By Anthony Diosdi
In order to provide the Internal Revenue Service (“IRS”) with information necessary to ensure compliance with Global Intangible Low-Taxed Income (“GILTI”) and the Subpart F provisions of the Internal Revenue Code, each year a U.S. person who owns more than 50% or more of the stock, by vote or value, of a foreign corporation must file a Form 5471, Information Return of U.S. Persons With Respect to Certain Foreign Corporations. See Treas. Reg. Section 1.6038-2(a) and (b). Other persons who must file a Form 5471 include 1) U.S. persons who acquire a 10% ownership interest, acquire an additional 10% ownership interest, or dispose of stock holdings to reduce their ownership in the foreign corporation to less than 10% and 2) U.S. citizens and residents who are officers or directors of a foreign corporation in which a U.S. person acquires a 10% ownership interest or an additional 10% interest.
In Form 5471, the individual must provide the following information regarding a controlled foreign corporation (“CFC”):
1. Stock ownership, including current year acquisitions and dispositions;
2. Information regarding other U.S. shareholders;
3. GAAP income statement and balance sheet;
4. Foreign income taxes paid;
5. Current and accumulated earnings and profits, including any actual dividend distributions during the year;
6. The U.S. shareholder’s pro rata share of GILTI and Subpart F income and any increase in earnings invested in U.S. property; and
7. Information regarding transactions between the CFC and shareholders or related persons.
A Form 5471 ordinarily is filed by attaching it to the U.S. person’s regular federal income tax return. Any U.S. person who fails to timely file a Form 5471 or files the Form 5471 incorrectly is subject to penalties. The failure to timely file a Form 5471 or to correctly file a Form 5471 with the IRS is significant. The penalty for failing to timely file a Form 5471 or correctly file a Form 5471 is $10,000 per year, with an additional $10,000 penalties accruing (ninety days after notification of failure) every thirty days thereafter to a $60,000 maximum. There is also a reduction of foreign tax credits by ten percent.
To make matters worse, 5471 penalties are what is known as assessable penalties. In other words, 5471 penalties can be assessed by the IRS once it determines that the penalty is appropriate and should be assessed. Assessable penalties are not subject to deficiency procedures. Which means that a 5471 penalty can be assessed by the IRS without issuing a notice of deficiency and providing a prepayment judicial forum to dispute the penalty.
This article will discuss three lines of defense to the 5471 penalty.
First Line of Defense: Select a Competent Tax Professional
The Form 5471 and its schedules are incredibly complicated. The preparation of this return should be left to seasoned professionals. Thus, the first line of defense is to select a tax professional that has significant experience preparing Form 5471s and file the Form 5471 or Form 5471s timely.
Second Line of Defense: Reasonable Cause
Once the IRS assesses a 5471 penalty, the most commonly cited defense is the reasonable cause defense. In order to obtain an abatement of the penalties associated with a Form 5471 penalty, it must be established that the individual that was assessed a penalty did not only act with “reasonable cause,” but also lacked “willful neglect.” Whether both “reasonable cause” and lack of “willful neglect” exist is a question of fact. The term “willful neglect” was defined by the United States Supreme Court in United States v. Boyle, 469 U.S. 241, 246 (1985) as a conscious, intentional failure or reckless indifference.” The IRS has interpreted the Boyle decision in its regulations to define “reasonable cause” and lack of “willful neglect” as the taxpayer exercised “ordinary business care and prudence.” See Treas. Reg. Section 301.6651-1(c)(1). Thus, if a taxpayer can show that he exercised ordinary business care and prudence, he may have a reasonable cause for a 5471 penalty. Of course, the question then becomes, what constitutes ordinary business care and prudence? In the past, the IRS considered the following examples to constitute reasonable cause for the purpose of a delinquent filing penalty.
1. A return mailed in time but returned for insufficient postage.
2. A return filed timely but in the wrong district with the Regional Commissioner or Commissioner of Internal Revenue.
3. Erroneous information from an IRS official.
4. Death or serious illness of the taxpayer or someone in his or her immediate family.
5. Unavoidable absence of the taxpayer.
6. Destruction of a business or business records by fire or other casualty.
7. A request proper for returns not timely furnished by the IRS.
8. An effort to obtain assistance or information necessary to complete the return by a personal appearance at an IRS office that was unsuccessful because the taxpayer, through no fault of his or her own, was unable to see an IRS representative.
