D.C. Circuit Court Reverses Farhy Decision in Victory for the IRS

In a unanimous decision on May 3, 2024, a three-judge panel from the D.C. Circuit Court overturned the Tax Court’s 2023 decision in Farhy v. Commissioner. The Tax Court previously held that the IRS did not have the authority to automatically assess penalties for certain international information returns. The closely monitored case has now been remanded back to the Tax Court for further consideration. 

IRC Section 6038 Information Return Requirements

IRC Sec. 6038(a) requires every U.S. person who controls certain foreign corporations or partnerships to file an information return providing detailed information about the corporation or partnerships. IRC Sec. 6038(b) provides that failure to timely file a return will result in a penalty of $10,000 for each annual period the return is not filed. The penalty increases by $10,000 for each 30-day period the return remains unfiled after 90 days of the IRS notifying the taxpayer of the requirement, not to exceed $50,000. The total penalty that may be imposed is $60,000. 

Background of Farhy v. Commissioner

The case began when the taxpayer, Alton Farhy, failed to timely file Form 5471 for two foreign entities he owned. The IRS assessed penalties under IRC Sec. 6038(b). Farhy appealed, arguing that the IRS was not granted specific authority to assess the penalties under IRC Sec. 6038(b), and must instead pursue them via civil litigation by the Department of Justice. The IRS argued that IRC Sec. 6201(a) gives the agency broad authority over Title 26 unless expressly prohibited by Congress. The Tax Court ultimately agreed with Farhy that the IRS was not granted the authority to assess IRC Sec. 6038(b) penalties. The government then appealed this decision to the D.C. Circuit Court.

D.C. District Court’s Decision

The issue before the D.C. Circuit Court appeared to be two extremes: Either the IRS had no authority to assess penalties unless it was explicitly authorized by Congress, or the IRS had extremely broad authority to assess penalties across the code under IRC Sec. 6201(a). However, the D.C. Circuit Court looked mainly at IRC Sec. 6038 itself and concluded that the “text, structure, and function of Sec. 6038 demonstrates that Congress authorized assessment of penalties imposed under subsection (b).” The Court considered the legislative history of the section, the fact that the section contains mechanisms to ensure penalties under IRC Secs. 6038(b) and 6038(c) are not duplicative, and the fact that IRC Sec. 6038(c)(4) provides for a reasonable cause waiver at the Secretary’s discretion in reaching their decision. The Court reversed and remanded the case back to the Tax Court.

Future of Farhy

On June 4, 2024, the taxpayer filed a petition for panel rehearing and a petition for rehearing en banc, which would require all the judges to hear the case. In his petition, Farhy argued that the District Court made errors of law in its decision and was incorrect in its assessment of Congressional intent. On June 13, 2024, Farhy’s en banc rehearing request was denied.

At the same time, the Tax Court has doubled down on its decision in Farhy in another case, Muhki v. Commissioner. The taxpayer in Muhki was also assessed a penalty under IRC Sec. 6038(b) and argued that the penalty violated the Eighth Amendment’s excessive fines clause. The Tax Court did not address the Eighth Amendment argument, but instead reiterated their decision in Farhy that the IRS did not have the authority to assess penalties under IRC Sec. 6038(b). 

With these two cases, it is likely the question will end up before the Supreme Court. While Farhy was appealable to the D.C. Circuit Court, Muhki is appealable to the Eighth Circuit. It is possible that Muhki will result in a decision against the IRS, causing a Circuit split that could lead to the Supreme Court providing clarification. Even if the Eighth Circuit agrees with the D.C. Circuit Court, the parties will likely continue to challenge the issue until it is fully settled. 

What’s at Stake in Farhy?

The D.C. Circuit Court attempted to resolve this issue without addressing the larger question: Does the IRS need to have explicit authority in order to assess penalties? If the case ends up before the Supreme Court, a decision addressing that issue could have implications reaching far beyond IRC Sec. 6038 and its associated penalties. A finding that express authority is required would have serious impacts on other international and information return penalties and severely limit the IRS’ ability to assess and collect these penalties. On the other hand, a finding for the IRS could result in a broadening of the agency’s authority to assess penalties outside of those addressed directly in the tax code.

It is important to note that even if the IRS is found to not have the authority to assess these penalties, the requirement to file remains. Taxpayers who are required to file foreign information returns should contact a trusted tax advisor to remain in compliance.