The IRS Has Become More Aggressive in Assessing Form 3520 and Form 3520-A Foreign Information Reporting Penalties, but the Courts Don’t Always Approve. By: MICHEL STEIN and ROBERT S. HORWITZ
The IRS recently has become more aggressive in assessing foreign information reporting penalties against taxpayers who fail to file required forms for foreign trusts or who file them late. For years, we have been writing about the IRS’ enforcement efforts with respect to offshore accounts and assets. With what has generally been perceived as successfully run programs, tens of thousands of taxpayers have participated in various announced Offshore Voluntary Disclosure Programs (“OVDP”) over the past decade. With the closure of OVDP in September 2018, taxpayers’ compliance options have now focused on the remaining filing options available for the non-compliant taxpayer. While rougher treatment by the IRS may lie ahead for the delinquent Form 3520-A and Form 3520 filers, at least one court has just provided relief.
Delinquent Filing Options.
Taxpayers who are not in compliance with their reporting and filing options regarding undeclared interests in foreign financial accounts, foreign trusts and other assets should consider various options to come into compliance, including:
(a) Formal Voluntary Disclosure: On November 28, 2018, the IRS released a memorandum addressing the process for all Voluntary Disclosure (domestic and foreign) following the closing of the 2014 OVDP. For all Voluntary Disclosures received after that date, the Service will examine a six-year disclosure period. Examiners will determine applicable taxes, interest and penalties, including a fraud penalty (75%) for the highest year and a willful FBAR penalty (up to 50%) will be asserted. Penalties for failure to file information returns, including Forms 3520-A and 3520 could also be imposed. Under the voluntary disclosure practice, taxpayers are required to promptly and fully cooperate during civil examinations. Formal Voluntary Disclosures are designed for taxpayers with exposure to potential criminal liability or substantial civil penalties due to a willful failure to report foreign financial assets and pay all tax due in respect of those assets. They provide taxpayers with such exposure potential protection from criminal liability and terms for resolving their civil tax and penalty obligations.
(b) Streamlined Procedures for Non-Willful Violations. In addition to the Formal Voluntary Disclosure, the IRS maintains other more streamlined procedures designed to encourage non-willful taxpayers to come into compliance. Taxpayers using either the Streamlined Foreign Offshore Procedures (for those who satisfy the applicable non-residency requirement) or the Streamlined Domestic Offshore Procedures are required to certify that their failure to report all income, pay all tax, and submit all required information returns, including FBARs, was due to “non-willful” conduct. For these Streamlined Procedures, “non-willful conduct” has been specifically defined 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.”
(c) Delinquent Submission Procedures. Taxpayers who do not need to use either the formal disclosure program or the Streamlined Filing Compliance Procedures to file delinquent or amended tax returns to report and pay additional tax, but who have reasonable cause for not filing a required FBAR or other international disclosure forms including Forms 3520-A and 3520, should considering filing the delinquent FBARs or other delinquent forms according to the instructions, along with a statement of all facts establishing reasonable cause for the failure to file. FBARs or delinquent information returns will not be automatically subject to audit but may be selected for audit through the existing IRS audit selection processes that are in place for any tax or information returns.
The Delinquent Form 3520-A and Form 3520 Quagmire.
Stiff penalties are being automatically applied to those who failed to timely file required Forms 3520-A and 3520, and the delinquent submission procedures, even for the appropriate taxpayer with reasonable cause, are not providing relief.
A Form 3520-A is the annual information return of a foreign trust with at least one U.S. owner. The form provides information about the foreign trust, its U.S. beneficiaries, and any U.S. person who is treated as an owner of any portion of the foreign trust under the grantor trust rules (IRC sections 671 through 679. A Form 3520 is used to report certain transactions with foreign trusts, ownership of foreign trusts, or the receipt of certain large gifts or bequests from certain foreign persons. A separate Form 3520 must be filed for transactions with each foreign trust.
For the taxpayer with reasonable cause and who do not need to use the other filing procedures, the Delinquent International Information Return Filing Procedures (DIF) should allow the taxpayer to get compliant without the automatic assessment of very severe penalties However, our experience has been is that there is a systemic problem with this procedure when it comes to Forms 3520-A and 3520 penalties. The issue seems to be that the reasonable cause statements being submitted as part of the DFP are not being considered (by agents) and the penalties are being automatically assessed. Most practitioners’ perception and expectation of the DFP is that the reasonable cause statement would be reviewed and considered by qualified IRS personnel and if it was not accepted, there would be some communication and dialogue between the Service and the taxpayer before assessment. That is simply not happening by and large.
The automatic assessment of penalties without an opportunity to have the matter previously reviewed and addressed by IRS personnel appears to go against the spirit of the DFP. The IRS website on DFP states:
“Information returns filed with amended returns will not be automatically subject to audit but may be selected for audit through the existing audit selection processes that are in place for any tax or information returns”.
The posted FAQ #1 on DFP states in part:
“Taxpayers who have unreported income or unpaid tax are not precluded from filing delinquent international information returns. Unlike the procedures described in OVDP FAQ 18, penalties may be imposed under the Delinquent International Information Return Submission Procedures if the Service does not accept the explanation of reasonable cause. The longstanding authorities regarding what constitutes reasonable cause continue to apply, and existing procedures concerning establishing reasonable cause, including requirements to provide a statement of facts made under the penalties of perjury, continue to apply. See, for example, Treas. Reg. § 1.6038-2(k)(3), Treas. Reg. § 1.6038A-4(b), and Treas. Reg. § 301.6679-1(a)(3).”