Thus, if an individual who was assessed a 5471 penalty can show he exercised ordinary business care and prudence under any of the examples listed above, this individual may have a reasonable cause defense to a 5471 penalty. Case law has also carved out a reasonable cause defense to a 5471 penalty based on the advice of a qualified tax advisor. To be clear, the failure to timely file a Form 5471 is not excused by an individual’s reliance on a tax professional. Such reliance is not ‘reasonable cause’ for purposes of a 5471 penalty. Reliance on a tax professional who is expected to attend to the matter, even reasonably so, does not relieve an individual with a Form 5471 filing obligation and is not a defense to a 5471 penalty.
With that said, a distinction is drawn between reliance on the act of a tax professional and reliance on the advice of a tax advisor. In Haywood Lumber & Mining Co. v. Commissioner, 172 F2d 769, 771 (2d Cir. 1950), the court said: “When a corporate taxpayer selects a competent tax expert, supplies him with all necessary information, and requests him to prepare proper tax returns, we think the taxpayer has done all that ordinary business care and prudence can reasonably demand.” Consequently, advice sought and received in good faith from a competent adviser constitutes reasonable cause for failure to file a Form 5471. Finally, in certain limited cases, ignorance of law may be considered reasonable cause if other factors support this contention, such as the individual being a first-time 5471 filer or the individual required to file a Form 5471 is not fluent in english.
Third Line of Defense: Section 6751
Another defense to the 5471 penalty is Section 6751. According to Internal Revenue 6771(b), all penalties (including 5471 penalties) must comply with certain procedural requirements. Section 6751 requires the IRS to follow two procedural requirements when imposing penalties on taxpayers. First, an individual must receive notice of the penalty, the section of the Internal Revenue Code that imposes the penalty, and how the penalty is computed. This requirement is usually easily satisfied. Second, the “initial determination” to assess the penalty must be approved “in writing” by an “immediate supervisor” or an “approved higher official.” See IRC Section 6751(b). The IRS has a long history of not complying with Section 6751.
Section 6751 states that these penalties must have been approved “in writing” by an “immediate supervisor” or an “approved higher official.” It is difficult to imagine the IRS having the resources to satisfy the statutory requirements of Section 6751. In this author’s experience, the IRS has not complied with Section 6751 in a substantial number of international penalty cases. Any failure to comply with Section 6751 should result in the automatic removal of a Section 5471 penalty. This raises two questions. First, how does an individual assessed a 3520 penalty obtain verification that the IRS complied with Section 6751? An individual assessed a 5471 penalty can request proof that the IRS complied with Section 6751 through a Freedom of Information Act (“FOIA”) request.
The second issue related to Section 6751 is how does an individual administratively utilize Section 6751 to contest a 5471 penalty. After a 5471 penalty is assessed by the IRS, the IRS only invites taxpayers to submit letters requesting an abatement on penalties based on reasonable cause. The IRS does not ask nor does it desire that taxpayers submit letters stating that its process of assessing 5471 penalties violated Section 6751. As such, it is unknown if the IRS would voluntarily remove a 5471 penalty if it was notified that its process of assessing penalties violated the procedural requirements of Section 6751.
Fourth Line of Defense: Litigation
Now since we have discussed the most common defenses to the 5471 penalty, we will now discuss litigating a Form 5471 penalty. The most common method to contest a 5471 penalty is for the individual to pay the 5471 penalty in full and sue the government in either a Federal district court with proper venue or in the United States Court of Federal Claims. The problem is individuals assessed Form 5471 penalties do not always have the means to fully pay these penalties. This is particularly the case when the IRS assesses multiple 5471 penalties against an individual. Sometimes, if the facts warrant, an individual or entity assessed a 5471 penalty can dispute the penalty in the United States Tax Court without having to prepay the penalty. There are two distinct procedures available to individuals who wish to contest a 5471 penalty before the Tax Court. First, an individual may challenge the validity of a 5471 penalty and ask the court to review an IRS’s penalty assessment de novo. Second, an individual may take the position that the IRS’s decision to assess a 5471 penalty was an abuse of discretion. We will discuss these two standards in more detail below.
