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The Internal Revenue Service (“IRS”) Form 5471, Information Return of U.S. Persons With Respect to Certain Foreign Corporations, is one of the most complicated international information reporting forms that some U.S. taxpayers may have to file each year depending on the U.S. taxpayer’s direct or indirect ownership in a foreign corporation.  The Form 5471 requires a significant amount of detail, especially if the U.S. taxpayer is a shareholder in a controlled foreign corporation.[1]  This information allows the IRS to identify areas where the U.S. taxpayer may have a deemed income inclusion (i.e., subpart f income, investments in U.S. property, or global intangible low-taxed income) on the taxpayer’s U.S. tax return even if no income was repatriated from the controlled foreign corporation to the U.S. taxpayer.

While I.R.C. Section 6038(a) authorizes the Form 5471 detailed reporting, I.R.C. Section 6038(b) imposes penalties for the failure to file Form 5471.  Specifically, I.R.C. Section 6038(b)(1) imposes a penalty of $10,000, with respect to each annual accounting period for which the failure exists, if any person fails to timely furnish certain required information with respect to any foreign business entity.  Further, I.R.C. Section 6038(b)(2) imposes a continuation penalty of $10,000 for each thirty (30) day period (or fraction thereof) during which such failure continues with respect to any annual accounting period after an initial ninety (90) day notice period, subject to a maximum of $50,000.  There is no statutory provision, in the Internal Revenue Code (“Code”) or otherwise, specifically authorizing assessment of these penalties.

I.R.C. Section 6201(a) authorizes and requires the Treasury Secretary to make assessments of all taxes (including interest, additional amounts, additions to tax, and assessable penalties) imposed by the Code, which the Treasury Secretary has delegated to the IRS. When a tax is assessed, the IRS may take certain actions to collect the tax administratively. However recent cases decided throughout the United States demonstrate conflicting views with respect to the IRS’s ability to assess and collect tax under I.R.C. Section 6038(b).

In Farhy v. Commissioner,^[2] the Tax Court held that the IRS did not have statutory authority to assess penalties under I.R.C. Section 6038(b) against a taxpayer who willfully failed to file a Form 5471 for the taxpayer’s 2003–2010 tax years. As a result, the IRS could not proceed with collection of such penalties from the taxpayer.

The taxpayer owned one hundred (100%) percent of a foreign corporation incorporated in Belize during 2003-2010. From 2005 through 2010, the taxpayer also owned one hundred (100%) percent of another foreign corporation incorporated in Belize.  For each year at issue, the taxpayer was required under I.R.C. Section 6038(a) to file Form 5471, but he did not.  The taxpayer’s failure to file the Forms 5471 for his two foreign corporations was willful and not due to reasonable cause.[3]

In 2016, the taxpayer was issued a notice for failure to file Form 5471.  After receiving the notice, the taxpayer still did not file Forms 5471 for his two foreign corporations and the IRS imposed penalties.  In Farhy v. Commissioner,^[4] the taxpayer argued that I.R.C. Section 6038(b) contains no provision authorizing assessment of the penalty for which it provides. Therefore, an I.R.C. Section 6038(b) penalty is not an assessable penalty, although it may be collected through a civil action. The IRS responded that the term “assessable penalties” includes any penalties found in the Code that are not subject to the Code’s deficiency procedures.

The Tax Court agreed with the taxpayer and found that the IRS assessed penalties under I.R.C. Section 6038(b) against the taxpayer without statutory authority.  The IRS could not proceed with the collection of those penalties from the taxpayer.  The Tax Court further noted that Congress explicitly authorized assessment with respect to many penalty provisions in the Code, but Congress did not for I.R.C. Section 6038(b) penalties.

The IRS appealed the case to the D.C. Circuit Court of Appeals, which reversed the Tax Court.[5]  The D.C. Circuit Court of Appeals held that the text, structure and function of I.R.C. Section 6038 supports the IRS’s authority to assess.  Specifically, the D.C. Circuit Court of Appeals noted the 1982 amendments to I.R.C. Section 6038 intended penalties to be assessable since originally if a taxpayer failed to file a Form 5471, the penalty was only a foreign tax credit reduction.  The D.C. Circuit Court of Appeals remanded the case back to the Tax Court.

A few months after the D.C. Circuit Court of Appeals decision in Farhy,[6] the IRS sought to reestablish its’ authority to assess penalties under I.R.C. Section 6038(b) in Mukhi v. Commissioner[7] another case involving the failure to file Form 5471.  In a motion for reconsideration filed on June 7, 2024, the IRS asked the Tax Court to follow the D.C. Circuit’s Farhy opinion.  On November 18, 2024, the Tax Court reaffirmed its decision in Mukhi on the basis of the Golsen rule,[8] and reasoned that it was not bound to follow the D.C. Circuit Court of Appeal’s decision because an appeal from this decision would go to the Eight Circuit Court of Appeals.

By declining to follow the D.C. Circuit’s Farhy ruling on the issue, the Tax Court instead affirmed its own decision in Farhy. The Tax Court noted that the parties in Mukhi had stipulated the case is appealable to the U.S. Court of Appeals for the Eighth Circuit and thus, the D.C. Circuit’s decision in Farhy was not binding to the taxpayer in Mukhi.

