Many businesses today have some international transactions. Many U.S. businesses even have operations in foreign countries–which may include ownership of entities, operations, or just sales.

Our tax laws include several provisions that require U.S. taxpayers to report most of these foreign business interests and activities. These filings are mostly made by filing various information returns.

Failing to file these information returns can result in significant penalties. The U.S. Tax Court had concluded that the IRS does not have the authority to assess these penalties. An appeals court did not agree. The issue came back before the U.S. Tax Court in Mukhi v. Commissioner, 4329-22L (Nov. 18, 2024), which again asks whether the IRS can assess these penalties or must pursue them through district court litigation.

Facts & Procedural History

The taxpayer in this case created three foreign entities in 2001 through 2005. This included a foreign corporation.

From 2002 through 2013, the taxpayer failed to file Forms 5471 to report his ownership interest in the foreign corporation. After the taxpayer pleaded guilty to criminal tax violations, the IRS assessed $120,000 in penalties under Section 6038(b)(1). That’s a $10,000 penalty for each year the taxpayer failed to file the returns.

The IRS then attempted to collect the penalties. It issued a notice of intent to levy and filed a federal tax lien. The taxpayer challenged these actions in the U.S. Tax Court, arguing that the IRS lacked authority to assess these penalties in the first place. As we’ll get into below, while the U.S. Tax Court initially ruled for the taxpayer based on its Farhy v. Commissioner, 160 T.C. 399, 403-13 (2023), decision, the D.C. Circuit reversed Farhy. See Farhy v. Commissioner, 100 F.4th 223 (D.C. Cir. 2024). The IRS filed a motion to reconsider based on the appeals court’s Farhy decision. That led to the current opinion reconsidering whether the IRS has assessment authority for these penalties.

To understand the significance of this case, it’s helpful to first understand the Form 5471 reporting requirements.

About the Form 5471 Information Return

Section 6038 requires U.S. persons to file information returns to report their ownership or control over certain foreign corporations. This is done by filing Form 5471, Information Return of U.S. Persons With Respect to Certain Foreign Corporations.

Form 5471 requires detailed information about the foreign corporation, including its ownership structure, financial statements, and various transactions with related parties. The form must be filed with the taxpayer’s annual tax return.

Different filing requirements apply based on the category of filer:

• Category 1: U.S. shareholders of specified foreign corporations
• Category 2: Officers and directors of foreign corporations with U.S. owners
• Category 3: U.S. persons who acquire or dispose of significant ownership
• Category 4: U.S. persons who control a foreign corporation
• Category 5: U.S. shareholders of controlled foreign corporations

Those who trigger these provisions have to pay attention to these requirements. The penalties for non-compliance can be substantial. This is particularly true given how many different categories of persons must file the form.

The Section 6038 Penalties

The IRS has a number of tools at its disposal to “encourage” taxpayers to voluntarily comply with filing requirements. Civil tax penalties are one such tool.

Congress has created a number of different penalties related to foreign transaction reporting. The FBAR reporting requirements for foreign bank accounts are probably the most notorious as they are often extremely large.

For the Form 5471, there are two distinct penalties for failing to file. First, Section 6038(b)(1) imposes a $10,000 penalty for each annual accounting period. This penalty can be increased by $10,000 per month (up to $50,000) if the failure continues after IRS notification. Second, Section 6038(c) reduces the taxpayer’s foreign tax credits by 10%. This reduction increases quarterly if the failure continues, potentially eliminating all foreign tax credits for the unreported corporation.

Both penalties can be avoided if the taxpayer shows reasonable cause for the failure to file. The standard reasonable cause defenses apply. We have covered many of them on this site before, such as reliance on a tax advisor, honest mistake, etc.

The IRS Assessment Authority Question

With these penalties in mind, we can now turn to the key issue in Mukhi: whether the IRS can assess these penalties directly or must pursue them through court action.

The term “assessment” refers to the recording of a tax balance on the IRS’s books. It is what creates a balance due by a taxpayer that the IRS can collect.

The IRS’s authority to assess penalties is found in Section 6201(a). This provision allows the IRS to assess “all taxes (including interest, additional amounts, additions to the tax, and assessable penalties).” The question in this court case is whether Section 6038(b)(1) penalties fall within this authority.

The U.S. Tax Court analyzed this issue by comparing Section 6038(b)(1) to other penalty provisions that explicitly state they are assessable. The Court found that unlike those other provisions, Section 6038(b)(1) contains no language suggesting Congress intended these penalties to be assessable. Without explicit authority, the U.S. Tax Court held the IRS must pursue these penalties through district court litigation.

But What About Farhy?

The U.S. Tax Court’s analysis, however, isn’t the end of the story. The previous D.C. Circuit decision in Farhy reached the opposite conclusion.

The appeals court in Farhy held that the IRS could assess these penalties. That appeals court focused on Congressional intent and administrative efficiency, reasoning that requiring district court litigation would make the penalties “largely ornamental.”

However, under the Golsen rule, the U.S. Tax Court follows the precedent of the circuit court where appeal would lie. Since Mukhi would appeal to the Eighth Circuit (not the D.C. Circuit), and the Eighth Circuit hasn’t addressed this issue, the U.S. Tax Court was free to follow its own analysis rather than Farhy.

This creates different results depending on where taxpayers reside. Those in D.C. Circuit states face immediate IRS assessment, while those in other circuits may get the procedural protections of district court litigation.

For taxpayers facing these penalties, the IRS can no longer simply assess and begin collection actions in most circuits. Instead, the Department of Justice must file suit in district court. This gives taxpayers additional procedural protections and opportunities to raise defenses before paying.

The Takeaway

For the time being, the U.S. Tax Court’s decision creates different procedures depending on where taxpayers reside. Outside the D.C. Circuit, the IRS must pursue these penalties through district court litigation rather than immediate assessment and collection. This gives taxpayers additional procedural protections and opportunities to raise defenses. However, the penalties themselves remain substantial – only the collection process has changed. Taxpayers should continue to prioritize compliance with foreign information reporting requirements to avoid these penalties entirely.

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