logo
Article Category
IRS Form 5471
Published on

Form 5471 Penalty Litigation Demonstrates how Federal Courts Work

Portrait of Phil Hodgen

Phil Hodgen

Attorney, Principal

Share

Form 5471 penalties are still in business

By now, you have undoubtedly heard about the Farhy v. Commissioner case: a Tax Court taxpayer win (the IRS cannot assess Form 5471 penalties), and an Appeals Court reversal (the IRS can, indeed, assess Form 5471 penalties).

The IRS is back in business, and able to assess Form 5471 penalties. Somewhat. The IRS can assess Form 5471 penalties for some taxpayers, but not for others.

Penalties are assessed (or not) depending on where you live

Why are some taxpayers at risk of penalty assessment, while others are not?

Penalties can be assessed if you live here

As of today (December 13, 2024), the only people who are at risk of having Form 5471 penalties assessed are:

  • Residents of the District of Columbia; and
  • Individuals living outside the United States.

(I am only talking about individual taxpayers here. But the same principles apply to corporations, trusts, partnerships, etc.)

The reason: the District of Columbia Court of Appeals decision controls the destiny of these people.

Penalties cannot be assessed if you live anywhere else

For everyone else, the Tax Court decision in Farhy v. Commissioner controls their destiny. The IRS may not assess Form 5471 penalties against these taxpayers.

Why does this unequal treatment exist?

Why can (in theory) the IRS assess Form 5471 penalties against an individual living abroad, but cannot assess penalties against an individual living in Missouri?

The answer is found in the way the Federal court system is organized (into thirteen “Circuits”) and how much an appellate court’s decision in one Circuit matters to an appellate court in another Circuit (answer: it can be followed or ignored).

This is my mini explanation of Federal court procedure that might be opaque to CPAs. I hope it helps you understand why Federal tax law is not always uniformly applied to everyone across the entire country.

First, the meaning of “assess”

Two ways the IRS can collect

If you want to collect a debt (including a tax debt) you need a final number—the amount that is owed to you. So, if the IRS wants to force you to pay a penalty, there are two ways that it can do so:

  • File a lawsuit against you, and win.
  • “Assess” the penalty against the taxpayer without going to court.

Assessment is easier

The IRS doesn’t want to file a lawsuit every time it imposes a penalty. Lawsuits are expensive and take a long time. Instead, it uses its power to “assess.” That just means it decides how much you owe the government.

The IRS decides you owe a penalty, and after you have administrative appeals (and maybe you go to court), the penalty amount you owe is final and the IRS can collect it from you.

Tax Court decision in Farhy: no assessment allowed

The Tax Court, in Farhy v. Commissioner, said that Congress gave the IRS the power to assess many penalties, but not penalties created by IRC Section 6038 (the Form 5471 penalties). If the IRS wants to impose Form 5471 penalties, it must file a lawsuit.

The IRS did not like that. No, not at all.

Venue for an appeal from Tax Court

The IRS appealed. This section explains how the appeal ended up being heard in the District of Columbia Circuit Court of Appeals.

Appeals from Tax Court go to the correct Circuit

Either party (the taxpayer or the IRS) may appeal a decision by the Tax Court. The appeal is filed with the Court of Appeals in the correct Circuit.

There are thirteen Circuits. Twelve are geographically-defined, and one (the Federal Circuit) is designed for special categories of litigation that don’t apply here.

Of the geographically-defined Circuits, one is for the District of Columbia, and the rest of the country is split into eleven other Circuits.

So the IRS had to determine which Circuit’s Court of Appeals was the right place for its appeal of the Tax Court’s decision in Farhy. This is called “venue.”

Venue for an appeal: residence of the taxpayer

The correct venue for an appeal from Tax Court is Circuit in which you find the residence on the individual taxpayer. IRC Section 7482(b)(1)(A).

For example, an appeal for a California resident would be filed with the Ninth Circuit. A New York resident’s appeal would be filed with the Second Circuit.

If the taxpayer lives outside the United States, he or she does not live in any Circuit. In that case, the correct venue for an appeal is the District of Columbia Circuit. IRC Section 7482(b)(1) (flush language).

That is why the IRS appealed the Farhy v. Commissioner decision to the Court of Appeals of the District of Columbia Circuit—Mr. Farhy is a resident of Israel.