1. Tax Court De Novo Review of a 5471 Penalty
5 U.S.C.A. Section 706(2)(f) provides that courts may invalidate agency action that is “unwarranted by the facts to the extent that the facts are subject to trial de novo by the reviewing court. (5 U.S.C.A. Section 706 governs Administrative Procedure (“APA”) Cases. Although the Tax Court has held that the APA does not govern its review of agency actions, in practice the Tax Court’s review of the IRS is similar to that of the APA). When engaging in de novo review, a court can make its own independent finding of facts in addition to examining the record developed by the agency. Under this standard, the Tax Court has the ability to review an IRS 5471 penalty assessment. Unfortunately, an individual assessed a 5471 penalty may not simply just bring a case before the Tax Court and request de novo review of the penalty. There are a number of prerequisites to this sort of de novo review by the Tax Court. The first prerequisite to Tax Court de novo review is the filing of a Collection Due Process Hearing (“CDP”). Through a CDP, an individual can challenge the existence of a 5471 penalty based on the fact that he or she acted with reasonable cause or the IRS did not follow Section 6751 procedures, and/or the IRS abused its discretion in assessing 5471 penalties. Should the IRS improperly reject a 5471 penalty challenge in a CDP hearing, the taxpayer can request judicial review of the IRS’s penalty assessment and/or the IRS’s decision not to remove the 5471 penalty. The taxpayer then can challenge the existence of the underlying 5471 penalty in a CDP and before the United States Tax Court without first having to pay the penalty.
As is typically the case in controversy matters, contesting a 5471 penalty through a CDP is all about timing. There is a very small window of time in which a taxpayer can contest a 5471 penalty. An individual contesting a 5471 penalty must wait for the IRS to issue a correspondence entitled “Final Notice of Intent to Levy and Notice of Your Right to a Hearing” or “Notice of Federal Tax Lien Filing and Your Right to a Hearing” before requesting a CDP. Once a taxpayer receives a correspondence entitled “Final Notice of Intent to Levy and Notice of Your Right to a Hearing” or “Notice of Federal Tax Lien Filing and Your Right to a Hearing,” he or she will have thirty days from the date of the letter to request a CDP. The request for a CDP must be made on an IRS Form 12153, Request for a Collection Due Process or Equivalent Hearing. The Form 12153 must be completed in its entirety and must state in detail the reason for contesting the 5471 penalty.
If more than 30 days lapses from the date of a “Final Notice of Intent to Levy and Notice of Your Right to a Hearing” or “Notice of Federal Tax Lien Filing and Your Right to a Hearing,” an individual will be foreclosed from using this process. A prematurely filed protest will also prevent a taxpayer’s ability to challenge a 5471 penalty through a CDP. If an individual files a protest with the IRS before receiving letters entitled “Final Notice of Intent to Levy and Notice of Your Right to a Hearing” or “Notice of Federal Tax Lien Filing and Your Right to a Hearing,” it will also probably prevent the taxpayer from challenging a 5471 penalty through a CDP.
For example, let’s assume that in 2017 Tom owed all the shares of a foreign corporation. Unbeknownst to Tom, he was required to file a Form 5471 with the IRS to disclose its earnings and profits. In 2019, Tom visits Phil, a CPA. Phil tells him about the 5471 filing requirement and files a late Form 5471 with the IRS on behalf of Tom. In 2020, the IRS mails Tom a letter advising Tom that the IRS has assessed a $60,000 5471 penalty against him. Tom retains Steve, a tax attorney to contest the 5471 penalty. Unfortunately for Tom, Steve knows nothing about the CDP process. Steve immediately challenges the 5471 penalty by filing a protest with the IRS before Tom received correspondence entitled “Final Notice of Intent to Levy and Notice of Your Right to a Hearing” or “Notice of Federal Tax Lien Filing and Your Right to a Hearing” The IRS rejects the protest letter but offers Steve the opportunity to submit an appeal to the IRS Appeals Office. Steve files an appeal with the IRS Appeals Office. The Appeals Office subsequently rejects the appeal. Because Steve prematurely filed a protest letter and was granted an appeal before Tom was issued a correspondence entitled “Final Notice of Intent to Levy and Notice of Your Right to a Hearing” or “Notice of Federal Tax Lien Filing and Your Right to a Hearing,” Tom can no longer contest the 5471 penalties de novo in a CDP or before the Tax Court. This is because Tom availed himself of a prior opportunity to challenge the 5471 penalties through Steve’s protest and appeal. In order to understand why Tom cannot challenge a 5471 penalty in a CDP, we will need to take a deeper dive into the procedural rules governing CDP penalty.
An individual may raise a CDP challenge to the existence or amount of his underlying tax liability only if he “did not receive any statutory notice of deficiency for such tax liability or did not otherwise have an opportunity to dispute such tax liability.” See IRC Section 6330(c)(2)(B). In determining whether the taxpayer had a prior opportunity to dispute his liability, the regulations distinguish between liabilities that are subject to deficiency procedures and those that are not. For liabilities subject to deficiency procedures, an opportunity for a post-examination conference with an IRS Appeals Office does not bar the taxpayer (in appropriate circumstances) from contesting his liability in a later CDP proceeding. See 301.6330-1(e)(3), Q&A-E2, Proceed. & Admin. Regs. On the other hand, where a liability is not subject to deficiency procedures, “[a]n opportunity to dispute the underlying liability includes a prior opportunity for a conference with Appeals that was offered either before or after the assessment of the liability.”
