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Update: How the Latest Ruling on Farhy v. Commissioner Could Affect Your Penalty Assessments

Executive Summary

In April 2023, the U.S. Tax Court made news when it ruled in favor of businessman Alon Farhy, who challenged the Internal Revenue Service (IRS)’s authority to assess penalties for the failure to file IRS Form 5471.
IRS Form 5471 is the Information Return of U.S. Persons With Respect to Certain Foreign Corporations.
In May 2024, the U.S. Court of Appeals for the D.C Circuit reversed the Tax Court’s initial ruling — underscoring the significance of context in assessing penalties for international information returns.

UPDATE (May 2024):

Recent developments in the Farhy v. Commissioner case have captured significant attention in the tax and legal sectors. On May 3, 2024, the U.S. Court of Appeals reversed the Tax Court’s initial decision, highlighting the importance of statutory context in penalty assessments for international information returns. This ruling emphasizes the need for a closer examination of statutory language, altering perspectives on penalty applicability for non-compliance.

The implications of this case extend to taxpayers and practitioners, as detailed in analyses by MGO (see below). The decision underscores the need for meticulous compliance practices and adept navigation of the complexities of U.S. international tax law, along with a deep understanding of judicial interpretations of tax regulations.

MGO’s professionals are well-positioned to assist clients in navigating the complexities arising from the recent Farhy v. Commissioner decision. With a comprehensive understanding of the changing landscape in penalty assessments for international information returns, we provide guidance to help companies adapt to new judicial interpretations and maintain compliance with evolving tax regulations.

ORIGINAL ARTICLE (published June 8, 2023):

On April 3, 2023, the U.S. Tax Court came to a decision in the case Farhy v. Commissioner, ruling that the Internal Revenue Service (IRS) does not have the statutory authority to assess penalties for the failure to file IRS Form 5471, or the Information Return of U.S. Persons With Respect to Certain Foreign Corporations, against taxpayers. It also ruled that the IRS cannot administratively collect such penalties via levy.

Now that the IRS doesn’t have the authority to assess certain foreign information return penalties according to the court, affected taxpayers may want to file protective refund claims, even if the case goes to appeals — especially given the short statute of limitations of two years for claiming refunds.

Our Tax Controversy team breaks down the Farhy case, as well as what it may mean for your international filings — and the future of the IRS’s penalty collections.

The IRS Case Against Farhy

Alon Farhy owned 100% of a Belize corporation from 2003 until 2010, as well as 100% of another Belize corporation from 2005 until 2010. He admitted he participated in an illegal scheme to reduce his income tax and gained immunity from prosecution. However, throughout the time of his ownership of these two companies, he was required to file IRS Forms 5471 for both — but he didn’t.

The IRS then mailed him a notice in February 2016, alerting him of his failure to file. He still didn’t file, and in November 2018, he assessed $10,000 per failure to file, per year — plus a continuation penalty of $50,000 for each year he failed to file. The IRS determined his failures to file were deliberate, and so the penalties were met with the appropriate approval within the IRS.

Farhy didn’t dispute he didn’t file. He also didn’t deny he failed to pay. Instead, he challenged the IRS’s legal authority to assess IRC section 6038 penalties.

The Tax Court’s Initial Ruling

The U.S. Tax Court then held that Congress authorized the assessment for a variety of penalties — namely, those found in subchapter B of chapter 68 of subtitle F — but not for those penalties under IRC sections 6038(b)(1) and (2), which apply to Form 5471. Because these penalties were not assessable, the court decided the IRS was prohibited from proceeding with collection, and the only way the IRS can pursue collection of the taxpayer’s penalties was by 28 U.S.C. Sec. 2461(a) — which allows recovery of any penalty by civil court action.

How This Decision Affects Your International Penalty Assessments

This case holds that the IRS may not assess penalties under IRC section 6038(b), or failure to file IRS Form 5471. The case’s ruling doesn’t mean you don’t have an obligation to file IRS Form 5471 — or any other required form.

