Recent Court Rulings Uphold Congressional Authority to Assess Taxes and Penalties on U.S. Taxpayers with Foreign Interests by Andrew Leonard, CPA
Posted on September 12, 2024
by
Andrew Leonard
The IRS scored significant wins in two separate cases before the U.S. Supreme Court and D.C. Court of Appeals. While both matters addressed different provisions of the tax code, the court’s decisions essentially fortified the IRS’s international reach and its ability to enforce compliance with various U.S. tax laws regarding taxpayers’ foreign investments and business interests. Taxpayers should pay attention and work with their tax advisors to ensure they comply with relevant tax reporting and liabilities.
Mandatory Repatriation Tax on Foreign Earnings
Before 2018, multinational businesses, like U.S. residents, paid U.S. taxes on their worldwide income. Still, they could defer a tax on foreign-earned active business profits until they brought those funds back to the U.S. parent company or its U.S. shareholders. This changed with the Tax Cuts and Jobs Act, which introduced two tax regimes intended to discourage companies from parking profits and assets overseas in lower-tax countries. The first is a one-minimum tax on global intangible low-taxed income (GILTI), which applies to U.S. individuals, corporations, partnerships, trusts and estates that own at least 10 percent ownership interest in a controlled foreign corporation (CFC).
The second regime, which was at the center of the case before the Supreme Court, is a one-time “deemed repatriation tax” U.S. shareholders in specific foreign corporations had to pay on previously untaxed and undistributed foreign earnings held overseas. With the mandatory repatriation tax (MRT), applicable taxpayers were subject to a one-time tax at a rate of 15.5 percent on liquid assets and 8 percent on non-cash assets, rather than the corporate tax rate of 21 percent they would have faced when they eventually brought those foreign earnings back to the U.S.
In Moore v. United States, a U.S. couple who owned a 13 percent stake in an Indian company paid a deemed repatriation tax of nearly $15,000 in 2018 on their pro rata share of the company’s accumulated earnings held overseas. However, they soon after sued the U.S. government for a refund, challenging the constitutionality of the MRT under the 16th amendment, which gives Congress “the power to lay and collect taxes on incomes, from whatever source derived, without apportionment among the several States, and without regard to any census or enumeration.” The Moores argued that because they did not personally receive any profits from their overseas investment, they were exempt from income tax treatment of the company’s undistributed foreign earnings.
The Supreme Court disagreed, ruling against the Moores and asserting that “Congress has long taxed shareholders of an entity on the entity’s undistributed income” and, therefore, has the authority to tax the entity or to attribute the entity’s income and the related taxes to its shareholders or partners. The Court held that the MRT is constitutional as it applies to U.S. shareholders with interests in a pass-through foreign company regardless of whether shareholders receive any profits from their investments, or the company reinvests its earnings overseas.
Penalties for Failure to Comply with Reporting of Foreign Business Interests
Under the Internal Revenue Code Sections 6038 and 6046, U.S. persons who control certain foreign corporations and partnerships must annually file informational returns about those entities with the IRS. Failure to comply can result in penalties starting at $10,000 for each year the return goes unfiled.
In the matter of Farhy v. Commissioner of Internal Revenue, the taxpayer acknowledged that he failed to report his control of a corporation and financial account in Belize over a seven-year period. However, he argued that the IRS lacks the authority to assess the nearly $500,000 in penalties he accrued and must instead sue Farhy to collect the civil penalties “prescribed for the violation of an Act of Congress.” While the Tax Court sided with Farhy in May 2023, the government appealed to the D.C. Court of Appeals, which, in 2024, ruled in favor of the government, concluding that “a narrower set of inferences suffices to show that Congress intended to render those penalties assessable” and supporting the IRS’s authority to assess and collect those penalties. Farhy has appealed to the Supreme Court. Should he be successful, taxpayers who fail to meet their information reporting obligations concerning ownership interests in foreign partnerships, corporations, disregarded entities, and foreign trusts and estates could have cause to challenge the IRS’s imposition of penalties in the future.
These two tax cases show the importance of taking proper positions in tax reporting. Some taxpayers and practitioners may have filed assuming that either of these cases would not be overturned and should quickly take action to remedy those positions. The longer a position is out of compliance, the more penalties and interest can be assessed.
About the Author: Andrew Leonard, CPA, is a director with Berkowitz Pollack Brant’s International Tax Services practice, where he provides tax structuring, pre-immigration planning and a wide array of international tax and consulting services to international companies, entrepreneurs, families and foreign trusts. He can be reached at the CPA firm’s Ft. Lauderdale, Fla., office at (954) 712-7000 or info@bpbcpa.com.
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