The effect is that taxpayers who file delinquent Forms 3520-A and 3520 face assessed penalties without any benefits offered by the DFP and are required to endure protracted administrative review for something the procedure was intended to avoid Moreover, counsel are being left in the odd position of explaining what if any benefits are gained from filing delinquent returns at all and becoming compliant for past periods. That is certainly against the compliance the IRS would want to encourage. We are hopeful that the IRS is working on a fix to this quagmire.
The District Court in Wilson to the Rescue
In Wilson v. United States, (E.D.N.Y. 11/17/19), however, the IRS’s aggressiveness met with rejection when the district court held that the IRS went too far in imposing a 35% penalty for filing a Form 3520 late. Sec. 6048 requires a U.S. person who is the owner of a foreign trust to report the activities and operations of the trust for the taxable year and a U.S. beneficiary of a foreign trust who received a distribution during the taxable year to report the distribution. Form 3520 is filed by both owners and beneficiaries. Under sec. 6677, a U.S. beneficiary who fails to timely file Form 3520 can be assessed a penalty equal to 35% of the amount distributed during the year and a U.S. owner of a foreign trust who fails to timely file can be assessed a penalty equal to 5% of the total assets in the trust at the end of the taxable year.
Joseph Wilson set up a foreign trust in 2003 and funded it with $9 million in U.S. Treasury bills. Each year he would report the trust assets and income on his income tax return. In 2007 he terminated the trust and transferred all the assets to his accounts in the United States. The total transferred was $9.203 million. The IRS assessed a penalty equal to 35% of the amount transferred, or $3,221,183, against him for late filing. He paid the amount with interest and filed a refund claim. When the IRS failed to act on the claim within 6 months, he filed a refund suit with the Court of Federal Claims (CFC). The CFC dismissed without prejudice because the refund claim was not properly executed.
Before the CFC dismissed the case, Wilson filed an amended refund claim asserting that there was reasonable cause for the late filing and as sole owner of the trust he only liable for a 5% penalty. When the IRS failed to act on his refund claim, he sued in district court. The IRS moved to dismiss Wilson’s cause of action that he was liable only for a 5% penalty on the ground that the refund claim lacked sufficient information to apprise the IRS of the exact basis for the claim. Wilson moved for partial summary judgment on the ground that as the trust’s owner he was only liable for the 5% penalty for late filing and for judgment on the pleadings.
The Court denied the Government’s motion, holding that the refund claim, which stated that as owner Wilson was only liable for a 5% penalty not a 35% penalty, had sufficient information to alert the IRS to Wilson’s claim and to compute the correct penalty.
The Court granted Wilson’s motion for partial summary judgment. According to the Court, the only material facts were undisputed: that Wilson was the sole owner and sole beneficiary of the trust; that during 2007 he transferred all the trust’s assets, $9.203 million, to his U.S. bank accounts; and that he filed Form 3520 late. Partial summary judgment was thus appropriate.
The Court turned to the language of sec. 6677. Where a person is both the owner and beneficiary of a foreign trust, he is only required to file one Form 3520. Subsection (a) imposes a penalty of up to 35% of the amount distributed on a beneficiary who fails to timely report the distribution. Subsection (b) provides that in the case of the owner of a foreign trust, 5% is substituted for 35%. The Court reasoned that the statutory language mandated that where a person is a trust owner, only a 5% penalty can be imposed. The Court rejected the Government’s argument that both a 5% and a 35% penalty can be applied to a person who is both an owner and a beneficiary.
The Court further noted that under Sec. 6677(a)(1), the penalties assessed may not exceed “the gross reportable amount.” For a trust owner, the gross reportable amount is the trust assets at the end of the year, which in Wilson’s case was zero. Since the penalty assessed by the IRS, $3.221 million, it exceeded the amount that could be assessed.
The Court also granted Wilson’s motion to find that as owner of the trust he is liable for a 5% penalty on the amount of the trust’s assets at the close of 2007. It denied, however, Wilson’s motion for judgment on the pleadings, since the Government had not filed an answer. What remains to be done, since the Court found that the maximum penalty that can be imposed is zero? Wilson will have to move for summary judgment or, after the Government files its answer, judgment on the pleadings.
The Wilson decision is a reminder that sometimes the IRS goes too far in asserting penalties.
MICHEL R. STEIN – For more information please contact Michel Stein – Stein@taxlitigator.com Mr. Stein is a principal at Hochman Salkin Toscher Perez, P.C. and represents clients throughout the United States and elsewhere involving federal and state, civil and criminal tax controversies and tax litigation. Mr. Stein has significant experience in matters involving previously undeclared interests in foreign financial accounts and assets, the IRS Offshore Voluntary Compliance Program (OVDP) and the IRS Streamlined Filing Compliance Procedures.
ROBERT S. HORWITZ – For more information please contact Robert S. Horwitz at firstname.lastname@example.org. Mr. Horwitz is a principal at Hochman Salkin Toscher Perez P.C., former Chair of the Taxation Section, California Lawyers’ Association, a Fellow of the American College of Tax Counsel, a former Assistant United States Attorney and a former Trial Attorney, United States Department of Justice Tax Division. He represents clients throughout the United States and elsewhere involving federal and state administrative civil tax disputes and tax litigation as well as defending criminal tax investigations and prosecutions.