In prior posts, I discussed the dangers of playingBattleship with the IRS and how taxpayers scored “a hit”. Recently, taxpayers took another turn in the game and scored another hit with the District Court’s recently issued decision in Huang v. United States, No. 3:24-cv-06298 (N.D. Cal. 2025) (“Huang”). Although the decision in Huang certainly shows that the IRS’s position in the game may not be as strong as some thought, the IRS still managed to hit our battleship.
The crux of the issue in Huang is the IRS’s motion to dismiss the taxpayer’s refund suit that was brought in order to recover penalties for failing to timely file Form 3520, which was required to disclose gifts from the taxpayer’s nonresident parents. Although the case raises a few procedural issues, the main discussion arising from the Huang decision relates to the ability of a taxpayer who utilizes tax software to submit a filing to establish reasonable cause (and thereby mitigate some or all of the penalties). In denying the IRS’s motion to dismiss the taxpayer’s case, the Court acknowledged that the taxpayer had sufficiently demonstrated facts that could establish reasonable cause, which included (along with other factors, showing that the taxpayer exercised ordinary business care and prudence) a screenshot of the tax software stating that, in relation to gifts, if the taxpayer “received the money, no matter how much or how little,” then the taxpayer “need not report anything.” This was certainly a win for the taxpayer, as “tax software defenses” have historically had a difficult time swaying courts. Nevertheless, this was a motion to dismiss, and the burdens of proof may be different at this stage than later in the court process. Thus, the taxpayer still has the burden to show reasonable cause exists and it has yet to be seen if the taxpayer’s facts and circumstances, including the use of tax software, will be able to establish reasonable cause.
But the game was not over! The taxpayer also argued in the complaint that the IRS lacked the authority to assess a penalty on the Form 3520 (under section 6039F), citing the Tax Court’s opinion in Farhy v. Commissioner, 160 T.C. 399 (2023) rev’d and remanded, 100 F.4th 223 (D.C. Cir. 2024) (“Farhy”). Since the time of the prior post relating to Farhy, the IRS successfully appealed and had that decision reversed. Nevertheless, this left open many procedural issues, such as: (1) could the argument made in Farhy be made relating to other parts of the tax law; and (2) did the Appeals Court’s decision apply anywhere outside of the D.C. Circuit? In answering these procedural issues, the Court in Huang was not persuaded by the Taxpayer’s argument. Instead, the Court was persuaded by the Circuit Court’s decision in Farhy. Nevertheless, in dismissing this part of the taxpayer’s claim, the Court noted that this argument was waived as a result of the Taxpayer not properly raising the issue. Thus, this portion of the Huang opinion may actually be dicta. Nevertheless, this is definitely another “hit” on our battleship.
The practical takeaway for our clients and U.S. accounting professional friends may be more in the nature of reminders:
- Reliance on tax preparation software may not be enough, alone, to establish reasonable cause; however, with other factors, such reliance should be considered by the IRS Office of Appeals when deciding whether or not (or the extent to which) to abate penalties, as any possible litigation may certainly make it beyond the initial motion to dismiss.
- The “Farhy defense” remains a viable argument in many states, and therefore should be argued to the IRS Office of Appeals when requesting penalty abatement; however, the weight the IRS Office of Appeals assigns to the Farhy defense in its decision making process may be being diminished in light of additional court criticism.
