D.C. Circuit Upholds IRS Penalty Authority, Creating Deepening Split With U.S. Tax Court

WASHINGTON — A U.S. Court of Appeals has reversed a landmark Tax Court decision, ruling that the Internal Revenue Service does possess the statutory authority to assess and administratively collect certain penalties for failure to file international information returns. The decision by the D.C. Circuit in Farhy v. Commissioner upends a 2023 ruling that had provided significant relief to taxpayers, but the Tax Court has since signaled its intent to stand by its original position, creating a complex and uncertain legal landscape for businesses with foreign holdings.

This ongoing conflict between the courts highlights a critical period of flux in tax enforcement and procedure. For businesses, navigating this uncertainty requires not just awareness, but a proactive strategy. The shifting legal ground means that a company’s compliance obligations and potential penalty exposure can now depend on its geographical location, making expert guidance more essential than ever.

The dispute began on April 3, 2023, when the U.S. Tax Court issued a surprising taxpayer victory in Farhy v. Commissioner. The court held that the IRS lacked the specific statutory authority to assess penalties under Internal Revenue Code Section 6038(b), which applies to the failure to file Form 5471, an information return for U.S. persons with respect to certain foreign corporations. The court found that while Congress had explicitly granted the IRS assessment power for many other penalties, it had not done so for this specific section.

This ruling was significant because, without the power to formally assess the penalty, the IRS could not use its potent administrative collection tools, such as levies and liens, to seize taxpayer assets. Instead, the Tax Court noted the government would have to pursue a more cumbersome route: referring the case to the Department of Justice to file a civil lawsuit to collect the funds. The decision was seen as potentially affecting penalties for other international information returns as well, including Forms 5472, 8865, 8938, and 926, which have similar statutory language.

The IRS appealed the decision, and the D.C. Circuit Court of Appeals reversed the Tax Court's ruling. The appellate court found that the IRS’s authority to assess these penalties was implied within the broader tax code framework, thereby restoring the agency’s ability to use its powerful administrative collection powers against taxpayers who fail to file Form 5471, at least for those within the D.C. Circuit's jurisdiction.

However, the story did not end there. In two subsequent cases, Mukhi v. Commissioner and Safdieh v. Commissioner, the Tax Court announced it would not adopt the D.C. Circuit’s reasoning. Citing a long-standing precedent known as the Golsen doctrine, the Tax Court stated it will continue to follow its own ruling in Farhy for any case that is not appealable to the D.C. Circuit. Under the Golsen rule, the Tax Court is only bound by an appellate court’s decision for cases involving taxpayers who reside within that specific circuit. For everyone else, the Tax Court can adhere to its own precedent.

This creates a confusing split where a taxpayer’s liability for certain penalties could be determined by their location. A business whose case would be appealed to the D.C. Circuit would lose on this issue at the Tax Court, while a similar business in another part of the country could win.

In our experience, this kind of judicial split creates significant operational and financial risks for small and mid-sized businesses. The lack of a uniform national standard makes planning difficult and exposes companies with international interests to unpredictable enforcement actions. This is precisely the type of complex situation where professional tax preparation and compliance services are vital. Companies need a clear understanding of their specific exposure based on their jurisdiction and facts, which is why we advise clients to conduct thorough reviews of their filing history. To navigate these challenges, business owners can consult with the advisors at C&S Finance Group LLC at csfinancegroup.com.

The Farhy case is part of a broader trend of federal courts increasingly scrutinizing the procedural authority of the IRS and the Treasury Department. In a separate case, Faulk Company, Inc. v. Becerra, a Texas district court invalidated an IRS assessment of Affordable Care Act (ACA) employer penalties, ruling the agency lacked the authority to act without prior certification from the Department of Health and Human Services. Similarly, in Hewitt v. Commissioner, the Eleventh Circuit invalidated a Treasury regulation related to conservation easements because the agency failed to follow proper rulemaking procedures under the Administrative Procedure Act (APA).

These cases collectively signal that courts are holding the IRS to a stricter standard, demanding that the agency act squarely within the authority granted by Congress. For businesses, the immediate consequence is a period of heightened uncertainty. The difference between facing a swift IRS levy on a bank account versus defending a lengthy civil suit brought by the Department of Justice is immense, affecting everything from cash flow management to long-term financial strategy.

This legal battle underscores that even long-standing IRS procedures are not immune to challenge. We believe businesses should view this not as a loophole, but as a reminder of the importance of meticulous record-keeping and procedural correctness in all tax matters. Proactive compliance remains the most effective defense against penalties, regardless of how the courts ultimately resolve these disputes over collection authority.

Looking ahead, the stark disagreement between the Tax Court and the D.C. Circuit makes this issue a prime candidate for review by the U.S. Supreme Court, which often steps in to resolve such splits among federal courts. Alternatively, Congress could intervene with a legislative fix to explicitly grant the IRS the assessment authority it seeks. Until then, businesses and their advisors must closely monitor developments as other circuit courts potentially weigh in on the matter.