Citing a fuzzy definition, the American Tax Court holds that the IRS lacks authority to assess and collect after an owner of foreign companies fails to file or pay penalties. How will this play out in future cases?
The U.S. Tax Court, in Farhy v. Commissioner, has distinguished between a penalty that the IRS is authorized to issue and a penalty that has been properly assessed.
For the tax years 2003 through 2010, Alon Farhy owned 100% of Katumba Capital Inc., a foreign corporation incorporated in Belize. For the tax years 2005 through 2010, Farhy was 100% owner of Morningstar Ventures Inc., also a foreign corporation incorporated in Belize.
Farhy had a reporting requirement under Section 6038(a) to report his ownership interests in both companies: Taxpayers must usually file Internal Revenue Service Form 5471, “Information Return of U.S. Persons With Respect to Certain Foreign Corporations,” to disclose interest or ownership in a foreign corporation. Failure to do incurs penalties starting at $10,000 per form per year.
During the years at issue, Farhy participated in an illegal scheme to reduce the amount of income tax that he owed and, in February 2012, signed an affidavit describing his role in that scheme. He was granted immunity in a non-prosecution agreement that he signed that September. Four years later, the IRS notified Farhy of his failure to file the 5471s; the Tax Court has acknowledged that Farhy’s failure to file was willful and not due to reasonable cause.
In late 2018, the IRS assessed an initial penalty (under Internal Revenue Code Sec. 6038(b)) of $10,000 for each year at issue and continuation penalties totaling $50,000 per year. The IRS did comply with the written supervisory approval requirements for the penalties. A few months later, the IRS levied to collect the penalties.
Rather than claim that he’d filed or paid, Farhy simply challenged whether the IRS had authority to assess Sec. 6038 penalties.
His argument hinged on another part of the IRC: Sec. 6201(a), which authorizes the Secretary of the U.S. Treasury to make assessments of all taxes (including interest, additional amounts, additions to tax and assessable penalties) imposed by the Code; in this case, the Secretary delegated these duties to the IRS.
“Assessment” is “the formal recording of a taxpayer’s tax liability.” When a tax is assessed, the IRS may take certain actions to collect the tax administratively. But the term “assessable penalties” in 6201(a) is, the Court found, “left undefined, creating uncertainty about which penalties the IRS may assess and ultimately collect through administrative means.”
Farhy argued – successfully, at least in this case – that no law actually gives the IRS authority to assess penalties under Sec. 6038(b) and that while the U.S. may be able to collect liabilities for these penalties through a civil action, the IRS can’t assess or administratively collect these penalties.
“Congress has explicitly authorized assessment with respect to myriad penalty provisions in the Code, but not for section 6038(b) penalties,” the Court decision added.
Observers stress that obligations to file Form 5471 are not in question and that Farhy was a matter of procedural authority. Many expect the IRS will appeal.
Few are yet speculating how much taxpayers in future situations resembling Farhy’s should depend on this decision
Your tax specialist needs to stay on top of this and many other issues of wealth, foreign income and tax enforcement. If we can help, please let us know.
About the Author
Alicea Castellanos is the CEO and Founder of Global Taxes LLC. Alicea provides personalized U.S. tax advisory and compliance services to high net worth families and their advisors. Alicea has more than 17 years of experience. Prior to forming Global Taxes, Alicea founded and oversaw operations at a boutique tax firm, worked at a prestigious global law firm and CPA firm. Alicea specializes in U.S. tax planning and compliance for non-U.S. families with global wealth and asset protection structures which include non-U.S. trusts, estates and foundations that have a U.S. connection.
Alicea also specializes in foreign investment in U.S. real estate property, and other U.S. assets, pre-immigration tax planning, U.S. expatriation matters, U.S. persons in receipt of foreign gifts and inheritances, foreign accounts and assets compliance, offshore voluntary disclosures/tax amnesties, FATCA registration, and foreign companies wanting to do business in the U.S. Alicea is fluent in Spanish and has a working knowledge of Portuguese.
Alicea is an active member of the Society of Trusts & Estates Practitioners (STEP), the New York State Society of Certified Public Accountants (NYSSCPAs), the American Institute of Certified Public Accountants (AICPA), the International Fiscal Association (IFA), a member of Clarkson Hyde Global, a world-wide association of accountants, auditors, tax specialists and business advisors and the Global Referral Network (GRN).
Distinctly, in 2020, Alicea was awarded with a prestigious NYSSCPA Forty Under 40 Award. She was selected as someone that has notable skills and is visibly making a difference in the accounting profession. Alicea has also been recognized as a leading expert for Tax advice and she has been invited to join Advisory Excellence, as their exclusively recommended tax expert in the USA.
In 2021 and 2022, Alicea was the Gold and Silver Winner, respectively, of Citywealth’s Powerwomen Awards in the category USA – Woman of the Year – Business Growth (Boutique). In 2023, she continued her winning streak by receiving the Gold award for Company of the Year Female Leadership (Boutique). Furthermore, Alicea is currently listed in the Global Elite Directory 2023, which is an annual exclusive directory of the world’s elite lawyers and outstanding wealth advisors advising ultra-high net-worth clients.
Please note: This content is intended for informational purposes only and is not a replacement for professional accounting or tax preparatory services. Consult your own accounting, tax, and legal professionals for advice related to your individual situation. Any copy or reproduction of our presentation is expressly prohibited. Any names or situations have been made up for illustrative purposes — any similarities found in real life are purely coincidental.
Have a question? Contact Alicea Castellanos, Global Taxes LLC .
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