Tax Court Ruling Against IRS Cracks Open Door to Penalty Refunds

For those recently paying certain penalties in connection with IRS Forms 5471, 5472, 8938, or 926, there may be an opportunity for a refund following the US Tax Court’s April 3 decision in Farhy v. Commissioner.

In Farhy, the court determined that noncompliance penalties applicable to Form 5471 category 4 and category 5 filers can’t be assessed because there’s no statutory provision authorizing their assessment. The IRS may neither assess the penalties nor collect them administratively, Instead, the Justice Department would have to sue a taxpayer in a federal court to reduce them to judgment to allow the IRS to collect.

The Tax Court’s analysis would apply equally as well to the noncompliance penalty provisions associated with Forms 5472, 8938, 926, and in certain instances Form 8865. There are no statutory provisions authorizing their assessment.

The analysis, however, wouldn’t apply to the noncompliance penalties associated with Form 5471 category 2 and category 3 filers; Forms 3520 (Parts I, II, and III) and 3520-A; or, in certain instances, Form 8865. Those penalties are imposed under Sections 6677(a) and 6679(a) of the tax code, which are assessable penalties. As a result, the court’s decision in Farhy provides no basis for halting administrative collection of penalties summarily assessed where those forms or instances are involved.

While the IRS is determining whether to appeal the decision, should refund claims be considered for payments of the nonassessable penalties without the Justice Department first having reduced them to judgment?

Generally, under Section 6402, the IRS is authorized to issue refunds of tax overpayments. Under Section 6401(a), an “‘overpayment’ includes that part of the amount of the payment of any internal revenue tax which is assessed or collected after the expiration of the period of limitation properly applicable thereto.”

Therefore, tax paid after the assessment statute expiration date, or ASED, without an assessment having been made is an overpayment. Similarly, tax paid on an assessment made after the ASED is an overpayment.

The government, however, is entitled to retain tax paid before the ASED even without an assessment subsequently being made. Similarly, as the US Supreme Court determined in Lewis v. Reynolds, expiration of the assessment statute doesn’t bar the government from “retain[ing] payments already received when they do not exceed the amount which might have been properly assessed and demanded.”

What if no lawful assessment can be made? A payment made in connection with such an invalid assessment should seemingly be treated the same as a payment made on an assessment made after the ASED—that is, an invalid assessment, making the payment refundable, with no right of the government to retain such payment.

In much the same way that there is no statutory authority authorizing assessment of the penalty under Section 6038(b), there is no statuatory authority treating that penalty as a tax, and such penalty would therefore seem not to fall within the Section 6401 definition of an overpayment.

But Section 6402 authorizes refunds of overpayments, and Section 6401 doesn’t provide the exclusive definition of an overpayment. As a reference, in Jones v. Liberty Glass Co., the US Supreme Court stated that “we read the word ‘overpayment’ in its usual sense, as meaning any payment in excess of that which is properly due,” and that “the payment of more than is rightfully due is what characterizes an overpayment.”

If the penalty at issue in Farhy can’t be lawfully assessed, a payment made in connection with an assessment of such penalty should be considered a refundable overpayment, with no right of the government to retain such payment—at least not without a judgment.

In anticipation of the IRS believing it’s entitled to keep the overpayment, a taxpayer would first have to file an administrative claim for the refund and then sue for it after the IRS doesn’t approve the claim. The government would then likely argue the merits of the penalty to obtain judgment in its favor. As a practical matter, taxpayers claiming refunds should be prepared to establish that the penalties have no merit—rather than simply relying on their being invalidly assessed—if they wish to see a refund of those penalties.

The case is: Farhy v. Commissioner, T.C., No. 10647-21L, 4/3/23

This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

Author Information

David Shuster is a tax and business services partner at Marcum LLP and national leader of the firm’s tax controversy practice.

We’d love to hear your smart, original take: Write for us.