In the recent case of Farhy v. Commissioner, the Internal Revenue Service assessed penalties against Alon Farhy for failing to file Form 5471, Information Return of U.S. Persons With Respect To Certain Foreign Corporations, reporting his interests in two Belize corporations.[1] U.S. Code Title 26, Subtitle F, Chapter 61, Subchapter A, Section 6038(a)(1) requires information reporting with respect to U.S. persons’ interests in foreign corporations or foreign partnerships. The IRS prescribes Form 5471 for information reporting under Section 6038(a)(1) with respect to foreign corporations.
IRC Section 6038(b)(1) provides that any person who fails to comply with the Section 6038(a)(1) reporting requirement “shall pay” a penalty of $10,000 for each annual accounting period with respect to which such failure exists. Section 6038(b)(2) provides that if a given failure continues for more than 90 days after the day on which the IRS mails notice of it to the United States person, such person “shall pay” a penalty (in addition to the penalty required under Section 6038(b)(1)) equal to $10,000 for each 30-day period (or fraction thereof) during which such failure continues with respect to any annual accounting period after expiration of the 90-day period. The increase in any penalty under Section 6038(b)(2) shall not exceed $50,000.
The IRS assessed a $50,000 penalty against Mr. Farhy for each year in controversy. Mr. Farhy did not pay the penalties. To collect the penalty, the IRS issued a Notice 1058, Final Notice of Intent to Levy and Notice of Your Right to a Hearing. Mr. Farhy responded by filing a Form 12153, Request for a Collection Due Process or Equivalent Hearing, under Section 6330. Upon hearing the IRS issued a Notice of Determination Concerning Collection Actions under Sections 6320 or 6330 sustaining the proposed collection action. Mr. Farhy timely petitioned the Tax Court for review of the Service’s actions. Mr. Farhy claimed that the IRS lacked legal authority to “assess” the penalties in controversy against him.
The Tax Court noted that Section 6201(a) authorizes and requires the Secretary of the Treasury to make assessments of all taxes (including interest, additional amounts, additions to tax, and assessable penalties). The Tax Court noted that the Secretary of the Treasury has delegated these duties to the Commissioner of Internal Revenue, who in turn has delegated them to other IRS officials.[2]
The Tax Court noted that assessment is “the formal recording of a taxpayer’s tax liability.”[3] The Tax Court noted that Section 6502(a) provides that, where tax has been timely assessed, it may be collected by levy or by a proceeding in court, provided the levy is made or the proceeding is begun within 10 years after assessment of the tax. The Tax Court noted that
[a]bundant precedent exists for the proposition . . . that liability for federal taxes does not hinge on whether the IRS has made a valid assessment. . . . While the absence of an assessment prevents the IRS from administratively collecting the tax, it may still file a civil action . . ..[4]
The Tax Court noted that the IRS may immediately assess tax determined by a taxpayer on his or her own return, Section 6201(a)(1), as well as certain assessable penalties not subject to the Code’s deficiency procedures.[5]
But the Tax Court found that the term “assessable penalties” as used in Section 6201(a) is left undefined, creating uncertainty about which penalties the IRS may assess and ultimately collect through administrative means. The Tax Court added that “[a]gencies have only those powers given to them by Congress.”[6]
Forms 3520, Parts I-III; Form 3520-A
Turning to the facts of the case before it, the Tax Court noted that U.S. Code Subtitle F, Chapter 61, Subchapter A, Section 6048 imposes a reporting requirement concerning interests in foreign trusts. The IRS prescribes Form 3520, Annual Return To Report Transactions With Foreign Trusts and Receipt of Certain Foreign Gifts, Parts I-III, and Form 3520-A, Annual Information Return of Foreign Trust With a U.S. Owner, for Section 6048 reporting. Title 26, Subtitle F, Chapter 68, Subchapter B, Section 6677 imposes a penalty for failure to perform reporting required by Section 6048. Subtitle F, Chapter 68, Subchapter B, Section 6671(a) provides that “[t]he penalties and liabilities provided by this subchapter shall be paid upon notice and demand by the Secretary, and shall be assessed and collected in the same manner as taxes.”[7] Thus, the penalties for failure to report information concerning foreign trusts on Form 3520, Parts I-III, and on Form 3520-A may be assessed upon notice and demand.
