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.
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