Ultimately, this decision is expected to have a broad reach and will affect most IRS Form 5471 filers, namely category 1, 4, and 5 filers (but not category 2 and 3 filers, who are subject to penalties under IRC section 6679).

However, the case’s impact could permeate even deeper. For years, some practitioners have spoken out against the IRS’s systemic assessment of international information return (IIR) penalties after a return is filed late, making it impossible for taxpayers to avoid deficiency procedures. The court’s decision now reveals how a taxpayer can be protected by the judicial branch when something is deemed unfair. Farhy took a stand, challenged the system, and won — opening the door for potential challenges in the future.

It’s uncertain as to whether the IRS will appeal the court’s decision. But it seems as though the stakes are too high for the IRS not to appeal. While we don’t know what will happen, a former IRS official has stated he expects that, for cases currently pending review by IRS Appeals, Farhy will not be viewed as controlling law yet.

The impact of the ruling is clear and will most likely impact many taxpayers who are contesting — or who have already paid — IRC 6038 penalties. It may also affect other civil penalties where Congress has not prescribed the method of assessment in the future.

How You Should Respond to the Court’s Decision

You should move quickly to take advantage of the court’s decision, as there is a two-year statute of limitations from the time a tax is paid to make a protective claim for a refund. It’s likely this legislation wouldn’t affect refund claims since that would be governed by the law that existed when the penalties were assessed. Note that per IRC section 6665(a)(2), there is no distinction between payments of tax, addition to tax, penalties, or interest — so all items are treated as tax.

If you’ve previously paid the $10,000 penalty, it’s important to file your protective claim now, unless you’ve entered into an agreement with the IRS to extend the statute of limitations, which can occur during an examination. Requesting a refund won’t ever hurt, but some practitioners believe the IRS may try to keep any penalty money it collected, even if the assessment is invalid — because, in its eyes, the claim may not be. Just know, you can file your protective claim for a refund, but may not get it (at least not any time soon).

The Farhy decision could likewise be applied to other US IRS forms, such as 5472, 8865, 8938, 926, 8858, 8854. Some argue the Farhy decision may also be applied to IRS Form 3520.

How MGO Can Help

Only time will tell if the court’s decision will open the government up to additional criticisms for other penalty assessments. If you have paid your penalties and are wondering what your current options are, MGO’s experienced International Tax team can help you determine if you’re eligible to file a refund claim.

The Real Oversight is NOT Having an Audit Committee

By Jim Godsey, CPA, CGMA, Partner, MGO

Everything changes, except when it doesn’t

Time and time again we’ve seen reactions to various accounting scandals, after which new policies, procedures, and legislation are created and implemented. An example of this is the Sarbanes-Oxley Act (SOX) of 2002, which was a direct result of the accounting scandals at Enron, WorldCom, Global Crossing, Tyco, and Arthur Andersen.

SOX was established to provide additional auditing and financial regulations for publicly held companies to address the failures in corporate governance. Primarily it sets forth a requirement that the governing board, through the use of an audit committee, fulfill its corporate governance and oversight responsibilities for financial reporting by implementing a system that includes internal controls, risk management, and internal and external audit functions.

Governments experience challenges and oversight responsibility similar to those encountered by corporate America. Governance risks can be mitigated by applying the provisions of SOX to the public sector.

Some states and local governments have adopted similar requirements to SOX but, unfortunately, in many cases only after cataclysmic events have already taken place. In California, we only need to look back at the bankruptcy of Orange County and the securities fraud investigation surrounding the City of San Diego as examples of audit committees that were established in response to a breakdown in governance.

Taking your audit committee on the right mission

Governments typically establish audit committees for a number of reasons, which include addressing the risk of fraud, improving audit capabilities, strengthening internal controls, and using it as a tool that increases accountability and transparency. As a result, the mission of the audit committee often includes responsibility for:

Oversight of the external audit.
Oversight of the internal audit function.
Oversight for internal controls and risk management.