The penalty for failure to report on Form 3520, Parts I-III is the greater of $10,000 or—
- 35 percent of the gross value of property transferred to a foreign trust and not reported on Part I of Form 3520;
- 35 percent of the gross value of distributions received from a foreign trust and not reported on Part III of Form 3520; and
- 5 percent of the gross value of the foreign trust’s assets treated as owned by the taxpayer under the grantor trust rules of Sections 671-679.[8]
The penalty for failure to report or the Form 3520-A is the greater of $10,000 or 5 percent of the gross value of the foreign trust’s assets treated as owned by the taxpayer under the grantor trust rules.[9]
Form 5471
In contrast, the Tax Court could find no provision in the law for the IRS to assess the penalties for failure to comply with the Form 5471 reporting requirement. U.S. Code Title 26, Subtitle F, Chapter 61, Subchapter A, Section 6038, the statutory authority for the Form 5471 filing requirement, was enacted by the Revenue Act of 1962,[10] and amended by later Acts of Congress. The Tax Court was “loath to disturb this well-established statutory framework by inferring power to administratively assess and collect Section 6038(b) penalties when Congress did not see fit to grant that power to the Secretary of the Treasury expressly as it did for other penalties of the Code.”[11] The Tax Court added that “28 U.S.C. § 2461(a) expressly provides that ‘[w]henever a civil fine, penalty, or pecuniary forfeiture is prescribed for the violation of an Act of Congress without specifying the mode of recovery or enforcement thereof, it may be recovered in a civil action.’”[12] The Tax Court concluded that the IRS may not assess upon notice and demand the penalty for failure to report on Form 5471, though it may bring a civil action seeking a judgment for such penalty.
The IRS filed a timely notice of appeal of the Tax Court’s decision in Farhy.
Form 8865
Farhy has implications for other international information return penalties. Section 6038 applies to interests in foreign partnerships as well as to interests in foreign corporations. The IRS prescribes Form 8865, Return of U.S. Persons With Respect to Certain Foreign Partnerships, for reporting interests in foreign partnerships. Section 6038(b)(1) provides that any person who fails to report on Form 8865 “shall pay” a penalty of $10,000 for each annual accounting period with respect to which such failure exists. Section 6038(b)(2) provides that if the failure continues for more than 90 days after the day on which the IRS mails notice of such failure to the United States person, such person “shall pay” a penalty (in addition to the penalty required under Section 6038(b)(1)) equal to $10,000 for each 30-day period (or fraction thereof) during which the failure continues after expiration of the 90-day period. The continuation penalty for a given failure may not exceed $50,000.
In Farhy, the Tax Court could find no authority for assessing upon notice and demand penalties provided by Section 6038(b). Therefore, the penalty for violation of the Form 8865 reporting requirement, like the penalty for violation of the Form 5471 reporting requirement, may not be assessed upon notice and demand, but may be imposed only by judgment.
Form 8938
U.S. Code Title 26, Subtitle F, Chapter 61, Subchapter A, Section 6038D(a) requires an individual taxpayer to report certain information concerning interests in “specified foreign financial assets” exceeding specified thresholds. The IRS prescribes Form 8938, Statement of Specified Foreign Financial Assets, for Section 6038D reporting. A “specified foreign financial asset” is—
- A financial account maintained by a foreign financial institution; or
- The following foreign financial assets if held for investment and not held in a foreign financial account:
- Stock or securities issued by someone that is not a U.S. person;
- Any interest in a foreign entity; or
- A financial instrument or contract that has an issuer or counterparty that is not a U.S. person.[13]
Section 6038D(d)(1) provides that any individual who fails to furnish the information required by Section 6038D(c) “shall pay” a penalty of $10,000. Section 6038D(d)(2) provides that if any failure described in Section 6038D(d)(1) continues for more than 90 days after the day on which the IRS mails notice of such failure to the individual, such individual “shall pay” a penalty (in addition to the penalty imposed by Section 6038D(d)(1)) of $10,000 for each 30-day period (or fraction thereof) during which such failure continues after expiration of such 90-day period. The continuation penalty for a given failure may not exceed $50,000.