On December 5, 2024, in Safdieh v. Commissioner,[9] another case involving I.R.C. Section 6038(b)(1) penalties, the Tax Court applied stare decisis and ruled again in favor of the taxpayer, thereby granting summary judgment against the IRS. The Tax Court stated that:

“Our Court’s tradition when we’ve been reversed is to reexamine our reasoning when the issue is next raised in a case appealable to a different circuit. As it turned out, Mukhi was not yet final and unappealable when the DC Circuit issued Farhy. Last week we issued Mukhi II […], in which we held that we still think we’re right in our interpretation of I.R.C. Section 6038, and expressly held that we would continue our disagreement with the DC Circuit in cases appealable to other circuits.”[10]

The Safdieh case is appealable to the United States Court of Appeals for the Second Circuit while the Mukhi case is appealable to the United States Court of Appeals for the Eighth Circuit. It has yet to be determined whether the IRS will appeal either case to the respective Circuits.  As it stands, for taxpayers whose cases are appealable to the D.C. Circuit Court of Appeals, the IRS has the authority to assess I.R.C. Section 6038(b)(1) penalties and, therefore, can proceed with the collection actions against those taxpayers related to those penalties via the proposed levy or lien as prescribed in the Code.  Taxpayers falling outside the D.C. Circuit Court of Appeal’s jurisdiction should continue to raise Farhy as authority that the IRS does not have statutory authority to assess penalties related to certain foreign information reporting requirements.  Given the divide between the Tax Court and the D.C. Circuit Court of Appeal, it is foreseeable that there will be more cases litigated in the future regarding the IRS’s authority to assess penalties under I.R.C. Section 6038(b)(1).

If a taxpayer is outside the D.C. Circuit Court of Appeals and has paid late-filing penalties under I.R.C. Section 6038(b), what if anything should the taxpayer do?  In light of the Tax Court’s holding, the question becomes whether the late-filing penalties are considered a payment or a deposit.  One difference between a payment and a deposit is the applicable statute of limitations for claiming a refund.

If considered a payment, then a claim for refund or overpayment may be made by the taxpayer.  Generally, I.R.C. Section 6511(a) provides that a refund claim must be filed within three (3) years form the time the return was filed or two (2) years from the time the tax was paid, whichever of such periods expires later; however, if no return was filed by the taxpayer then the refund claim should be filed within two (2) years from the time the tax was paid.  In Rev. Rul. 74-580,[11] The IRS held that any tax payment assessed and collected after the expiration of the statutory period for assessment qualified as an overpayment under I.R.C. 6401(a).  Overpayments must be refunded under I.R.C. Section 6402(a), provided the taxpayer had timely submitted a refund claim as provided by I.R.C. Section 6511(a).

If considered a deposit, I.R.C. Section 6603 permits taxpayers to make deposits and I.R.C. Section 6603(c) mandates the return of a deposit except when there is a tax collection jeopardy.  But how does a taxpayer request return of a deposit? Rev. Proc. 2005-18[12] provides that a deposit is not subject to claim for refund or credit, but instead the taxpayer may request the return of all or part of a deposit at any time before the IRS has used the deposit for payment of tax (i.e., no statute of limitations unless applied by the IRS).  If a taxpayer wants the IRS to return a deposit, the taxpayer must submit a written statement to the Internal Revenue Service Center or examining office to which the original deposit was remitted to request that the deposit be returned.  The written statement must include: (1) the date and amount deposited; (2) the type of tax to which the deposit was intended to be applied; and (3) the tax year that the deposit was intended to be applied.  If Mukhi is upheld on appeal, any prior remittances for late-filing penalties should be viewed as deposits and not payments.

Taxpayers should consider filing protective refund claims that reference both I.R.C. Section 6603(c) and Rev. Proc. 2005-18.  A protective claim is filed to preserve the taxpayer’s right to claim a refund when the taxpayer’s right to the refund is contingent on future events and may not be determined under after the statute of limitations expires.  A protective claim is generally based on an expected change in tax law, legislation, regulations or (as in this case) case law.  A protective claim is valid even if it does not state a particular dollar amount or demand an immediate refund; however, the protective refund claim must sufficiently and clearly identify the claim, describe the contingencies affecting the claim, and identify a specific year or years to which a refund is desired.  Once the contingency is resolved, the IRS may request additional information necessary to process the claim or may decide to either allow or disallow the claim.  The IRS has discretion in deciding how to process protective claims.  Since Form 843, Claim for Refund and Request for Abatement, is used for filing a refund claim related to penalties, taxpayers should consider preparing protective refund claims related to late-filing penalties under I.R.C. Section 6038(b) by using Form 843.

 

[1]              A controlled foreign corporation is defined under I.R.C. Section 957(a) as any foreign corporation in which more than fifty percent (50%) of the total combined voting power of all classes of stock entitled to vote or the total value of the stock of the corporation is owned (directly or indirectly) by U.S. shareholders on any day during the taxable year of such foreign corporation.

[2]              160 T.C. No. 6 (April 3, 2023).

[3]              The taxpayer participated in an illegal scheme during the tax years at issue to reduce the amount of income tax that he owed, and on February 14, 2012, he signed an affidavit describing his role in that illegal scheme. He was granted immunity from prosecution in a non-prosecution agreement that he signed on September 20, 2012.

[4]              160 T.C. No. 6 (April 3, 2023).

[5]              Farhy v. Comm’r, No. 23-1179 (D.C. Cir. 2024).

[6]              Id.

[7]              163 TC No. 8 (Nov. 18, 2024).

[8]              Generally, when the Tax Court’s decision is reversed by an appellate court, the Tax Court will “reconsider the problem in the light of the reasoning of the reversing appellate court and, if convinced thereby, … follow the higher court.” Mukhi, 163 TC No. 8 (2024).  However, the Golsen rule is the exception to this rule. The Golsen rule provides that when a “decision of the appellate court to which an appeal would lie contradicts [the Tax Court’s] precedent, [the Tax Court] will follow the appellate court’s decision.” Mukhi, 163 TC No. 8 (2024).

[9]              No. 11680-20L (TC Dec. 5, 2024).

[10]             Safdieh, No. 11680-20L (TC Dec. 5, 2024).

[11]             1974-2 C.B. 400.

[12]             2005-1 C.B. 798.