Recent Judicial Developments on Foreign Reporting Obligations

Recent judicial rulings on foreign reporting obligations have sparked significant debate and raised concerns about potential legal inconsistencies. Key developments in cases like Farhy v. Commissioner and Mukhi v. Commissioner have questioned the IRS’s authority to assess penalties under IRC §6038(b) for failing to file Form 5471, with the courts having conflicting opinions on the issue. Decisions in Schwarzbaum and Toth regarding Report of Foreign Bank and Financial Accounts (FBAR) penalties create a possible circuit split over whether excessive fines under the Eighth Amendment apply to such penalties. These developments highlight the importance for U.S. taxpayers with foreign bank accounts and foreign asset interests to be aware of ongoing appeals and their impact on tax obligations.

Court Decisions in Farhy and Mukhi

Taxpayers need to keep an eye on potential Circuit Split

Controversy about the IRS’s authority to assess penalties under IRC §6038(b) for failure to file Form 5471 recently emerged after the decision made in Farhy v. Commissioner was reversed. In the 2023 tax court case, a Category 4 filer[1] successfully challenged years of penalties assessed against him by the IRS for failing to file Forms 5471 that disclosed his ownership of foreign corporations. The court held that, while IRC §6038(b) imposes penalties for noncompliance, the method of collection pursued by the IRS ― an assessment ― was not explicitly authorized in the statute, and that the penalties would require the filing of a civil suit to be enforced.

However, in May of 2024, the U.S. Court of Appeals reversed the tax court’s decision, stating that “explicit language directing that the penalty ‘shall be assessed’ is not determinative,” holding instead that based on the statute’s “text, structure and function,” penalties under IRC §6038(b) are actually assessable.

This meant that, in the case of any understatement of tax applicable to assets that were erroneously excluded under IRC §6038, the rate of the penalty (if a penalty is applicable) can be increased from 20% to 40%.

Prior to this reversal, the tax court relied on the Farhy decision passed down in April of 2024, determining in Mukhi v. Commissioner that the IRS lacks authority to assess IRC §6038(b) penalties. The Tax Court decided Mukhi, notwithstanding the then-pending Farhy appeal, as Mukhi is appealable to the Eighth Circuit and “any ruling from the D.C. Circuit [in Farhy] would not be binding” on Mukhi.

If the IRS appeals Mukhi and the Eighth Circuit affirms, it will cause a circuit split, which could lead to U.S. Supreme Court review of the issue. It’s important to note that failure to file Form 5471, or simply submitting an incomplete form, can result in severe penalties as well as the extension of the statute of limitations.

FBAR Court Rulings in Schwarzbaum and Toth

This, in fact, does create Circuit Split on excessive penalties

In the 2024 ruling of U.S. v. Schwarzbaum, the District Court for the Southern District of Florida found that the defendant had violated FBAR, “willfully” allowing for a higher penalty. However, the court also found that the IRS used the wrong base numbers to calculate the statutory maximum. The court calculated its own penalty of $12.9 million. The Eleventh Circuit sided with the District Court on the “willful” violation but disagreed with its penalty amount. The Eleventh Circuit remanded the matter to the IRS to recalculate penalties, which was even higher this time. The defendant appealed again to the Circuit.

On August 30, 2024, the Eleventh Circuit ruled that the Excessive Fines Clause of the Eighth Amendment applies to penalties for failing to report foreign bank accounts, creating a split with the First Circuit’s ruling on the same issue (discussed below). The Eleventh Circuit cut $300,000 of additional fines on accounts that were $16,000 or less, stating that such penalties are in violation of the Eighth Amendment. The Eleventh Circuit court upheld the remaining $12.3 million in penalties against the defendant.

This ruling creates a circuit split with the First Circuit, as in 2022, U.S. v. Toth said the Excessive Fines Clause doesn’t curb FBAR penalties. In particular, Judge Marcus of the Eleventh Circuit stated, “We decline to follow the First Circuit. Rather, we hold that FBAR penalties are in substantial measure punitive in nature. Therefore, under controlling Supreme Court precedent, they are subject to review under the Eighth Amendment’s Excessive Fines Clause.” That clause, Marcus said, applies to FBAR because it is “at least in part” a punishment, not merely a remediation of the government’s expense of enforcing the tax law.

Yet, in the most recent case, U.S. v. Hughes, the Ninth Circuit, which is considered taxpayer friendly, found that the taxpayer was “non-willful” during the first two years of the FBAR filing violation and “willful” in the subsequent two years. The Court noted that, by answering the question about foreign financial accounts on her tax returns in 2012 and 2013, the taxpayer in the case had “at least the basic instructions” that she was required to file FBARs. Failing to do so after being so informed was reckless, and willful FBAR penalties applied.

The Court, nonetheless, held that there was no evidence that Hughes knew about the filing requirement in 2010 or 2011, so only non-willful penalties could be imposed for the earlier two years.

Note that the IRS describes non-willfulness as “conduct that is due to negligence, inadvertence, or mistake or conduct that is the result of a good faith misunderstanding of the requirements of the law.” Willfulness was determined by the U.S. Supreme Court in U.S. v. Cheek. The Supreme Court held that “the standard for the statutory willfulness requirement is the voluntary, intentional violation of a known legal duty.” In other words, to be willful in the tax context, a taxpayer needed to have knowledge of the requirement for which a violation was asserted.

***

With the potential for circuit splits on key issues — ranging from the IRS’s authority to assess penalties under IRC §6038(b) to the applicability of the Eighth Amendment’s Excessive Fines Clause in FBAR cases — taxpayers must pay close attention to how these issues impact their businesses. These cases reinforce the need for careful compliance with foreign reporting requirements, as future rulings may significantly impact both penalty assessments and the legal defenses available to taxpayers. Learn more by talking to our team of expert international tax professionals.

About Our Authors

Elena Mossina, J.D., LL.M., is the principal of Sikich’s International Tax practice. She is a tax attorney with experience in advising U.S. multinational clients on a wide range of international and domestic tax issues. Her experience includes cross-border restructurings, cash repatriation strategies, IP migrations and transfer pricing matters. She combines U.S. and foreign tax analysis to provide clients with the most advantageous integrated solution from a U.S. and a foreign tax perspective.

Tom Bayer, CPA, CExP, has specialized expertise in the areas of business succession planning, tax planning and compliance, and business advisory. He has deep experience providing a range of accounting, tax, and business advisory services to commercial clients across industries.

Lesley Keller, CPA, MT, AEP^®, is a director who provides tax consulting and compliance services to clients in a variety of industries, including manufacturing and distribution, real estate, professional and technology services, and not-for-profit organizations. She advises individuals, trusts, estates and closely held businesses with U.S. and state taxation and reporting with a focus on international transactions, assets and investments.

Bryan Lake, EA, is a director of expatriate tax services and international tax compliance and consulting. He specializes in the taxation of U.S. expatriates, foreign nationals and third country nationals.

[1] Category 4 filer is a U.S. person who controls a foreign corporation by vote or value.