The recent Tax Court decision in Farhy demonstrates that clever and novel arguments can carry the day in complex tax litigation matters. In that case, the taxpayer stipulated that he: (1) had Form 5471 filing obligations for his 2003 through 2010 tax years; (2) participated in an illegal scheme to reduce the amount of income tax that he owed; and (3) did not have reasonable cause for abatement of the civil penalties assessed against him for his multi-year failure to file Forms 5741. Indeed, the sole contention raised by the taxpayer in Farhy was a statutory interpretation argument: according to the taxpayer, the IRS simply did not have the authority to assess the civil penalties against him in the manner in which they were assessed.
In a division opinion, the Tax Court agreed with the taxpayer’s contention. Although Farhy requires a careful read of various relevant statutory provisions within and outside the Internal Revenue Code of 1986, as amended (the “Code”), the decision is worth a close read. In the meantime, below are some high points from the decision.
Facts in Farhy
The taxpayer in Farhy owned 100% interests in two foreign corporations. Because of these interests, the taxpayer was required to file timely and complete IRS Forms 5471, Information Return of U.S. Persons with Respect to Certain Foreign Corporations, for his 2003 through 2010 tax years. The taxpayer failed to do so.
Under section 6038(b)(1), the IRS can impose civil penalties against taxpayers who fail to file Forms 5471. Generally, the civil penalties are $10,000 per failure to file; however, these civil penalties may be increased to $50,000 if the IRS notifies the taxpayer of the failure to file, and the taxpayer continues not to file a timely and complete Form 5471 by a prescribed period of time. In this latter case, the IRS may impose increased “continuation penalties” of $50,000 in addition to the initial $10,000 civil penalty.
The IRS made initial and continuation penalty assessments against the taxpayer. Thereafter, the IRS moved to collect on the assessments through levy actions. After the IRS issued the taxpayer a Letter 1058, Final Notice of Intent to Levy and Notice of Your Right to a Hearing, the taxpayer timely filed a request for a Collection Due Process (CDP) hearing. During the CDP hearing, the taxpayer contended that the IRS lacked the statutory authority to make the civil penalty assessments against him.
Predictably, the IRS Settlement Officer (“SO”) disagreed with the taxpayer’s contention and issued a Notice of Determination sustaining the levy actions. The taxpayer timely filed a petition with the Tax Court, again asserting that the IRS lacked the statutory authority to make the civil penalty assessments against him.
The Statutory Arguments
Under section 6201(a), the IRS has the authority to make various types of assessments, such as “all taxes (including interest, additional amounts, additions to tax, and assessable penalties).” The IRS argued that this provision permitted it to assess civil penalties against the taxpayer on the basis that the section 6038(b) civil penalties were a tax or an assessable penalty. The Tax Court disagreed.
First, the Tax Court recognized that Congress specifically empowered the IRS to make certain penalty assessments in various parts of the Code. For example, section 6671(a) provides that numerous penalties found in subchapter B of chapter 68 of subtitle F (i.e., sections 6671 through 6725) “shall be assessed and collected in the same manner as taxes.” In addition, section 6665(a)(1) similarly provides that additions to tax, additional amounts, and penalties provided in chapter 68 of subtitle F (i.e., sections 6651 through 6751) “shall be assessed, collected, and paid in the same manner as taxes.” Regarding penalties outside the scope of these provisions, the Tax Court further noted that Congress embedded within the particular penalty statute the express authority for the IRS to make such penalty assessments. By contrast, section 6038 only cross-referenced criminal penalties and not civil penalties. See I.R.C. § 6038(f)(1).
Second, the Tax Court reasoned that Congress enacted 28 U.S.C. § 2461 to capture instances in which the means or mode of recovery or enforcement was not specified. Under 28 U.S.C. § 2461(a), if Congress fails to so specify for a “civil fine, penalty or pecuniary forfeiture,” the fine, penalty, or forfeiture must be “recovered in a civil action.”
Third, the Tax Court squarely rejected the IRS’s position that the term “assessable penalties” within section 6201 applied to all penalties in the Code that were not subject to deficiency procedures. In this regard, the Tax Court noted:
‘Assessable penalties’ is not a term used to distinguish between penalties subject to deficiency procedures and those that are not. The label of assessable penalty . . . does not automatically bar a taxpayer from using the deficiency procedures to challenge the liability. An assessable penalty, rather, must be paid upon notice and demand and assessed and collected in the same manner as taxes. While some provisions explicitly exempt certain assessable penalties from deficiency procedures, others do not specify whether those procedures apply. In those cases, we consider whether the assessable penalty at issue is included in the statutory definition of ‘deficiency,’ or whether the assessable penalty depends upon a deficiency or, to the contrary, may be assessed even if there is an overpayment of tax.
Respondent’s argument that section 6038(b) penalties are necessarily assessable penalties because they are not subject to deficiency procedures assumes a faulty premise and must be rejected.
Fourth, the Tax Court held that the term “taxes” in section 6201(a) did not include the section 6038(b) penalties. The Tax Court reasoned that “[p]recedent firmly establishes that taxes and penalties are distinct categories of exactions, at least in the absence of a provision treating the same.” See Grajales v. Comm’r, 156 T.C. 55, 61 (2021); Nat’l Fed’n of Indep. Bus. v. Sebelius, 567 U.S. 519, 546 (2012).
In sum, the Tax Court concluded that the IRS lacked the statutory authority to make the assessment of civil penalties against the taxpayer. Accordingly, the Tax Court held that the IRS could not proceed with levy action against the taxpayer to collect the section 6038(b) civil penalties.
The Farhy decision is a major win for taxpayers. Although the government will no doubt appeal the decision, taxpayers should take proactive actions now to protect their rights. These actions may include, for example, filing claims for refund prior to the statutory deadline to claim the refund expires. Taxpayers should also consult their tax professionals regarding the impact of Farhy on other potential compliance decisions, such as an upcoming filing of a voluntary disclosure or a submission under the IRS Streamlined Compliance Procedures.
Tax Court Litigation Attorneys
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