdensome and costly for taxpayers. In practice, this may be a lose-lose situation.

BRIAN DILL: I agree. From both advisory and compliance perspectives, this is burdensome for taxpayers.

HOST: BROOKS NELSON: Briefly compare and contrast Fari with the Bitner case.

BRIAN DILL: Both Fari and Bitner are setbacks for the government. In Fari, Treasury and the IRS were aware of the assessability issue and did not get it fixed. That is a notable administrative failure.

BRIAN DILL: Bitner concerned FBAR reporting. The Supreme Court held that FBAR penalties apply on a per-report basis, not per account. That was a clear win for taxpayers, reversing some circuit court decisions that had sided with the government.

BRIAN DILL: So Bitner was a clear taxpayer victory, while Fari creates a procedural mess that both taxpayers and the government must navigate.

HOST: BROOKS NELSON: What are you recommending to clients about international assets, operations, and reporting in light of Fari?

BRIAN DILL: International reporting and compliance are complex. Get your affairs in order and ensure reporting is done correctly. If you need to litigate, be prepared for expense and uncertainty. It's better to get the reporting right up front so you avoid penalties and subsequent disputes.

BRIAN DILL: Constructive ownership rules can pull investors into reporting obligations even when investments are held through pass-through entities. Work with advisors to determine facts and circumstances and make sure reporting is accurate.

SARAH MCGREGOR: It is not always intuitive what must be reported. As businesses go global, the complexity increases and so does the need for precise compliance.

HOST: BROOKS NELSON: Final thoughts.

BRIAN DILL: Make a good-faith effort to get reporting right up front and avoid litigation with the courts, Department of Justice, IRS Appeals, or IRS agents when possible. The amounts at stake make it necessary to respond proactively.

HOST: BROOKS NELSON: That wraps today's discussion of international information reporting penalties and the Tax Court ruling in the Fari case. This podcast is not providing tax advice. Consult with your tax advisor, preferably at Cherry Bekaert, for specific tax issues or to discuss information from today's podcast.

HOST: BROOKS NELSON: For the firm's latest guidance and materials on this and other tax and business topics, check the firm's website at cb.com for more information.

HOST: BROOKS NELSON: Thank you, Brian, and thank you to our listeners for spending your time with us.