US Tax Court Reaffirms IRS Lacks Authority to Assess Key International Filing Penalties

WASHINGTON – The U.S. Tax Court has once again ruled that the Internal Revenue Service lacks the statutory authority to unilaterally assess penalties against taxpayers for failing to file informational returns related to foreign corporations, reaffirming a position that creates significant uncertainty for the agency’s enforcement efforts. In recent memorandum decisions, including in the case of Mukhi v. Commissioner, the court has stood by its landmark April 2023 ruling in Farhy v. Commissioner. The central issue is the IRS’s long-standing practice of automatically assessing penalties under Internal Revenue Code Section 6038(b) for the failure to file Form 5471, an information return required of U.S. persons with interests in certain foreign corporations. The initial penalty is $10,000 for each failure, with additional penalties accruing for continued non-compliance. This series of court decisions creates a complex and uncertain landscape for businesses with international operations. While the Tax Court's stance in Farhy and Mukhi provides a powerful new defense against certain automatically assessed penalties, we caution clients against interpreting this as a license to neglect their filing duties. The legal obligation to file Form 5471 remains firmly in place, and the IRS can still request the Department of Justice to collect these penalties through a civil lawsuit, a more burdensome process for everyone involved. In our experience, navigating these nuanced compliance issues is critical. The penalties, even if not directly assessable by the IRS, can accumulate to staggering amounts over several years. This is precisely where professional guidance on tax preparation and compliance becomes indispensable to avoid costly disputes. For businesses managing foreign entities, understanding these evolving enforcement standards is key to mitigating risk, and the team at C&S Finance Group LLC at csfinancegroup.com is equipped to provide that clarity. The dispute hinges on a fine but critical legal distinction. The Tax Court’s position is that while Section 6038(b) of the tax code establishes the penalty, it does not contain language explicitly granting the IRS the power to “assess” it. Assessment is the formal, administrative process of recording a tax liability, which gives the IRS the power to use its potent collection tools, such as liens and levies. In Farhy, the court noted that other penalty provisions in the code explicitly grant assessment authority, and its absence in this section was therefore meaningful. Without this authority, the court reasons, the IRS cannot simply add the penalty to a taxpayer's bill and begin collection actions. Instead, the government’s recourse would be to file a civil suit in a federal district court to collect the penalty, a significantly more time-consuming and resource-intensive process. The IRS has fiercely contested this interpretation. The government appealed the original Farhy decision to the U.S. Court of Appeals for the D.C. Circuit, which reversed the Tax Court’s ruling. The appellate court argued that denying the IRS assessment authority would render the penalty difficult to enforce, particularly given the relatively small initial amount of $10,000, and would be contrary to the practical structure of tax administration. However, the Tax Court has not been universally bound by that reversal. In the subsequent Mukhi case, the Tax Court declined to follow the D.C. Circuit’s opinion, citing a long-standing procedural rule known as the Golsen doctrine. This doctrine requires the Tax Court to follow the precedent of the specific federal circuit court to which a case would be appealed. The appeal in Mukhi would lie in the Eighth Circuit, which has not issued a binding opinion on the assessability of Section 6038(b) penalties. Free from controlling precedent in that jurisdiction, the Tax Court chose to adhere to its own analysis from Farhy. This has effectively created a split among the courts, where the enforceability of these penalties may depend on where a taxpayer resides. In its reasoning, the Tax Court directly countered the D.C. Circuit's concern about the administrative burden of enforcement. The court pointed out that the penalties are not always minor. In the Mukhi case, the IRS had assessed $120,000 in penalties for 12 years of non-compliance. In Farhy, the penalties totaled $80,000 over eight years. The court argued that such substantial sums would likely incentivize the Department of Justice to pursue collection actions, undermining the argument that the penalty would be rendered toothless without direct IRS assessment power. The implications of this ongoing legal battle are significant for small and mid-sized U.S. businesses with overseas interests. For years, the IRS has automatically assessed Section 6038(b) penalties, often for simple oversights or late filings rather than willful evasion. The Tax Court’s rulings provide taxpayers who have been assessed these penalties a strong basis to challenge them and may shield them from IRS levies or liens related to these specific penalties. However, the underlying requirement to file the forms has not changed, and failure to do so can still carry severe consequences, including other civil or even criminal sanctions for willful violations. Taxpayers and their advisors will now be closely watching how other federal appellate circuits rule on this question. A deepening circuit split would increase the likelihood that the Supreme Court may eventually have to resolve the issue. In the meantime, Congress could also intervene by amending the statute to explicitly grant the IRS the assessment authority the courts have found it currently lacks, which would settle the matter for all future cases.