Chart(er) your course

Most successful audit committees are created by a formal mandate by the governing board and, in some cases, a voter-approved charter. Mandates establish the mission of the committee and define the responsibilities and activities that the audit committee is expected to accomplish. A wide variety of items can be included in the mandate.

Creating the governing board’s resolution is the first step on the road to your audit committee’s success.

Follow the leader(ship)

In practice we see a combination of these attributes, ranging from the full board acting as the audit committee, committees with one or more independent outsiders appointed by the board, and/or members from management and combinations of all of the above. While there are advantages and disadvantages for all of these approaches, each government needs to evaluate how to work within their own governance structure to best arrive at the most workable solution.

Strike the right balance between cost and risk

The overriding responsibility of the audit committee is to perform its oversight responsibilities related to the significant risks associated with the financial reporting and operational results of the government. This is followed closely by the need to work with management, internal auditors and the external auditors in identifying and implementing the appropriate internal controls that will reduce those risks to an acceptable level. While the cost of establishing and enforcing a level of zero risk tolerance is cost prohibitive, the audit committee should be looking for the proper balance of cost and a reduced level of risk.

Engage your audit committee with regular meetings

Depending on the complexity and activity levels of the government, the audit committee should meet at least three times a year. In larger governments, with robust systems and reporting, it’s a good practice to call for monthly meetings with the ability to add special purpose meetings as needed. These meetings should address the following:

External Auditors

Confirmation of the annual financial statement and compliance audit, including scope and timing.
Ad hoc reporting on issues where potential fraud or abuse have been identified.
Receipt and review of the final financial statements and auditor’s reports
Opinion on the financial statements and compliance audit;
Internal controls over financial reporting and grants; and
Violations of laws and regulations.

Internal Auditors

Review of updated risk assessments over identified areas of risk.
Review of annual audit plan, including status of the prior year’s efforts.
Status reports of ongoing and completed audits.
Reporting of the status of corrective action plans, including conditions noted, management’s response, steps taken to correct the conditions, expected time-line for full implementation of the corrective action and planned timing to verify the corrective action plan has been implemented.

Establish resources that are at the ready

Audit committees should be given the resources and authority to acquire additional expertise as and when required. These resources may include, but are not limited to, technical experts in accounting, auditing, operations, debt offerings, securities lending, cybersecurity, and legal services.

Taking extra steps now will save time later

While no system can guarantee breakdowns will not occur, a properly established audit committee will demonstrate for both elected officials and executive management that on behalf of their constituents they have taken the proper steps to reduce these risks to an acceptable tolerance level. History has shown over and over again that breakdowns in governance lead to fraud, waste and abuse. Don’t be deluded into thinking that it will never happen to your organization. Make sure it doesn’t happen on your watch.

Does Your Organization have a Need for an Independent Eye on Performance?

Alternative Engagement Types: Consulting Services, Agreed-Upon Procedures, and Performance Audits

By Scott P. Johnson, CPA, CGMA
Partner, Macias Gini & O’Connell LLP
State and Local Government Advisory Services

I have spent most of my professional career over the past 35 years serving government agencies and focusing on performance improvement, accountability, and transparency. I recognize the need for continuous monitoring and oversight in the public sector to ensure performance, public accountability, and stewardship of public resources. While participating on a number of professional panels and presentations throughout my career, I have often stated that I embraced the auditor and have welcomed them with open arms into the organizations that I had responsibility over. Why? Because I see auditors as an independent and objective lens, adding value to review and evaluate performance and to make recommendations for improvement. The organizations I have had the pleasure to work for took public accountability very seriously and supported performance improvement as a means to better serve their communities and stakeholders.

Much like a traditional CPA firm can provide different types of services related to an entity’s financial statements, i.e., audit, review, or compilation, based on need, when government agencies are considering an independent evaluation of performance of their programs or operations, the CPA firm’s advisory or consulting arm can step in and offer a number of engagement types based on the agency’s unique needs: consulting services engagements, attestation engagements (e.g., agreed-upon procedures), and performance audits. It all depends on if, and at what level, assurance is needed. The primary driver of what type of product should be considered is typically based on, for instance, issue complexity, taxpayer concerns or expectations, statute requirements, or increased need for transparency on the efficiency and effectiveness of operations. While the driver of the engagement may differ, time constraints and budget are also determining factors.

