On April 3, 2023 the United States Tax Court issued a ruling that may have profound consequences for US citizens with interest in overseas corporations. In Farhy v. Commissioner, 160 T.C. No. 6, the Tax Court held that the IRS did not have statutory authority to assess penalties for failure to file Form 5471.
Form 5471 is a lengthy and sometimes burdensome filing that is required when US citizens or residents have ownership interest in a non-US corporation. The exact reporting that’s required varies depending on the level of ownership the US person has, and the level of activity of the business itself. The exact rules here can be complex, but for the purposes of this article, Form 5471 is something a US citizen or resident may need to file if they own more than 10% of an overseas corporation and will almost always need to file if they own more than 50% of an overseas corporation. If you’re just learning about this requirement as you read this article, you’re not alone. Many US taxpayers are completely unaware of this requirement.
In many parts of Latin America, it is customary to own your personal home or automobile in a holding corporation (“Sociedad” in most Spanish speaking countries). Even these holding corporations must be reported on form 5471.
Form 5471 Penalties
Internal Revenue Code Section 6038 is the legal basis for the Form 5471 requirement. This section states that a US Taxpayer can be penalized by $10,000 per foreign corporation per year if they don’t file the form. Furthermore, this penalty can be increased by up to $50,000 if the taxpayer does not respond to IRS notices about the form.
A US Taxpayer living in Costa Rica, who holds their personal home in a Sociedad Anonima and their automobile in a Sociedad De Responsibilidad Limitada technically has two corporations subject to this reporting requirement. If that taxpayer failed to report those two corporations for five years, they would be subject to up to $100,000 in Section 6038 penalties. These penalties can quickly get completely out of hand for the unwary US citizen living abroad.
Luckily for taxpayers, the Tax Court stated that this is not an “assessable” penalty.
While the Internal Revenue Service may seem to be an omnipresent force of nature and undeniable fact of life for most US Taxpayers, the Internal Revenue Service did not always exist. The U.S. Constitution did not create the IRS. Like most federal agencies, the IRS only has the powers that are given to it by Congress. Article 1 of the constitution gives Congress the right to collect taxes. Obviously, we don’t have Nancy Pelosi or Mitch McConnell coming to our houses every April, because Congress has enacted a series of laws over time that created the IRS and gave it the power to collect taxes. Among those laws is Code Section 6038.
Since a federal agency like the IRS only has the powers granted to it by Congress, the taxpayer in this case argued that Congress never gave the IRS the explicit power to assess these $10,000 penalties for form 5471. The Tax Court agreed.
What does this mean? Most of the various Internal Revenue Code Sections that deal with penalties explicitly state the IRS can collect, impose, or assess these penalties without first taking the taxpayer to court. Code Section 6038 states that there is a $10,000 penalty but does not explicitly state that the IRS can collect those penalties on its own.
To greatly simplify, for most IRS penalties, the laws enacted by congress say something to the effect of “If you do something wrong, it costs you this much and the IRS can assess the penalty.” The Section 6038 penalty for failure to file Form 5471 says something to the effect of “If you do something wrong it costs you this much” but leaves off the “and the IRS can assess the penalty” part.
Since the IRS only has the powers that Congress gives it, and the IRS didn’t explicitly state in Code Section 6038 that the IRS can collect these penalties without a court proceeding, the Tax Court ruled in favor of the taxpayer, and this is great news for any US citizen with an overseas corporation.
Not The End of the Story
While this is extremely good news, it doesn’t entirely close the book on Form 5471 penalties. The IRS cannot assess these penalties administratively, but they can still institute a civil action (in other words, sue the taxpayer) for these penalties. The IRS could also appeal this decision, and an appeals court could very well reverse the tax court. This would put us right back where we were before April 3. Taxpayers with 5471 requirements still need to comply and file this form.
While this ruling is the law of the land, it would be a great time for taxpayers who are behind on filing 5471s, but who do not qualify for the zero penalty Streamlined Offshore program, to catch up using Delinquent Information Return procedures. Taxpayers who have recently paid a 5471 penalty may want to consider filing for a refund of those penalties. As always, consult a tax advisor.
Please note that the information provided in this article is for general informational purposes only and should not be considered legal advice. The article is not a substitute for professional tax advice, and readers should not rely on the information in this article as such. If you have specific questions regarding your own tax situation, it is recommended that you consult a qualified tax professional. The author and publisher of this article make no representations or warranties with respect to this article, and shall not be held liable for any losses or damages arising from the use of the information in this article.