Playing Battleship with the IRS: Assessing the Damages

In a prior post, I discussed the dangers of playing Battleship with the IRS. Recently, taxpayers made a move and scored a hit with the Tax Court’s  recently issued decision in Alon Farhy v. Commissioner, 160 T.C. No. 6 (April 3, 2023) (“Farhy”). Although we may not know if this sunk an IRS battleship, Farhy may substantially impact the ability of the IRS to collect penalties issued with respect to Form 5471. 

The crux of the issue in Farhy is that Internal Revenue Code (“Code”) Section 6201(a) provides that the IRS is authorized and required to make assessments of all taxes (including interest, additional amounts, additions to the tax, and assessable penalties). In this regard, the IRS argued that “assessable penalties” were defined broadly, including any penalties under the “not subject to deficiency” procedures. The IRS also argued that “taxes” could include the penalties for the Form 5471. In contrast, the taxpayer argued that law authorizing the Form 5471 penalty contains no provision authorizing assessment of the penalty for which it provides. 

In rejecting the IRS’s arguments, the Tax Court said that “Congress has explicitly authorized assessment with respect to myriad penalty provisions in the Code, but not for [Form 5471 penalties].” The Tax Court went on to say that it was “loath to disturb this well-established statutory framework by inferring the power to administratively assess and collect the [Form 5471 penalties] when Congress did not see fit to grant that power to the Secretary of the Treasury expressly as it did for other penalties in the Code.” Furthermore, the Tax Court went on to say that the term “assessable penalties” under Code Section 6201 does not automatically apply to all penalties not subject to deficiency procedures.

As a bottom line, the Tax Court in Farhy has distinguished a penalty that the IRS is authorized to issue and a penalty that has been properly assessed. This distinction, without a change in the law or a successful appeal of Farhy, may impact the IRS’ ability to collect the Form 5471 penalties that it imposes.

What may be more important are the unanswered questions that Farhy raises, such as:

- The extent to which the holding of the case may apply to other Code Sections (and therefore penalties). For example, the penalties for Forms 5472, 8865, 3520, 8938, 926, etc.
 
- How the holding in Farhy may impact currently existing appeals of certain penalties.

- How taxpayers should respond to penalty notices received from the IRS (but not yet in the appeals process) in light of the Farhy holding.

- The extent to which the IRS may attempt to collect on issued penalties by offsetting refunds.

- The extent to which claims for refunds (or protective claims) should be made for penalties that have been paid on certain forms.

- Whether or not an issued but unassessed penalty may be considered in relation to significant tax debt with the IRS and the related possibility of a taxpayer losing his or her passport.

Needless to say, Farhy has changed the game, and the extent of those changes is yet to be seen.