As assessable penalties, 5471 penalties are not subject to deficiency procedures. See Smith v. Commissioner, 133 T.C. 424, 428-430 (2009). Notwithstanding the absence of a notice of deficiency, a taxpayer may be able to dispute international penalties (without paying them first) by resisting IRS collection efforts through the Collection Due Process Hearing and then seeking review in the United States Tax Court. See Williams v. Commissioner, 131 T.C. 54, 58 (2008); Gardner v. Commissioner, 145 T.C. 161 (2015)(upholding Tax Court jurisdiction to review penalties in the Collection Due Process context). But this route to prepayment judicial review is available only if the individual “did not otherwise have an opportunity to dispute such tax liability.” See IRC Section 6330(c)(2)(B).
For example, in Yari v. Commissioner, 143 T.C. 157 (2014), aff’d,___F. App’x___, 2016 WL 5940054 (9th Cir. Oct. 13, 2016), the IRS assessed an “assessable penalty” against a taxpayer and issued him a notice of intent to levy. After receiving a notice of determination sustaining the levy, the taxpayer petitioned the United States Tax Court. There was no evidence in the record that the taxpayer had received notice of the assessment, that he had been offered the opportunity to protest the assessment, or (if so) that he had taken advantage of that opportunity. Under these circumstances, the Tax Court allowed the taxpayer to contest the amount of the penalty because he had not had a prior opportunity to dispute it.
Under this framework, an individual in a Collection Due Process Hearing case is entitled to challenge his or her underlying “assessable penalty” only if he or she did not have a prior opportunity to dispute it. For this purpose, a prior opportunity includes “a prior opportunity for a conference with Appeals.” See Treas. Reg. Section 301.6330-1(e)(3), Q&A-E2, Proced. & Admin. Regs. The United States Tax Court has sustained the validity of this regulation even though the taxpayer had no right to judicial review of the prior Appeals Office determination. See Lewis v. Commissioner, 128 T.C. 48, 60-61 (2007). Since Lewis, the United States Tax Court has consistently precluded an individual from raising a liability challenge in a “assessable penalty” case when he had an opportunity to present that challenge to the Appeals Office before the IRS commenced collection action.
This means if an individual had, and availed himself of, a prior opportunity of contesting an “assessable penalty” by filing a protest with IRS before a Collection Due Process Hearing was conducted, the IRS through a CDP and the Tax Court will not have jurisdiction to review a 5471 penalty under a de novo standard. In other words, an individual may raise a challenge to the existence or amount of his or her 5471 penalty liability under either a theory of reasonable cause and/or the IRS did not adhere to the 6751 rules. This is the case even if an individual did not request an administrative hearing with the IRS to contest a 5471 penalty, if the IRS provided a taxpayer with an opportunity to contest the penalty through some resemblance of an appeals conference and the individual refused to participate in the hearing, this may deprive the individual of the ability to contest a 5471 penalty. See IRC Section 6330(c)(2)(B).
In the example above, Tom availed himself a prior opportunity to challenge the 5471 penalties as a result of Steve’s protest with the IRS. Tom was then offered, and Steve an opportunity to appeal (within the IRS) the 5471 penalty. This process unquestionably afforded Tom “a meaningful opportunity to dispute * * * the 5471 penalty. Thus, Tom is precluded from disputing the 5471 penalties during the CDP hearing. And because Tom could not challenge his liability from the penalties at the CDP hearing, he is likewise precluded from disputing the penalties before the Tax Court. See Giamelli v. Commissioner, 129 T.C. (2007). Where there is or can be no challenge to the amount of the 5471 liability. However, the Tax Court may still review the IRS determination for abuse of discretion which is discussed in more detail below.