This is the first article in a three-part series focusing on performance audits. The primary focus of this article is to discuss the differences of the three aforementioned types of engagements – consulting services, agreed-upon procedures, and performance audits – and to provide guidance when a performance audit might be an option.

It is important to identify the differences between (1) performance audits, (2) consulting services engagements, and (3) agreed-upon procedures attestation engagements. On numerous occasions throughout my government service career and also while serving clients, questions have come up regarding the objectives sought, the scope of the engagement, and the engagement type when considering an evaluation of performance for a particular program or area of operations. Each of these engagements differ in purpose and reporting requirements, as well as potential cost, as shown below in Figure 1.0. These engagements are governed by different standards, formal reports are not always required for each, and independence is not always required (i.e., consulting services).

Performance Audits Defined

Performance audits are defined as engagements that provide objective analysis, findings, and conclusions to assist management and those charged with governance and oversight to, among other things, improve program performance and operations, reduce costs, facilitate decision making by parties with responsibility to oversee or initiate corrective action, and contribute to public accountability. *1

Furthermore, GAGAS states that management and officials of government programs are responsible for providing reliable, useful, and timely information for transparency and accountability of these programs and their operations. Legislators, oversight bodies, those charged with governance, and the public need to know whether (1) management and officials manage government resources and use their authority properly and in compliance with laws and regulations; (2) government programs are achieving their objectives and desired outcomes; and (3) government services are provided effectively, efficiently, economically, ethically, and equitably. *2

Agreed-Upon Procedures (AUP)

Based on my experience, it usually comes down to identifying a few factors that determine the engagement. First, the agency must determine the purpose and scope of the work, specifically what questions they would like to have answered. These questions can be broad or very narrow. For example, in an AUP, management may make an assertion about whether a subject matter is in accordance with, or based on, established criteria that is the responsibility of a third party and hires a CPA to add credibility to that assertion by performing specific procedures to test compliance with the criteria. If an agency needs to know something very specific and wants an independent party to perform specific procedures and tell them what was found, then an AUP is appropriate. However, an AUP report does not provide recommendations, an opinion, or conclusion about whether the subject matter is in accordance with, or based on, the criteria, or state whether the assertion is fairly stated. While the agency may want to use an AUP, some key steps that are taken in consulting engagements and performance auditing, such as planning, are not required in an AUP engagement. Also, risk is not assessed in developing the scope, nor does the auditor use a risk-based approach, which is required in a performance audit. Finally, in an AUP, auditors do not perform sufficient work to be able to develop elements of a finding or provide recommendations.

1 See Paragraph 1.21 of GAGAS.
2 See Paragraph 1.02 of GAGAS.

Consulting Services Engagement vs. Performance Audit

For a consulting services engagement or performance audit, the initial questions are then turned into the objectives of the engagement. If the agency wants an objective review of operations or a program to assist them in making decisions, for example, to assess the management of specific funds, and wants findings and recommendations to improve operations, then the agency should discuss the options of a consulting services engagement or a performance audit. From here, the decisions are truncated. The agency needs to consider whether the report is for an internal audience, such as governing officials, management, or staff, or an external audience, e.g., a regulatory agency or the public. If the communication is intended for internal use, then a consulting services engagement with observations and recommendations may suffice. For these engagements, findings, recommendations, and a conclusion is provided to assist management in decision making. Or, an independent third party, such as a CPA or an internal auditor, may be asked to answer the engagement’s objectives to an external audience, in which case a performance audit may be more appropriate due to the need for an independent, objective report that can withstand scrutiny and is subject to peer review. Sometimes there isn’t a choice; some agencies are bound by the government code or local ordinance to conduct audits under GAGAS.

