Taxpayer Scores: Farhy Blocks International Reporting Penalties

Tax Notes reporter Andrew Velarde discusses the penalty dispute in Farhy v. Commissioner and the case’s implications for other penalties and future refund decisions.

This transcript has been edited for length and clarity.

David D. Stewart: Welcome to the podcast. I’m David Stewart, editor in chief of Tax Notes Today International. This week: no penalty on the play.

There’s been a controversy of late over when and how the IRS can require taxpayers to pay penalties for some violations. This issue recently made its way to the Tax Court where a taxpayer successfully pushed back on the IRS’s interpretation of its authority.

So what does this case mean, and where do things go from here?

Here to talk more about this is Tax Notes senior legal reporter Andrew Velarde.

Andrew, welcome back to the podcast.

Andrew Velarde: Thanks, Dave. It’s good to be here.

David D. Stewart: Now, before we get into the specifics of the case that we’re talking about, could you tell us about the penalty issue more broadly?

Andrew Velarde: Sure. It basically boils down to whether the IRS has assessment authority over international information return penalties.

Let me level set here. Some penalties under the code are subject to deficiency procedures. For these, the IRS must issue a notice as deficiency, and the taxpayer can petition the Tax Court for review of the penalty before they have to pay it. Some penalties under chapter 68 of the code are assessable penalties, penalties that are not subject to notice of deficiency. For those penalties, taxpayers must pay the penalties before they can get judicial review in district court or the Court of Federal Claims.

David D. Stewart: OK, so we have these two categories with different procedures. So why is there confusion? Why is there controversy here?

Andrew Velarde: For years the IRS has been engaging in systemic and summary assessment of international information return penalties after returns are filed late. Practitioners have been complaining about the operation of this system for years, arguing that they can’t avail themselves of deficiency procedures and that many of their clients may have reasonable cause to excuse nonfiling.

These reasonable cause statements are going unread by the agency, at least initially, and for several years the taxpayer advocate has identified the assessment of penalties under section 6038 and 6038A as one of the most serious problems taxpayers encounter and that systemic assessments of these penalties are legally unsupportable. Their words.

It has recommended legislation that would subject these reporting penalties to deficiency procedures. Now, just as an aside, section 6038 and 6038A deal with information reporting related to foreign corporations and partnerships, and those sections are found under chapter 61 of the code.

David D. Stewart: All right, so tell us about this case that just came up in the Tax Court.

Andrew Velarde: Sure. It’s Farhy v. Commissioner. Decision was handed down just last month. As I mentioned, though, this issue has been out there for a while.

In Alon Farhy’s case, he managed to raise solely this issue before the Tax Court so that a Tax Court answer to whether the IRS could use its assessment powers for section 6038 penalties was unavoidable in any decision it handed down. Farhy’s case involved the failure to timely file Form 5471 for his Belize foreign corporations, for which he was assessed $60,000 in penalties per year from 2003 through 2010.

At its core, the argument from the taxpayer is very simple and straightforward. As Farhy’s attorney, Ed Robbins, succinctly summarized to me last fall when I first spoke about this case with him, it boils down to, “If it ain’t in the code, it don’t exist.”

Farhy didn’t argue that his penalties were subject to deficiency procedures since section 6038 is not subject to those relevant code provisions. But, he also pointed out that summary assessment penalties are in chapter 68 of the code, and there is no corresponding authority in the code for assessment of section 6038 penalties.

He argued that without assessment or deficiency procedures, the IRS needed to ask the Justice Department to reduce the penalties to judgment for collection through a district court action. This would be similar to what is done in the case for foreign bank account reporting penalties.

The government, on the other hand, argued that assessable penalties are any penalties in the code not subject to deficiency procedures, and nothing in section 6201 related to the IRS’s assessment authority limited it to chapter 68 penalties.

For the government, it essentially became an either-or proposition between assessable penalties and those subject to deficiency procedures. It also argued that the term “taxes,” found under section 6201, should be read broadly enough to apply to section 6038 penalties.

David D. Stewart: All right, so this went before the Tax Court, and how did they interpret this?

Andrew Velarde: Sure. Well, the Tax Court rejected the government’s view, with Judge Paige Marvel noting that Congress had been specific about assessment authority in other contexts. I want to quote from the court here because I think this is good language: “Congress has explicitly authorized assessment with respect to myriad penalty provisions in the code, but not for section 6038(b) penalties. We are loath to disturb this well-established statutory framework by inferring the power to administratively assess and collect the section 6038(b) penalties when Congress did not see fit grant that power to the Secretary of Treasury expressly as it did for other penalties in the code.”

