What You Need to Know About Farhy v. Commissioner
After years of litigation, on April 3, 2023, the U.S. Tax Court gave a ruling in Alon Farhy v. Commissioner that had far-reaching implications on how some tax penalties are adjudicated in the United States.
The ruling, which sided with Farhy in his dispute concerning penalties in foreign information returns, made drastic changes to the Internal Revenue Service’s (IRS) authority to penalize taxpayers. The changes stemmed directly from the U.S. Code, which did not give the IRS explicit authority to administer penalties.
In this article, we’ll take a closer look at the Farhy case and dive into why the ruling is so significant and how taxpayers should move forward.
The Farhy Case
Alon Farhy was a taxpayer who held ownership in various foreign corporations in the 2000s, who failed to file the required Form 5471, “Information Return of U.S. Persons With Respect to Certain Foreign Corporations”.
The IRS issued Farhy a notice of non-compliance in 2016, to which he did not respond, which prompted the IRS to impose an initial penalty of $10,000 for each year that the form was not filed. The IRS would soon increase the penalty to $50,000 per year, under Section 6038(b)(2).The IRS eventually escalated further, issuing a levy notice to collect the Section 6038 penalties.
Farhy subsequently requested a collection due process (CDP) hearing. However, after the hearing, the IRS sided with their decision, issuing a Notice of Determination upholding Farhy’s liabilities for the penalties.
After the ruling went against Farhy, he petitioned the U.S. Tax Court for review of the Notice of Determination, asking whether the IRS possessed the statutory authority to assess Section 6038(b) penalties. He argued that nowhere in the Code was the IRS explicitly authorized to assess the penalties, and that they could only be collected through a civil action under Title 28.
In a win for Farhy and taxpayers more broadly, the Court ruled that the IRS lacked the statutory authority to assess Section 6038(b) penalties.
How does the ruling impact taxpayers?
First, the ruling does not mean that individuals and businesses may cease filing Form 5471, but there are advantages for filers if they have paid penalties in the past.
Filers should immediately petition for a refund if they have paid a penalty in the past. Filing as quickly as possible is imperative because of the two-year statute of limitations on tax claims. It may enable taxpayers to receive the $10,000 back, and possibly more under certain circumstances and depending on past penalties.
It is important to note that individuals should hope for a refund but not expect it. The IRS is generally slow to initiate refunds, and may not issue refunds here at all, with further litigation pending.
Implications beyond 6038(b)
The consequences of the Farhy case may also potentially impact other parts of tax law, including penalties and statutes of limitations.
Other penalties
Similar to Section 6038(b), several other penalty provisions exist outside of Chapter 68 that do not explicitly designate treatment as “taxes” or “assessable penalties,” meaning that like 6038(b), the IRS may not have the same leeway in collecting penalties.
Industry experts have identified Sections 6038A(d) (related to Form 5472), 6038B(c) (related to Forms 926 and 8865), and 6038D(d) (related to Form 8938). Based on the Farhy ruling, the IRS may lack the authority to assess these penalties and can only enforce or recover them through civil actions as authorized by 28 U.S.C. § 2461(a).
Statute of limitations
The Farhy decision raised questions about the relevant statute of limitations for penalty enforcement. Given that Section 6201’s definition of “taxes” does not seem to encompass Section 6038(b) penalties, it follows that the term “tax” under Section 6501 might similarly fall short of covering such penalties.
This aligns with the IRS’s long-standing position that penalties assessed outside of Chapter 68 do not have a statute of limitations under the Code. Instead, these penalties might be subject to a different limitations period—28 U.S.C. § 2462—which outlines a five-year timeframe for civil penalty enforcement, instead of two.
What comes next
Unfortunately, there are more questions than answers.
The IRS will likely try to regain ownership of the penalty by appealing the decision or making their case to Congress for legislation that gives them new authority. In the meantime, enforcement of Section 6038(b) falls on the Department of Justice, where it is unclear how and through what mechanism enforcement could happen.
Additional lawsuits will likely be brought forward to challenge other sections where the authority of the IRS is questionable.
Full resolution will take years, but one thing is clear: Farhy v. Commissioner is a landmark moment that has already reshaped the boundaries of IRS authority and the taxpayer-IRS relationship.
The implications of the ruling will most certainly evolve in the months and years to come. Until there is firm guidance from the courts, taxpayers should remain vigilant, stay informed and seek professional guidance from a qualified tax professional to navigate their own individual circumstances effectively.
For more information, contact your Windham Brannon advisor today, or reach out to Brandi Samuel.