Performance audits are typically the more costly engagement type of the three, given the amount of work required to conduct an audit and adhere to stringent standards. As we’ll explore in later articles, performance audits conducted under GAGAS provide the highest level of assurance among the three options, based on the level of work required. These audits involve developing the required elements of a finding and the documentary evidence required for planning, fieldwork, and reporting. The amount of work involved is much greater than in consulting services engagements, where observations and recommendations will suffice. Consulting services engagements are not audits and, therefore, offer no assurance. Similarly, in attestation engagements, where only specific procedures are performed, no assurance is provided. *3

Conclusion

Having been on both sides of deciding what engagement to recommend, either for an agency I worked at or to a client, it’s important to discuss the level of work required for each engagement type, the number of hours required to do the work under the appropriate standard within a reasonable time period, and the available budget. Finally, and most importantly, clients should understand that performance audits and consulting services engagements each have their place and serve unique purposes. A performance audit offers independence and objectivity at a step above a consulting services engagement, and might be the best option if a rigorous audit of a program or agency is needed. This is where the consideration of the agency’s need is paramount. There may not always be the budget or time available to conduct a comprehensive performance audit, nor a need for an in-depth evaluation or a legislative requirement to do so. In these instances, a consulting services engagement is a good option, especially when time and budget are factors. A consulting services engagement can provide a sufficient report with recommendations and advice. However, it’s important to make the agency aware of the limitations of non-audit services. In addition, the audience of the final report product and any regulatory requirements should strongly influence the decision-making process.

Forthcoming articles in this series will drill down and focus in more detail on the professional standards associated with performance audits as compared to other types of engagements, “why” an agency would want a performance audit instead of a consulting engagement or an agreed-upon procedures engagement, when a performance audit would be recommended, what key factors should be considered, and what are the expectations of the audience of the report. The third article in this series will focus on the reporting elements of a performance audit and a sample performance audit report.

*3 Attestation engagement standards are covered in GAGAS Chapter 7, and include agreed-upon-procedures, reviews, and examination engagements. Attestation examinations have the highest level of assurance, as an opinion is given; not so for the others. Auditors may use GAGAS in conjunction with other professional standards such as American Institute of Certified Public Accountants (AICPA), International Auditing and Assurance Standards Board (IAASB), or Public Company Accounting Oversight Board (PCAOB) standards. For financial audits and attestation engagements, GAGAS incorporates by reference for AICPA Statements on Auditing Standards and Statements on Standards for Attestation Engagements. In addition, the AICPA promulgates the consulting standards. AICPA standard committees have taken the position that only the U.S. Government Accountability Office (GAO) sets performance audit standards.

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SOURCES OF INFORMATION AND DOCUMENTATION CONSIDERED

Government Auditing Standards, issued by the Comptroller General of the United States
– July 2018 Revision (effective for performance audits beginning on or after July 1, 2019; effective for attestation engagements for periods ending on or after June 30, 2020; early implementation is not permitted)
United States General Accounting Office. Best Practices Methodology – A New Approach for Improving Government Operations. May 1995

About the Author

Scott Johnson has 35 years of experience in government administration, with a focus on successfully overseeing internal service operations including; debt management, information technology, human resources, municipal finance, and budget. He has led large and mid-sized operations for California government agencies including the cities of Santa Clara, Milpitas, San Jose, Oakland, and Concord and the County of Santa Clara. Scott is a past president of the California Society of Municipal Finance Officers (CSMFO) and a member of the AICPA Government Performance and Accountability Committee (GPAC). He is currently a partner with Macias Gini & O’Connell LLP (MGO), leading the Advisory Services sector specializing in State and Local Governments, based out of California. He welcomes any questions or comments via email: [email protected].

Greta MacDonald, MPA – Special recognition is given to Ms. MacDonald for her contributions and research for this article. Ms. MacDonald is a Director with MGO in the State and Local Government Advisory Services division. She has over 17 years of experience conducting over 35 performance audits in accordance with GAGAS, which is her specialization area.

Disclaimer: The views expressed in this article are those of the author and do not reflect the official policy or position of the GAO, AICPA, or Macias Gini & O’Connell LLP.