When is a court decision binding precedent?

When a court decides the answer to a legal question, all future rulings must follow the decision made in the original ruling. This is called “precedent.”

Tax Court decisions: everyone, until there’s an appeal

The Tax Court’s decision on a particular issue is binding on all taxpayers, everywhere. Until, however, that decision is appealed.

So before Farhy v. Commissioner appeal to the DC Circuit, the “IRS cannot assess Form 5471 penalties” position was the law for all U.S. taxpayers. End of story.

Decisions of the Court of Appeals: only in that Circuit

If the Tax Court decision is appealed, it is a different story. When an Appeals Court decides a case, that decision is binding for all taxpayers within that Circuit only.

Therefore, when the DC Circuit overruled Farhy v. Commissioner, the only people affected were:

  • Residents of the District of Columbia, and
  • U.S. taxpayers living abroad.

For residents of any of the 50 States, the Tax Court’s ruling (“the IRS cannot assess Form 5471 penalties”) continued to be the final word.

And that, as of today (December 13, 2024) is the current state of the law.

The IRS needs eleven more wins

If the IRS wants total power to assess Form 5471 penalties against all taxpayers, it will need to win 11 more appeals from Tax Court—one in each of the other Federal judiciary circuits.

  • One appeal is currently pending in the Eighth Circuit: ​Muhkti v. Commissioner​ is a Tax Court case in which the Tax Court said “We are right and the District of Columbia Circuit Court of Appeals is wrong.” The IRS appealed.
  • Another appeal by the IRS is likely in the Second Circuit: for ​Safdieh v. Commissioner​. This is a Tax Court case where the judge said Farhy still applies and therefore an attempted assessment of Form 5471 penalties is void.

It might take years for enough cases to be filed in the Tax Court and appealed by the IRS to the remaining Circuits. And even then, the IRS must win all eleven times to achieve uniform power to assess Form 5471 penalties against all taxpayers.

Weird, huh?

And now you can see how we arrive at the strange outcome: “assessable penalties for thee, but not for me.” The IRS can assess Form 5471 penalties against Mr. Farhy (DC Circuit). But the IRS cannot assess Form 5471 penalties against Mr. Muhkti (Eighth Circuit) or Mr. Safdieh (Second Circuit)—at least, not yet.

Not exactly “equal justice for all,” is it?

The end game

There are two ways the Form 5471 penalty assessment question will be resolved:

  • By the Supreme Court; or
  • By Congress.

How the Supreme Court resolves the problem

What happens if, hypothetically, the Eighth Circuit Court of Appeals sides with the taxpayer in the Muhkti appeal? Then we have two different Circuits with opposite conclusions on the same question.

  • One Circuit says that Section 6038 gives the IRS power to assess Form 5471 penalties, and
  • The other says that the IRS does not have that power.

This is called a “split in the circuits.”

One of the Supreme Court’s jobs is to resolve disagreements among the Circuits. So, for instance, if the taxpayer wins in the Eighth Circuit Court of Appeals, the IRS can appeal to the Supreme Court to resolve the difference of opinion between the DC Circuit and the Eighth Circuit.

The Supreme Court’s decision is the final ruling on the question, and all Circuits must follow the Supreme Court’s decision.

How Congress solves the problem

Congress can solve the problem without breaking a sweat. All that is necessary is to amend IRC Section 6038 to give the IRS explicit power to assess the Form 5471 penalties.

Will that happen? Probably yes, at some point. How soon? If sanity prevails in Washington DC, probably in 2025.

Conclusion

That ends our little Federal Civil Procedure lesson for the day. Key points to remember:

  • When you appeal a Tax Court case, you appeal it to the Federal Circuit Court of Appeals for the taxpayer’s residence.
  • Appeals court decisions taken on an appeal from Tax Court are controlling for only taxpayers who live in the Circuit in which the appeal decision was reached.
  • It is possible for one Court of Appeals to disagree with another Court of Appeals.
  • If a decision in one Circuit disagrees with another Circuit’s decision, this is called a “split in the circuits.” We are seeing a potential split in the circuits play out right now with Farhy, Muhkti, and Safdieh, all appealed or appealable to different Circuit Courts of Appeals.

Opportunity is found in turmoil. The government is temporarily immobilized. Clean up your messes.