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US Tax Court Ruling: IRS Cannot Assess Penalties Under IRC Section 6038(b) for Willfully Failing to Report Foreign Income

In a recent decision, the United States Tax Court ruled that the Internal Revenue Service (IRS) cannot assess penalties under IRC Section 6038(b) for willfully failing to report foreign income in the case of Farhy v. Commissioner. This ruling has significant implications for taxpayers who may have previously faced steep penalties for failing to comply with reporting requirements related to foreign income.

IRC Section 6038(b) requires certain U.S. taxpayers to report information about certain foreign transactions and interests in foreign entities. The section imposes penalties for failure to timely file the required information returns or for filing inaccurate or incomplete information returns. These penalties can be substantial, with the maximum penalty for willful failure to file or to furnish information being $10,000 per failure.

In the case of Farhy v. Commissioner, the IRS had assessed penalties against the taxpayer for failing to report foreign income on a required information return. The taxpayer had failed to file Form 5471, which is used to report certain transactions between U.S. taxpayers and foreign corporations. The IRS assessed penalties against the taxpayer under IRC Section 6038(b)(1) and 6038(b)(2), arguing that the taxpayer had willfully failed to file the required form.  However, the taxpayer argued that the IRS did not have the authority to assess penalties under IRC Section 6038(b) for willful failures to report foreign income. The taxpayer contended that the statute did not specifically provide for such penalties and that the IRS’s position was based on an incorrect interpretation of the law.

The Tax Court ultimately agreed with the taxpayer and ruled that the IRS cannot impose penalties under IRC Section 6038(b) for willfully failing to report foreign income. The court explained that the statute does not expressly provide for such penalties and that the IRS’s position was based on an interpretation that went beyond the language of the law.

The taxpayer argued that the IRS could not assess the penalty because no statutory provision in the Code or otherwise authorizes the IRS to assess IRC Section 6038(b) penalties. While IRC Section 6201 expressly allows the IRS to assess “assessable penalties,” the Code does not expressly specify that IRC Section 6038 is an assessable penalty; therefore, Congress did not authorize the IRS to assess it.

The court’s decision in Farhy v. Commissioner has important implications for taxpayers who have failed to report foreign income. While the IRS can still assess penalties under other provisions of the law, the ruling suggests that the agency may not have as broad of an authority as it previously thought. The court also noted that the legislative history of IRC Section 6038(b) supports its interpretation that penalties are not authorized for willful failures to file. The court found that Congress had intended the penalty provision to be a deterrent against noncompliance but had not intended it to be used as a punitive measure for intentional noncompliance.

Although the Tax Court’s ruling is subject to appeal and pertains solely to IRC Section 6038, taxpayers who have been charged penalties under IRC Section 6038 (or similar penalty provisions not explicitly designated as assessable penalties) solely on the basis of the IRS’s assertion may wish to evaluate if they should file a refund claim or take other action in light of the Tax Court’s decision. Refund Claims should be filed on a protective basis while awaiting the resolution of any appeal or other action required for the Tax Court’s decision to become final.

Article by Zaid Butt, Director

Zaid Butt
Author: Zaid Butt
Zaid is a certified public accountant with significant tax compliance and consulting experience in diverse industries, including private equity, software, construction, manufacturing, retail, and financial services.