The court has also held that the term “assessable penalties” does not automatically apply to all penalties not subject to deficiency procedures, essentially rejecting the government’s either-or proposition.

David D. Stewart: That seems to be a fairly thorough rejection of the IRS’s interpretation here. So how significant does it look like this will be?

Andrew Velarde: According to many practitioners I have spoken with about this, very significant, assuming of course it is upheld. There is going to be a lot of litigation on this — and many taxpayers affected by the fallout from it, possibly numbering in the thousands.

First, you have a lot of Form 5471 filers that could be affected. That’s the same form at issue in Farhy. Some practitioners are advising their clients looking to take advantage of the decision to file protective claim for refund before the two-year statute of limitations for such claims expires.

But there are concerns from practitioners that the IRS may be able to keep penalty money already collected with invalid assessments since the IRS may argue that the claim itself is not invalid, and some practitioners think that the government may take no action on refund claims. If the taxpayer files suit, the government may counterclaim for the penalty.

Outside the code is 28 U.S.C. section 2462. It’s a general statute of limitations provision, and it states that a suit to enforce penalties must be commenced within five years from the date a claim accrued. That could loom large in the government’s ability to bring suits to collect illegally assessed penalties since many of these penalties have been at IRS appeals for longer than that time frame.

Some practitioners are arguing the government should abate penalties similarly assessed that are not under chapter 68, which are now at Appeals. Others have recommended taxpayers amend abatement requests or refunds claims now being considered by the IRS so that they specifically mention the Farhy decision.

Now, to go a little beyond 5471s, you have many other international information return penalties that the logic of the decision from Farhy could likewise be applied to, since there’s no explicit assessment authority in the code for them.

So just to run down a list of these right now, you have Form 5472, “Information Return of a 25 Percent Foreign-Owned U.S. Corporation or Foreign Corporation Engaged in a U.S. Trade or Business”; Form 8865, “Return of U.S. Persons With Respect to Certain Foreign Partnerships”; Form 8938, “Statement of Specified Foreign Financial Assets”; Form 926, “Return by a U.S. Transferor of Property to a Foreign Corporation”; Form 8858, “Information Return of U.S. Persons With Respect to Foreign Disregarded Entities”; and Form 8854, “Initial and Annual Expatriation Statement.”

Some practitioners have also argued the decision could be applied to Form 3520, “Annual Return to Report Transactions With Foreign Trusts and Receipt of Certain Foreign Gifts.”

David D. Stewart: Now, given that there seems to be a significant amount of money involved here — you mentioned Farhy alone has a fairly large amount of penalties that were at issue. Is there any sense of how this could ultimately get resolved?

Andrew Velarde: It’s a good question, Dave. I think there’s a lot of uncertainty at this point. But first, everyone I’ve spoken with about this case expects an appeal. I haven’t gotten the IRS on the record, but every practitioner and expert I’ve spoken with on this expects an appeal from this case. The stakes are just too high for the IRS not to appeal. In the meantime, a former IRS official told me that he expects that for cases pending review by IRS Appeals, Farhy will not be viewed as controlling law yet.

Secondly, while it’s never a good idea to bet on legislation with a divided Congress, that is a possibility. Any legislation likely wouldn’t affect refund claims since that would be governed by the law that existed when the penalties were assessed.

Following the decision in Farhy, the national taxpayer advocate (NTA), Erin Collins, reiterated her position that Congress should take up legislation to make international information returns subject to deficiency procedures. It’s not just a legal point for the NTA, but also an issue of resource management.

They provided some numbers here that I think are interesting. Over almost the last decade the IRS has assessed nearly 10,000 section 6038 penalties per year, with an average abatement rate of 69 percent per year. Put another way, $281 million of the $354 million in penalties was abated during that time. This rate of abatement was far higher than the abatement of manually assessed penalties.

Without a legislative fix, and if the decision is upheld on appeal, then you have the very real prospect that the government would need to commence a suit to reduce a claim to judgment for these penalties. That would require a referral from the IRS to chief counsel and from chief counsel to the Justice Department Tax Division. That could be a significant burden on the government going forward. In the words of Erin Collins in a recent blog post, “The situation cries out for a congressional fix.”

David D. Stewart: Well, all right, I guess there’s going to be a lot to watch here. We’ve got the appeal, we’ve got the potential for congressional action on this. Andrew, thank you very much for being here.

Andrew Velarde: Thank you, Dave. It’s been great.