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An important update for U.S. owners of businesses incorporated outside of the United States

An important update for U.S. owners of businesses incorporated outside of the United States

In a landmark ruling that could have far-reaching implications, the U.S. Tax Court has recently made a decision that could significantly impact U.S. owners of businesses incorporated outside of the United States.

The case Farhy v. Commissioner has challenged the IRS authority to impose and collect certain tax penalties.

Whether you're an individual or a business owner with international ties, it's crucial to understand these recent developments and how they might impact your tax obligations.

Farhy v. Commissioner - IRS case

Farhy v. Commissioner, a case heard by the US Tax Court on April 3, 2023, resulted in a ruling that determined the Internal Revenue Service (IRS) did not possess the legal authority to impose tax penalties as outlined in Code Section 6038(b) and subsequently collect those penalties through levies on the taxpayer.

This decision holds significance due to the IRS frequently imposing civil tax penalties for delayed submission of international information return forms, such as Form 5471, which pertains to US individuals and their involvement with foreign corporations. Furthermore, taxpayers who have already paid penalties for late filing of Form 5471 may have grounds to challenge the legitimacy of the penalty assessment and potentially seek a refund of the amount paid.

Failure to file 5471 - penalty of $10,000+

Per the Internal Revenue Code,

If any person fails to timely file the form 5471 with respect to the foreign business entity, such person shall pay a penalty of $10,000 for each annual accounting period with respect to which such failure exists.

NOTE! This penalty can quickly accumulate if the form is not filed for several years, potentially leading to substantial financial consequences. Therefore, it's crucial for U.S. individuals with foreign business interests to ensure they are compliant with their filing obligations to avoid these hefty penalties.

Tax Court Ruling - 5471 penalty not “assessable”

On April 3, 2023 The U.S. Tax Court ruled that the IRS does not have authority to assess penalties against a taxpayer who willfully failed to file Form 5471 for the prior years.

The Tax Court ruled and held that the $10,000 penalty related to Form 5471 was not an assessable penalty. The assessable penalty is a penalty that may be assessed and collected in the same manner as taxes. Whereas penalties related to the form 5471 are non-assessable.

As opposed to assessable penalties, collection of non-assessable penalties may not be enforced through the traditional means, such as wage garnishment, bank levy, reduced tax refunds, asset seizure, and seizure of passports.

Other forms pertaining to expats owning foreign corporations potentially affected

The ramifications of this ruling could apply to other forms, including Forms 5472, 8858, 8938, 926, 8854 and perhaps even form 3520.

What are all of these the forms for:

  1. Form 5472 - Information Return of a 25% Foreign-Owned U.S. Corporation or a Foreign Corporation Engaged in a U.S. Trade or Business;
  2. Form 8858 - Information Return of U.S. Persons With Respect to Foreign Disregarded Entities (FDEs) and Foreign Branches (FBs);
  3. Form 8938 - Statement of Specified Foreign Financial Assets;
  4. Form 926 - Return by the U.S. Transferor of Property to a Foreign Corporation;
  5. Form 8854 - Initial and Annual Expatriation Statement;
  6. Form 3520 - Annual Return To Report Transactions With Foreign Trusts and Receipt of Certain Foreign Gifts.

Penalties may be demanded, but collection not enforced

The consequences are that the IRS still may demand the penalties for the late filing of the form 5471. However, they may not enforce the collection of 5471 penalties in a traditional way. If they want to enforce the penalty, they must file a civil lawsuit to do so. In reality, the IRS will rarely do so for a small debt.

Practical advice for a U.S. person who received a Notice of Determination from the IRS with regard to 5471 penalties: immediately file a petition to U.S. Tax Court. This will give you a strong chance to have those penalties dismissed.

How to file petition with US tax court

Disputing with the IRS directly will not give any result and will only exhaust the short 90 day time frame for the U.S. Tax Court filing. To file a petition with the US Tax Court, taxpayers must follow these general steps:

  1. Prepare the petition: The taxpayer needs to draft a petition that includes specific information. The petition must state the taxpayer's name, address, and taxpayer identification number, as well as the tax year(s) and tax-related issue(s) in question. It should also provide a clear statement of the facts, applicable laws, and the relief sought.
  2. Timely filing: The petition must be filed within the designated time frame, which is typically 90 days from the date of the IRS's final determination letter or notice of deficiency. It is crucial to adhere to this deadline to preserve the right to challenge the IRS's decision.
  3. Pay the filing fee: Please see the link above to the tax court for current filing fees.
  4. Serve the petition: The taxpayer is also required to serve a copy of the petition on the IRS Chief Counsel or the appropriate IRS office handling the case. This step ensures that the IRS is aware of the legal challenge and can participate in the proceedings.
  5. Wait: Once the petition is filed, the US Tax Court will acknowledge receipt and assign a docket number to the case. The court will then review the petition and notify the taxpayer of any additional requirements or actions needed.

Bottom line

The recent U.S. Tax Court ruling in the Farhy v.  Commissioner case has significant implications for U.S. owners of businesses incorporated outside of the United States.

The court's decision challenges the IRS's authority to impose and collect certain tax penalties, particularly those related to the late filing of Form 5471 and potentially other forms.

While the IRS may still demand penalties for late filing, they may not enforce the collection of these penalties in traditional ways. If they wish to enforce the penalty, they must file a civil lawsuit, which is unlikely for smaller debts.

For U.S. individuals who have received a Notice of Determination from the IRS regarding 5471 penalties, it's advisable to immediately file a petition to the U.S. Tax Court. This could provide a strong chance to have those penalties dismissed.

Remember, it's crucial to adhere to the filing deadlines and ensure compliance with all tax obligations. If you're unsure about your situation, consider seeking advice from a tax professional to understand your potential liabilities and the best course of action.

Ines Zemelman, EA
Founder of TFX