Does the IRS Have the Authority to Assess International Penalties Associated with Form 5472?

Recently, in Farhy v. Commissioner, 160 T.C. No. 6 (2023), the United States Tax Court determined that the Internal Revenue Service (“IRS”) does not administratively have the authority to enforce penalties under Section 6038(b) for the failure to timely file a Form 5471, Information Return of U.S. Persons With Respect to Certain Foreign Corporations. This article discusses if the IRS has administrative authority to enforce a penalty assessment under Section 6038A for the failure to timely file a Form 5472, Information Return of a 25% Foreign-Owned U.S. Corporation or a Foreign Corporation Engaged in a U.S. Trade or Business or a Foreign Corporation Engaged in a U.S. Trade or Business.

Special Information Reporting and Record Maintenance Requirement for Some Foreign Persons Conducting Business in the U.S.

Congress has enacted a requirement that each year certain reporting corporations must file Form 5472 and maintain certain books and records. A domestic corporation is a reporting corporation if, at any time during the taxable year, 25% or more of its stock, by vote or value, is owned directly or indirectly by one foreign person. A foreign corporation is a reporting corporation if, at any time during the taxable year, it is engaged in a U.S. trade or business, and 25% or more of its stock, by vote or value, is owned directly or indirectly by one foreign person. In the past, for tax purposes, a foreign-owned U.S. disregarded entity was just that- the entity was disregarded. Prior to the finalization of the new regulations issued by the Treasury Department and IRS, there was no requirement for disregarded entities most of its transactions to the IRS. Under Regulations enacted by the IRS in 2016, a domestic disregarded entity owned by foreign persons will be required to obtain an Employer Identification Number (“EIN”), prepare a pro-forma Form 1120 and file Form 5472. In filing the Form 5472, the disregarded entity will need to provide information regarding its foreign owners, information regarding related parties, and the dollar amounts of transactions that it entered into during the taxable year. A separate Form 5472 is filed for each foreign or domestic related party with which the disregarded entity engaged in reporting transactions during a tax year.

In addition to filing Form 5472, a reporting corporation (or disregarded entity) also must maintain permanent books and records sufficient to establish the correctness of the reporting corporation’s or disregarded entity’s U.S. tax liability. Certain reporting corporations and disregarded entities are exempted from these special record maintenance requirements, but must still file Form 5472 with the IRS.

Penalties for Noncompliance

Any reporting corporation or disregarded entity that fails to file either Form 5472 or maintain requisite records may be subject to a minimum penalty of $25,000.

Does the IRS Have Administrative Authority to Enforce Penalties Associated with Form 5472?

In Farhy v. Commissioner, 160 T.C. No 6 (2023), the Tax Court found that the IRS could not enforce penalties under Section 6038 of the Internal Revenue Code administratively due to a lack of authority. The Tax Court held that Congress did not provide the IRS statutory authority for the IRS to assess taxes, interest, additions to tax, and assessable penalties. Under Section 6201(a), Congress authorized the IRS to assess taxes, interest, additions to tax, and assessable penalties. However, Section 6038 does not fall into any of these categories. The Internal Revenue Code does not define “assessable penalties.” Congress has used specific language that categorizes penalties as assessable, but Section 6038 does not follow this language. Taxes and penalties are distinct categories, precluding Section 6038 penalties from being a tax, Section 6038 are not additions to tax because they are not enumerated in Chapter 68 of the Internal Revenue Code nor assessed, collected, or paid in the same manner as taxes.

Congress has specified which penalties are assessable under Section 6671 and 6665 both provide penalties found in specific sections “shall be assessed.” Outside these sections (found in Chapter 68 of the Internal Revenue Code), penalty provisions expressly provide the IRS an ability to assess such penalties for purposes of assessment and collection. Section 6038 does not provide an assessable penalty without either a governing section providing for assessment or an express subsection doing so with Section 6038. The Tax Court in Farhy determined that Section 2461 of the Internal Revenue Code applied “Whenever 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.

Under this framework, the Tax Court in Farhy determined that the IRS did not have the administrative authority to enforce a penalty assessed against a taxpayer for failing to timely file a Form 5471 with the IRS. Instead, if the IRS wished to collect such a penalty, the IRS would need to refer the matter to the United States Attorney. The United States Attorney could attempt to liquidate the penalty into a judgment in a United States district court and collect the penalty after it has been liquidated into a judgment. In most cases, the United States Attorney will not go through such an extraordinary effort to collect a civil penalty.

Section 6038A authorizes the IRS to assess a $25,000 penalty against any reporting corporation or disregarded entity that fails to timely file a Form 5472. Does the IRS have authority to enforce such a penalty under the holding in Farhy? Section 6038A of the Internal Revenue Code does not provide for a tax, addition to tax, or assessable penalty, for the same reasons as Section 6038 of the Internal Revenue Code. Section 6038A mirrors the penalty provisions of Section 6038. Since Section 6038A mirrors the penalty provisions of Section 6038, under the holding in Farhy, a Section 6038A penalty failing to timely file a Form 5472 cannot legally be enforced by the IRS. In addition, to a so-called Farhy defense to a penalty associated with a Form 5472, reporting corporations and disregarded entities assessed Section 6038A penalty should also consider a Seventh Amendment defense to the penalty. For more information, please find a link to an article which discusses in detail defenses available under the Seventh Amendment of the U.S. Constitution to international penalties.

https://sftaxcounsel.com/blog/does-the-seventh-amendment-invalidate-international-penalties/

Conclusion

This article is intended to provide the reader with a basic understanding regarding the IRS’s legal authority to assess a Section 6038A penalty under the Farhy decision. There are a significant number of hurdles associated with challenging a Section 6038A penalty. If your reporting corporation or disregarded entity has been assessed a Section 6038A penalty, you should consult with a qualified tax attorney that has significant experience in resolving international penalties.

Anthony Diosdi has settled a significant number of disputes involving international penalties with the IRS. Anthony has also litigated international penalty controversies before a number of district courts, the Court of Federal Claims, and the Tax Court.

Anthony is the author of a number of published articles addressing cross-border taxation. Anthony also frequently provides continuing educational programs regarding various international tax topics.

Anthony is a member of the California and Florida bars. He can be reached at 415-318-3990 or adiosdi@sftaxcounsel.com.

This article is not legal or tax advice. If you are in need of legal or tax advice, you should immediately consult a licensed attorney.