The Section 6038D penalty lacks a provision for assessment upon notice and demand. Therefore, the penalty for failure to comply with the Form 8938 reporting requirement may not be assessed upon notice and demand, but may be imposed only by judgment.
Form 3520, Part IV
U.S. Code Title 26, Subtitle F, Chapter 61, Sections 6039F(a), (b) provide that a U.S. person who receives gifts or bequests from foreign persons exceeding $10,000 must report the gifts or bequests on Form 3520, Annual Return To Report Transactions With Foreign Trusts and Receipt of Certain Foreign Gifts, Part IV. The IRS raised the reporting threshold to receipt of gifts or bequests from foreign sources in excess of $100,000 for the tax year, and prescribes Form 3520, Part IV for the reporting.[14] Section 6039F(c)(1)(B) provides that a United States person who fails to comply with the Form 3520, Part IV reporting requirement “shall pay” (upon notice and demand by the IRS and in the same manner as tax) a penalty equal to 5 percent of the aggregate of such foreign gifts or bequests for each month for which the failure continues, not to exceed 25 percent of the aggregate of such foreign gifts or bequests. The penalty may be abated for reasonable cause.[15]
Given the express language of Section 6039F(c)(1)(B), the penalty for failure to report foreign gifts or bequests on Form 3520, Part IV may be assessed upon notice and demand.
Form 5472
U.S. Code Title 26, Subtitle F, Chapter 61, Subchapter A, Section 6038A(a) provides that a United States domestic corporation with at least 25 percent foreign ownership, by vote or value, shall report, in such manner as the IRS shall be regulations prescribe, the information specified in Section 6038A(b), and shall maintain such records appropriate to determine correct treatment of transactions with related parties as the IRS may by regulations prescribe. U.S. Code Title 26, Subtitle F, Chapter 61, Subchapter A, Section 6038C(a) provides that a foreign corporation engaged in a trade or business within the United States shall maintain records appropriate to determine its United States income tax liability and report information as described in Section 6038C(b) and such other information as the IRS may by regulations prescribe.
The IRS prescribes Form 5472, Information Return of a 25% Foreign-Owned U.S. Corporation or a Foreign Corporation Engaged in a U.S. Trade or Business, for reporting required by Sections 6038A(a) and 6038C(a). Section 6038A(d)(1) provides that a corporation that fails to comply with the information reporting requirement or the recordkeeping requirement of Section 6038(A)(a) “shall pay” a penalty equal to $25,000 for each taxable year with respect to which such failure occurs. Section 6038A(d)(2) provides that if any failure described in Section 6038A(d)(1) continues for more than 90 days after the day on which the IRS mails notice of the failure to the reporting corporation, the corporation “shall pay” a penalty (in addition to the initial penalty) of $25,000 for each 30-day period (or fraction thereof) during which such failure continues after expiration of such 90-day period. Section 6038A(d)(3) provides that the time prescribed by regulations to furnish information or maintain records, and the beginning of the 90-day period after notice by the IRS, shall be treated as not earlier than the last day on which (shown to the satisfaction of the IRS) reasonable cause existed for failure to furnish information or maintain records.
Section 6038C(c) provides that a corporation that fails to comply with the Section 6038C(a)(1) information reporting requirement or the Section 6038C(a)(2) recordkeeping requirement “shall pay” a penalty in the same manner as if such failure were a failure to comply with the provisions of Section 6038A.
There is no provision in the law for assessment upon notice and demand of penalties for violation of the Sections 6038A or Section 6038C reporting requirement. Therefore, the penalties for failure to comply with the Form 5472 reporting requirement may not be assessed upon notice and demand, but may be imposed only by judgment.
