The IRS shifted its focus to international issues about ten years ago. This included having the penalty group within the IRS’s Small Business/Self-Employed division focus on international reporting penalties. This is in addition to the Treasury’s FBAR filing requirements.
The SB/SE division’s focus on penalties started with a few penalty notices. The number of these penalty notices have increased over the years. At first, it was penalty notices for not filing Forms 5471s or 8856s. The penalty notices have shifted to Forms 3520 in the past few years.
These foreign compliance initiatives have generated quite a bit of controversy. This is now the leading international tax dispute issue. This is due to the penalty statutes not being all that clear and the amount of the penalties being so large. The Wilson v. United States, Docket No. 20-603 (2nd Cir. 2021) case addresses a question about the wording for the penalty statute that applies to the failure to file Form 3520. We addressed the trial court’s opinion in this case previously.
Facts & Procedural History
The taxpayer was the estate for an individual who had died. The individual taxpayer was either a U.S. citizen or a resident.
The individual taxpayer had established a foreign trust during his lifetime. He apparently did so to hide assets from his wife in advance of a divorce.
The foreign trust was funded with $9 million in 2003. The individual taxpayer distributed the $9 million to himself in 2007.
The foreign trust did not file Form 3520-A, Annual Information Return of Foreign Trust With a U.S. Owner. The individual taxpayer did not file a Form 3520, Annual Return To Report Transactions With Foreign Trusts and Receipt of Certain Foreign Gifts, for the trust distribution.
The IRS assessed a late penalty of $3,221,183, 35% of the $9 million distribution. The individual taxpayer paid the penalty and filed a refund claim to recover the penalty. Then he died. His estate took up the fight with the IRS over the penalty.
Foreign Trust Reporting by U.S. Persons
U.S. citizens and residents have to report ownership and certain transactions with foreign entities. This includes the ownership and certain transactions with foreign trusts (and no, it isn’t always easy to tell whether a foreign entity is a foreign trust includes).
This reporting requirement for foreign trusts is found in Section 6048. It requires taxpayers to report ownership of foreign trusts and distributions from foreign trusts.
Failure to satisfy this reporting requirement can trigger stiff penalties. These penalties are set out in Section 6677.
Section 6677 imposes a minimum $10,000 penalty and a maximum five percent penalty for failing to report the ownership of a foreign trust. Section 6677 imposes a minimum penalty of $10,000 and a maximum penalty of thirty-five percent penalty for failing to report a distribution from a foreign trust.
The five and thirty-five percent amounts are applied to the reportable amount, being either the value of the trust or the amount of the distribution. This is why these penalties can be quite sizeable, as in this case. The penalty was over $3 million dollars.
The question before the court was whether the taxpayer was subject to the five or thirty-five percent penalty. The district court had sided with the estate that the IRS could only impose the five percent penalty.
The Higher 35 Percent Penalty
The appeals court concluded that the IRS could in fact impose the thirty-five percent penalty. The district court reasoned that the Code imposed the lower five percent penalty on owners who fail to report the ownership of foreign trusts. The Code does say that the penalty is thirty-five percent but then says that the thirty-five percent is five percent for trust owners.
The appeals court did not read the Code as the district court did. It concluded that the Code does not limit the IRS’s ability to impose the higher penalty or even both penalties in cases like this. The result is that the IRS is free to impose the higher penalty and both penalties in cases where an owner of a foreign trust fails to report the ownership of the trust and distributions from the trust.
U.S. persons who have an interest in a foreign trust have to take care to comply with the foreign reporting requirements. This includes ownership and distributions from the trust. Failing to comply with the reporting requirements can trigger stiff penalties.
Luckily, Section 6677 includes a reasonable cause exception. It allows taxpayers to avoid the imposition of either the five or thirty-five percent penalty. Given the size of the penalties, special care should be taken to document and establish the facts needed to show reasonable cause. This can help avoid having to wait out the IRS’s ability to collect from a deceased taxpayer’s estate, as in this case.