On November 18, 2024, the U.S. Tax Court reaffirmed its prior decision in Mukhi v. Commissioner, holding that the U.S. Internal Revenue Service (IRS) did not have statutory authority to assess penalties against a taxpayer who willfully failed to file Form 5471, Information Return of U.S. Persons With Respect to Certain Foreign Corporations.1
WHY THIS MATTERS
The Tax Court’s decision in this case reopens questions concerning the extent of the IRS’s authority to assess penalties against individual taxpayers for failure to report their interests in foreign corporations on Form 5471. The outcome of this case is surprising given that the U.S. Court of Appeals for the D.C. Circuit ruled in favor of the IRS on this issue earlier this year in the case of Farhy v. Commissioner.2
The Tax Court’s decision in the Mukhi case is likely to be appealed to the U.S. Court of Appeals for the 8th Circuit and, if that court rules in favor the taxpayer, this will create a circuit split that could only be resolved if the issue is ultimately taken up by the U.S. Supreme Court.
Background
Between 2001 and 2005, Raju Mukhi, a Missouri resident, created two foreign trusts and a foreign corporation and transferred approximately $15 million to those entities. For tax years 2002 through 2013 he failed to file Form 3520, Annual Return To Report Transactions With Foreign Trusts and Receipt of Certain Foreign Gifts, and Form 3520-A, Annual Information Return of Foreign Trust With a U.S. Owner, in relation to the foreign trusts and failed to file Form 5471, Information Return of U.S. Persons With Respect to Certain Foreign Corporations, in relation to the foreign corporation. After he had pleaded guilty in 2014 to filing false individual income tax returns and willful failure to file FinCEN Form 114, Report of Foreign Bank and Financial Accounts, the IRS audited his returns for the years in issue and assessed $120,000 in civil penalties under U.S. Internal Revenue Code (I.R.C.) section 6038(b) for his failure to file Form 5471, and over $10 million in penalties under I.R.C. section 6677 for his failure to file Forms 3520 and 3520-A.
The taxpayer filed suit in the Tax Court seeking relief from the penalties and on April 8, 2024, the Tax Court upheld the penalties imposed under I.R.C. section 6677, but concluded that the IRS lacked authority to assess the penalties under I.R.C. section 6038(b), based on its previous decision in Farhy v. Commissioner.3 In May 2024, the D.C. Circuit reversed the Tax Court’s decision in Farhy and, as a result, the IRS filed a motion in the Mukhi case asking the Tax Court to reverse its holding in relation to the penalties under I.R.C. section 6038(b) for failure to file Form 5471.
Tax Court’s Decision
The Tax Court, sitting en banc (i.e., with all judges of the court hearing the case), ruled by a majority of 15-1 that the IRS lacks the authority to assess penalties under I.R.C. section 6038(b), thus reaffirming its original decision. In reaching this conclusion, the Tax Court relied on its own decision in Farhy and declined to follow the D.C. Circuit’s decision in that case. The Tax Court noted that an appeal in Mukhi would lie to the Eighth Circuit as opposed to the D.C. Circuit, and the Tax Court was not therefore bound by the precedent set by the D.C. Circuit’s decision in Farhy.
In reaffirming its earlier decision in Mukhi, the Tax Court stated that the statutory language of I.R.C. section 6038(b) does not expressly authorize the IRS to assess penalties or set out the procedure the IRS must follow to collect any tax due under that provision. The court compared this provision with other I.R.C. provisions that expressly authorize the IRS to assess penalties for violations.
The Tax Court also rejected the IRS’s argument that when Congress recodified the tax laws in 1954 it did not intend to change the scope of the IRS’s penalty assessment authority from the prior version, even though the relevant language in the new version omitted a blanket power to assess all penalties. In addition, the Tax Court rejected the D.C. Circuit’s reasoning in Farhy, on the basis that it failed to cite any legislative history in support of its conclusion that the IRS does have penalty assessment authority under I.R.C. section 6038(b).
KPMG Insights
The Tax Court’s decision creates some uncertainty as to the scope of the IRS’s ability to assess penalties for failure to file Form 5471. The decision is likely to be appealed and litigation on this issue could also arise in other federal circuits. Until this uncertainty is finally resolved, taxpayers are advised to be diligent in reporting their interests in foreign entities.
FOOTNOTES:
1 Mukhi v. Commissioner, 163 T.C. No. 8 (November 18, 2024). Read the Tax Court’s opinion.
2 Farhy v. Commissioner, 100 F.4th 223 (D.C. Cir. 2024), rev'g and remanding 160 T.C. 399 (2023). For coverage of the Farhy case, see GMS Flash Alert 2024-116 (May 21, 2024).
3 Farhy v. Commissioner, 160 T.C. 399 (2023).
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