Form 926
U.S. Code Title 26, Subtitle F, Chapter 61, Subchapter A, Section 6038B(a)(1)(A) provides that a U.S. person who transfers property to a foreign corporation in an exchange described in Section 332, 351, 354, 355, 356, or 361 must report the transfer on Form 926, Return by a U.S. Transferor of Property to a Foreign Corporation. The Form 926 Instructions add transfers pursuant to Sections 367(d) or 367(e) to the reporting requirement. A U.S. person who fails to comply with this reporting requirement “shall pay” a penalty equal to 10 percent of the fair market value of the property at the time of the exchange.[16] The penalty shall not apply if the U.S. person shows that the failure was due to reasonable cause and not willful neglect.[17] The penalty with respect to any exchange shall not exceed $100,000, unless the failure with respect to the exchange was due to intentional disregard.[18]
For example, assume that John Smith, a U.S. citizen, transfers $100,000 to an Israeli corporation in exchange for stock of the corporation, and that immediately after the transfer Smith owns more than 50 percent of the outstanding stock of the corporation, by vote or value. Smith must report the transfer on Form 926.
There is no provision in the law for assessment upon notice and demand of the penalty for violation of the Form 926 reporting requirement. Therefore, such penalty may be imposed only by judgment.
Assessment Statute of Limitations
Generally, once a taxpayer files an income tax return, the IRS has three years to assess additional tax or penalties with respect to that tax return.[19] But if a taxpayer fails to file an international information return specified in Section 6501(c)(8), the assessment statute of limitations is tolled as to the taxpayer’s income tax return for that year.[20 But if the failure to file the international information return(s) was due to reasonable cause and not willful neglect, then the tolling of the assessment statute of limitations “shall apply only to the item or items related to such failure.”[21] Presumably, “item or items related to such failure” means the penalty(ies) for failure to comply with the international information return reporting requirement.
The international information returns specified in Section 6501(c)(8) are—
Form 8621, Information Return by a Shareholder of a Passive Foreign Investment Company or Qualified Electing Fund, authorized by Section 1298(f).
Form 5471, Information Return of U.S. Persons With Respect To Certain Foreign Corporations, authorized by Sections 6038 and 6046.
Form 5472, Information Return of a 25% Foreign-Owned U.S. Corporation or a Foreign Corporation Engaged in a U.S. Trade or Business, authorized by Section 6038A.
Form 926, Return by a U.S. Transferor of Property to a Foreign Corporation, required by 6038B.
Form 8938, Statement of Specified Foreign Financial Assets, authorized by Section 6038D.
Form 8865, Return of U.S. Persons With Respect to Certain Foreign Partnerships, authorized by Section 6046A.
Form 3520, Annual Return To Report Transactions With Foreign Trusts and Receipt of Certain Foreign Gifts, and Form 3520-A, Annual Information Return of Foreign Trust With a U.S. Owner, both authorized by Section 6048.
A taxpayer with unfiled international information returns should file the international information returns as soon as possible, to avoid tolling of the assessment statute of limitations as to the taxpayer’s income tax returns and as to penalties for failure to file the taxpayer’s international information returns.
Voluntary Disclosure Programs
Voluntary disclosure programs are available for a taxpayer to minimize tax and penalties incurred in filing delinquent international information returns. These include the Delinquent International Information Return Submission Procedures;[22] the Streamlined Compliance Procedures for Persons Residing in the United States;[23] and the Streamlined Compliance Procedures for Persons Residing Outside of the United States.[24]
Claim for Refund
A taxpayer who has paid a nonassessable penalty pursuant to a purported assessment should file a claim for refund of the penalty paid. A taxpayer does this on Form 843, Claim for Refund and Request for Abatement.
Section 6511(a) provides in part:
Claim for credit or refund of an overpayment of any tax imposed by this title in respect of which tax the taxpayer is required to file a return shall be filed by the taxpayer within 3 years from the time the return was filed or 2 years from the time the tax was paid, whichever of such periods expires the later, or if no return was filed by the taxpayer, within 2 years from the time the tax was paid.
