IRS Lacks Authority to Assess Penalties for Failure to Report Foreign Business Ownership, Tax Court Says

U.S. taxpayers must disclose their ownership interests in foreign corporations to the IRS in yearly reports. The failure to report foreign business ownership can result in steep penalties. But a recent United States Tax Court case says that the IRS’s ability to collect on those penalties is limited, and at least in one case, the IRS investigator got it wrong, saving the U.S. taxpayer hundreds of thousands of dollars in penalties.

Belize Companies Caught Up in Income Tax Avoidance Scheme

Alton Farhy was a U.S. taxpayer living in Israel. Between 2003 and 2010, Farhy was the sole owner of Katumba Capital Inc, a company incorporated in Belize. Between 2005 and 2010, he took on a second Belize-based business, Morningstar Ventures, Inc. He then participated in an illegal scheme to reduce his income tax, the details of which are not included in the Tax Court’s opinion. On February 14, 2012, he signed an affidavit describing his role in the scheme as part of a non-prosecution agreement subsequently signed on September 20, 2012. However, in escaping criminal consequences for tax fraud, Fahry opened himself up to tax assessments and penalties for his failures to file the appropriate forms during the same time period.

Penalties for Failure to Report Foreign Business Ownership

Section 6038 of the U.S. Tax Code requires U.S. taxpayers who are business owners, like Farhy, to report any ownership interest in a foreign business entity. Specifically, US taxpayers must file Form 5471, Information Return of U.S. Persons With Respect to Certain Foreign Corporations each year they hold the business interest.

Failure to report foreign business ownership interests on Form 5471 can be a costly error. The Internal Revenue Code imposes a $10,000 penalty for each report missed. After a 90-day notice period, the law imposes an additional continuation penalty of another $10,000 per 30 days (or fraction thereof) that the report is late up to a maximum of $50,000 each year. However, unlike many other penalties for failure to file reports, the Code does not specifically authorize the IRS to assess those penalties using its usual administrative process.

Even so, it did just that for Mr. Farhy. On February 9, 2016, the IRS issued a notice for failure to file the required business information returns, but Farhy never corrected the error. On November 6, 2018, the IRS assessed an initial penalty of $10,000 per year. On November 12, 2018, it assessed additional continuation penalties for $50,000 per year.

Then, on January 30, 2019, the IRS issued a levy notice, seeking to collect the penalties issued under Section 6038. Mr. Fahry requested a Collection Due Process hearing challenging the IRS’s authority to assess the penalties (among other defenses). When the IRS sustained the penalties, Farhy took the matter to court. He filed a complaint in the U.S. Tax Court challenging the IRS’s authority to assess the penalties against him and collect those penalties through its proposed levy.

IRS Has No Authority to Levy Against Business Owner, Tax Court Says

Not all penalties can be assessed through the IRS’s administrative processes. Undoubtedly, the IRS has the authority to assess taxes, including interest and assessable penalties on those taxes, as directed by the Internal Revenue Code. However, the Code doesn’t define what those “assessable penalties” are.

Within the Internal Revenue Code, Section 6201 outlines a variety of tax penalties and additions, authorizing the IRS to assess those penalties using the administrative process. Assessment is the formal recording of a taxpayer’s tax liability; it allows the IRS to collect on that liability using its administrative process. This includes issuing tax levies against property to collect unpaid taxes and penalties.

However, the penalty for a failure to report foreign business ownership isn’t included in that section. Other penalties listed outside that section have their own language either cross-referencing to the IRS’s administrative authority, or granting the IRS assessment authority directly in the law. The foreign business reporting requirement does neither. The Tax Court said this meant the IRS should have filed a civil action against Mr. Fahry, rather than assessing penalties directly under its administrative authority.

The IRS argued that it could assess penalties because they did not fall within a separate statute describing how tax deficiencies could be collected. However, the Tax Court said that determining whether a penalty was assessable based on whether it was a tax deficiency was “putting the proverbial cart before the horse.” Since there is no provision requiring penalties for failure to report foreign business ownership to be paid upon notice, demand, and assessment in the first place, the fact that the penalties were not subject to deficiency procedures did not decide the case.

Nor were the reporting penalties “taxes” subject to assessment under Section 6201(a). The Tax Court said taxes and penalties are two separate things unless the law says otherwise. It refused to accept the IRS’s position that simply because Section 6201(a) included certain “assessable penalties,” it was intended to cover all penalties and exactions imposed by the IRS. Because the penalty for failure to report foreign business ownership was not among the penalties listed in Section 6201(a), and no other law allowed administrative assessment of the penalties, the IRS could not extend its authority to bypass the legal system and administratively assess those penalties against Mr. Fahry. The assessments were issued without statutory authority, so the IRS was prevented from collecting those penalties by way of its proposed levy.

The Fahry case demonstrates the importance of reviewing any notices, levies, or other collections efforts with an experienced tax attorney. Had Mr. Fahry failed to timely object to the illegal assessments, he may have been liable to pay hundreds of thousands of dollars in tax assessments the IRS had no authority to levy in the first place.

Attorney Joseph R. Viola is a tax attorney in Philadelphia, Pennsylvania with over 30 years experience. If you have questions regarding penalties for failure to report foreign business ownership to the IRS, contact Joe Viola to schedule a free consultation.