Asking the Tax Court to review a 5471 penalty de novo offers an individual a number of advantages as compared to an IRS administrative request (a letter asking for penalty relief) to remove a 5471 penalty. The Tax Court affords individuals the opportunity to expand the record well beyond what he or she could have presented in a written correspondence. Typically, individuals are precluded from offering testimony as to why they acted reasonably. Litigants contesting a 5471 penalty in a de novo setting can offer testimony of their reasonable attempts to comply with the 5471 requirements such as reliance on tax professionals or computer software. Litigants can also offer testimony regarding limitations that prevented them from complying with the 5471 filing requirements such as the inability to write or comprehend the English language. If necessary, litigants can also place the IRS’s administrative record into evidence challenging the very procedure used to assess the 5471 penalty. Finally, through a de novo proceeding, the individual assessed a 5471 penalty is assured their case will be heard by a neutral third party. It is difficult to imagine a scenario in which a de novo review of a 5471 penalty would not benefit a taxpayer. The problem is that it is not always possible for an individual that wishes to contest a 5471 penalty in Tax Court to satisfy the procedural requirements to get the case before the Tax Court. In many cases, the IRS will offer a taxpayer opportunity to contest a 5471 penalty by inviting the taxpayer to submit a letter to contest the 5471 penalty. Just because a taxpayer was provided an opportunity to contest a 5471 penalty or appealed a 5471 penalty through a written correspondence does not mean that the taxpayer is foreclosed from Tax Court judicial review. In this case, the taxpayer will be foreclosed from Tax Court de novo review. However, the taxpayer may ask the Tax Court to review the 5471 penalty for abuse of discretion.
Challenging a 5471 Penalty on Grounds that the IRS Acted Arbitrarily, Capriciously or Abused Its Discretion in Assessing the Penalty
Where there is or can be no challenge to the amount of a 5471 penalty under a de novo standard discussed above, the Tax Court will review a 5471 penalty for abuse of discretion only. An abuse of discretion may be set aside only if they are found to be “arbitrary, capricious, an abuse of discretion or otherwise not in accordance with law.” For example, in carrying out its adjudicatory duties, the IRS makes findings of fact. Under this standard, the Tax Court can set aside an IRS penalty assessment if the penalty is premised on facts “unsupported by substantial evidence.” See 5 U.S.C.A. Section 706(2)E).
The abuse of discretion standard may be appropriate when the IRS assesses a 5471 penalty, but the administrative record contains no explanation of the IRS’s decision to impose penalties. The abuse of discretion standard may also be brought in cases where the IRS failed to follow Section 6751. Successfully bringing an abuse of discretion case requires obtaining the IRS administrative record regarding the assessment of the 5471 penalty. Once the administrative record is obtained, the record should provide a rational connection between the facts found by the IRS and the reason for the assessment of the penalty. If the record does not contain a rational connection between the facts found by the IRS and the reason for the assessment of a 5471 penalty or the record is completely void as to why a penalty was assessed, the 5471 penalty may be attacking on grounds that the IRS acted arbitrarily, capriciously, or abused its discretion in assessing the penalty. The same is true if the record does not provide evidence of a “writing” indicating that an “immediate supervisor” or “approved higher official” approved the 5471 penalty.
Although an abuse of discretion standard can be used to attack a 5471 penalty, the remedy offered by the abuse of discretion standard is not as sweeping as the above discussed de novo standard. Under the de novo standard, the Tax Court can order the IRS to remove a 5471 penalty. Under the abuse of discretion standard, the Tax Court can only remand the case back to the IRS for further consideration. For example, the United States Supreme Court has stated:
“If the record before the agency does not support the agency action, if the agency has not considered all relevant factors, or if the reviewing court simply cannot evaluate the challenged agency action on the basis of the record before it, the proper court, except in rare circumstances, is to remand to the agency for additional investigation or explanation. The reviewing court is not generally empowered to conduct a de novo
injury into the matter being reviewed and to reach its own conclusions based on such an inquiry.” See Florida Power & Light Co. v. Lorion, 470 U.S. 729, 744 (1985).
Although the remedies available to individuals are not as broad under the abuse of discretion standard, a remand to the IRS for further consideration may prove to be very useful in facilitating a successful resolution to a 5471 penalty. A remand will likely be under the supervision of the Tax Court. At a minimum, a remand should provide the individual contesting a 5471 penalty a more fair process and it may even invite an IRS concession of a 5471 penalty or a favorable settlement. Finally, if the IRS violated Section 6751 when assessing a 5471 penalty, the Tax Court may compel the IRS to concede the penalty.
5471 penalties can be significant. If you have been assessed a 5471 penalty, it is important to have an international tax attorney well versed in the preparation of the Form 5471 and experienced in contesting Form 5471 penalties determine a course of action to remove the penalty as early as possible.
Anthony Diosdi is one of several tax attorneys and international tax attorneys at Diosdi Ching & Liu, LLP. As a domestic and international tax attorney, Anthony Diosdi provides international tax advice to individuals, closely held entities, and publicly traded corporations. Diosdi Ching & Liu, LLP has offices in San Francisco, California, Pleasanton, California and Fort Lauderdale, Florida. Anthony Diosdi advises clients in international tax matters throughout the United States. Anthony Diosdi is a frequent speaker at international tax seminars. Anthony Diosdi may be reached at (415) 318-3990 or by email: email@example.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.