[Emphasis added.] Section 6511(a) on its face only applies to claims to recover a tax, not to claims to recover a penalty.[25]
Section 6532(a)(1) provides:
No suit or proceeding under section 7422(a) for the recovery of any internal revenue tax, penalty, or other sum, shall be begun before the expiration of 6 months from the date of filing the claim required under such section unless the Secretary renders a decision thereon within that time, nor after the expiration of 2 years from the date of mailing by certified mail or registered mail by the Secretary to the taxpayer of a notice of the disallowance of the part of the claim to which the suit or proceeding relates.
Therefore, a taxpayer who has overpaid an international information return penalty or paid an international information return penalty which was not due should file Form 843 claiming refund of the overpayment as soon as possible, and in any event—
- At least six months before filing suit under Section 7422 for the overpayment; and
2. Within two years after the IRS notifies the taxpayer in writing of disallowance of the claim.
A version of this article was published in Tax Notes Federal and in Tax Notes International.
[1] Alon Farhy v. Commissioner, 160 T.C. 231 (Apr. 3, 2023).
[2] Id. at 233, citing Treas. Reg. §§ 301.6201-1(a), 301.7601-1, and 301.7701-9.
[3] 160 T.C. at 233, quoting Baltic v. Commissioner, 129 T.C. 178, 183 (2007).
[4] 160 T.C. at 234, quoting Goldston v. United States, 104 F.3d 1198, 1200-01 (10th Cir. 1997).
[5] 160 T.C. at 233-234, citing Williams v. Commissioner, 131 T.C. 54, 58 n.4 (2008).
[6] 160 T.C. at 234, quoting West Virginia v. EPA, 142 S.Ct. 2587, 2609 (2022).
[7] See also U.S. Code Title 26, Subtitle F, Chapter 68, Subchapter A, Section 6665(a)(1): “[P]enalties provided by this chapter shall be paid upon notice and demand and shall be assessed, collected, and paid in the same manner as taxes.”
[8] Form 3520 Instructions (2022), at 2-3.
[9] Form 3520-A Instructions (2022), at 2.
[10] Pub. L. No. 87-834, § 20(a), 76 Stat. 960, 1059.
[11] 160 T.C. at 235.
[12] Id.
[13] Section 6038D(b); Form 8938 Instructions (Rev. Nov. 2021), at 7.
[14] Form 3520, Part IV (2022).
[15] Section 6039F(c)(2).
[16] Section 6038B(c)(1).
[17] Section 6038B(c)(2).
[18] Section 6038B(c)(3).
[19] Section 6501(a).
[20] Section 6501(c)(8)(A).
[21 Section 6501(c)(8)(B).
[22] https://www.irs.gov/individuals/international-taxpayers/delinquent-international-information-return-submission-procedures.
[23] https://www.irs.gov/individuals/international-taxpayers/streamlined-filing-compliance-procedures; https://www.irs.gov/individuals/international-taxpayers/u-s-taxpayers-residing-in-the-united-states.
[24] https://www.irs.gov/individuals/international-taxpayers/streamlined-filing-compliance-procedures; https://www.irs.gov/individuals/international-taxpayers/us-taxpayers-residing-outside-the-united-states.
[25] Strategic Housing Finance Corp. v. United States, 608 F.3d 1317, 1331 (Fed. Cir. 2009). Many courts have applied the Section 6511(a) statute of limitations to a claim for refund of a trust fund recovery penalty paid under U.S. Code Title 26, Subtitle F, Chapter 68, Subchapter B, Section 6672. E.g., Kuznitsky v. United States, 17 F.3d 1029, 1032-1033 (7th Cir. 1994) and cases there cited; Pham v. United States, 42 Fed.Cl. 886, 888 (1999); Clark v. United States, 76 AFTR 2d 95-7831, 7833, 96-1 USTC ¶ 50027 (1995). This is entirely appropriate given U.S. Code Title 26, Subtitle F, Chapter 68, Subchapter B, Section 6671, which provides in part: “Except as otherwise provided, any reference in this title to “tax” imposed by this title shall be deemed also to refer to the penalties and liabilities provided by this subchapter.” A federal trust fund recovery penalty consists of federal income tax withheld from employees’ wages pursuant to 26 USC § 3402 and Social Security tax and Medicare tax withheld from employees’ wages pursuant to 26 USC § 3101(a), (b), and thus really is tax.