Foreign Trust Beneficiary Liable for a Double Tax Penalty?

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Foreign Trust Beneficiary Liable For A Double Tax Penalty?, Houston Tax Attorney
Foreign Trust Beneficiary Liable For A Double Tax Penalty?

Can the sole owner of a foreign trust who is also its sole beneficiary be penalized twice for not filing a single Form 3520? Can the IRS choose the higher penalty for the beneficiary in this situation? In Wilson v. United States, No. 19-cv-5037 (BMC) (E.D.N.Y. 2019), the IRS argued that it could impose pick the higher penalty amount and, if it had wanted to, it could impose two penalties for the same taxpayer for failing to file one Form 3520.

Facts & Procedural History

The taxpayer died while waiting for the IRS to process his refund claim. His estate filed suit once the IRS failed to respond.

The dispute involved a trust the taxpayer had set up during his lifetime. He set up a foreign trust to hold $9 million. The trust was structured as a revocable living trust.

The taxpayer apparently set up the trust to put the money beyond the reach of his wife, as he was expecting a divorce at the time.

After the divorce, he transferred the trust and moved the funds back to his U.S. account.

The taxpayer reported the income from the trust to the IRS from 2003-2007. He filed the Form 3520, Annual Return To Report Transactions With Foreign Trusts and Receipt of Certain Foreign Gifts, late for the 2007 tax year.

The IRS assessed a $3 million dollar tax penalty for the late return filing. The taxpayer appealed the decision to the IRS Office of Appeals and paid the penalty. He then filed the refund claim that is the subject of this dispute.

About the Form 3520

The Form 3520 has to be filed by U.S. persons have an interest in a foreign trust. It also has to be filed by a U.S. person who receives a distribution from a foreign trust.

While not relevant to this article, the form also has to be filed by those who receive more than $100,000 gifts from foreign individuals or estates.

A U.S. person is a U.S. citizen or resident or a U.S. corporation, partnership, trust, or estate.

The form is filed annually and is typically due when the individual income tax return is to be filed. An extension for the income tax return will extend the due date for the Form 3520.

The IRS announced a new compliance campaign for Form 3520 last year, which is part of the IRS’s focus on international tax issues. This campaign was to focus the IRS’s audit resources on late-filed and incomplete returns filed with the IRS service centers.

About the Section 6677 Penalty

The Section 6677 penalty is for filing late or incorrect Forms 3520.

The penalty is the greater of (1) $10,000 or (2) (a) 35% of the gross value of any property transferred to a foreign trust, (b) 35% of the gross value of the distributions received from a foreign trust, or (c) 5% of the gross value of the portion of the foreign trust’s assets treated as owned by a U.S. person under the grantor trust rules.

The penalty can be abated for reasonable cause. The typical reasonable cause defenses for penalties are available for this penalty.

No Double Penalty for One Tax Form

As noted above, the penalty is higher for those who receive trust distributions. It is lower for the trust owner. Can the IRS assess the higher penalty if the owner is the person who received the distribution?

The IRS did just that in this case. In fact, the IRS argued in court that it could impose the penalty twice–once for receiving the trust distribution and once for being the trust owner.

The court did not go for it:

A plain language reading of 26 U.S.C. § 6677 counsels that a trust owner cannot be penalized as a beneficiary for violating a provision of 26 U.S.C. § 6048(b). There is a clear instruction under 26 U.S.C. § 6677(b)(2) to “substitute” 5% for 35%, not to choose between the two or to simply apply a 5% assessment without reference to an otherwise applicable penalty. Therefore, the statute mandates that the 5% replace the 35% whenever there is a “case of a return required under section 6048(b).”

Thus, the taxpayer cannot be penalized twice for failing to file Form 3520. This should come as a relief to those who establish foreign trusts. It can also help with foreign estates. As tax attorneys in Houston, we see a lot of foreign estate penalties given the international population here for the oil and gas industry. The IRS is assessing these penalties for taxpayers in the Houston metro area.

Taxpayers who have been assessed the higher penalty amount as the trust beneficiary rather than the lower penalty amount for trust owners should consult a tax attorney about filing refund claims.

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