The Sec. 6677(a) 35% penalty for the failure by a beneficiary to timely file an information return for a distribution from a foreign trust is not reduced to a 5% penalty when the beneficiary is also the owner of the trust.
In 2003, when Joseph Wilson's wife was planning to divorce him, Wilson established an overseas trust for the sole purpose of putting his assets outside the reach of his wife. Wilson was the sole owner and beneficiary of the trust. He named himself its grantor and funded the trust with approximately $9 million in U.S. Treasury bills, accruing annual interest of 5% or less. In 2007, upon conclusion of the divorce proceedings, Wilson terminated the trust and transferred the assets, which were worth approximately $9.2 million, back to his U.S. bank accounts.
Sec. 6048 imposes disclosure requirements related to foreign trusts. Sec. 6048(b) requires a foreign trust's owner to file a return reporting the trust's activities and operations for the year and any other information specified by the IRS. The trust reports this information on Form 3520-A, Annual Information Return of Foreign Trust With a U.S. Owner. Sec. 6048(c) requires a beneficiary of a foreign trust that receives a distribution from the trust in a year to file a return reporting the distributions received from the trust. A beneficiary reports this information on Form 3520, Annual Return to Report Transactions With Foreign Trusts and Receipt of Certain Foreign Gifts.
To ensure that trusts and their owners and beneficiaries comply with these information reporting requirements, Sec. 6677 provides penalties for the failure to meet them. Under Sec. 6677(a), if a person required to file a return under Sec. 6048 does not file the return on time or files an incomplete return, the person generally is subject to a penalty of 35% of the amount of the reportable distribution. However, Sec. 6677(b) provides that in the case of a return required under Sec. 6048(b), the penalty in Sec. 6677(a) is applied by substituting "5 percent" for "35 percent."
For 2007, Wilson failed to timely file a Form 3520 disclosing the approximately $9.2 million he received from the trust, and the trust failed to timely file a Form 3520-A reporting the information required under Sec. 6048(b). The IRS, applying Sec. 6677(a), assessed a penalty of $3,221,183 (35% of the distribution from the trust) for Wilson's failure to report the distribution to himself.
Wilson initially paid the penalty, but less than two months later, he submitted a claim to the IRS for a full refund. He argued that because he was both the sole beneficiary and the sole owner of the trust, only the 5% penalty under Sec. 6677(b) applied to his failure to timely report the distribution.
While his refund claim was pending, Wilson died. When the IRS denied the refund claim, his estate brought a refund suit in district court. The district court held in favor of Wilson's estate. According to the court, because Wilson, as an owner of the trust, violated Sec. 6048(b) by failing to ensure that the Form 3520-A was timely filed, the Sec. 6677(b) requirement that a 5% penalty replace the 35% penalty applied. Thus, the court concluded that under Sec. 6677 the IRS could assess only the 5% penalty under Sec. 6677, not both or either the 5% and/or 35% penalty, for Wilson's untimely filing of his 2007 Form 3520. The IRS appealed the decision to the Second Circuit.
The Second Circuit's decision
The Second Circuit vacated the district court's judgment and held that when an individual is both the sole owner and beneficiary of a foreign trust and fails to timely report distributions he or she received from the trust, the IRS can impose a 35% penalty under Sec. 6677(a). The court found that the plain language of the statutes allowed the IRS to impose the penalty and that the language of the instructions to Forms 3520 and 3520-A did not change the result.
Plain language of the statutes: The Second Circuit explained that Sec. 6048(c), which requires the reporting of distributions, applies to a "United States person," which, as normally understood, includes both U.S. owners and U.S. beneficiaries of foreign trusts. No exception is made in the statute for a beneficiary who is also an owner, so Wilson was required to report the 2007 distribution under Sec. 6048(c). Sec. 6677(a) imposes a 35% penalty on a failure to file a return as required by Sec. 6048(c). Consequently, the court determined that, under the plain language of the statutes, the IRS properly assessed a 35% penalty against Wilson.
The court noted that the district court had relied on Sec. 6677(b) in its determination that the 35% penalty could not apply to the violation of Sec. 6048(c) in Wilson's case. The district court had concluded that the language of Sec. 6677(b) that substituted a 5% penalty for the 35% penalty for a failure to file a return under Sec. 6048(b) meant that because Wilson had violated Sec. 6048(b) as an owner, the 5% penalty replaced the 35% penalty.
The Second Circuit found that the district court's analysis was flawed because Sec. 6677(b) does not have an effect on the 35% penalty that applies to all the other Sec. 6048 reporting requirements, including the requirement under Sec. 6048(c) for beneficiaries to disclose distributions. The court found that Wilson's estate and the district court had failed to point to any text in the statute that altered the Sec. 6048(c) reporting requirement when the beneficiary is also the owner of a foreign trust or that supported the view that when the owner and beneficiary are one person, a failure to timely report a distribution received violates only Sec. 6048(b) and not Sec. 6048(c).
The district court also had asserted that because Sec. 6677(a) instructs the penalty should not exceed the gross reportable amount, "a taxpayer should not be liable for any two penalties if their combined assessment would add up to more than the gross reportable amount for any one violation." Because, under Sec. 6677(c), the gross reportable amount for an owner's untimely filing under Sec. 6048(b) is the gross value of the portion of the trust's assets at the close of the year, and Wilson (having distributed all the trust assets in 2007) had $0 in trust assets at the end of 2007, the penalty exceeded the gross reportable amount.
However, as the Second Circuit pointed out, the gross reportable amount is different for violations of Sec. 6048(b) and Sec. 6048(c). For violations of Sec. 6048(c), the gross reportable amount is the amount of the distribution that the taxpayer fails to report. Because the IRS was imposing a penalty under Sec. 6048(c) for 2007, and Wilson had taken an unreported distribution of approximately $9.2 million in that year, the gross reportable amount exceeded the penalty imposed by the IRS.
Wilson's estate in addition argued that because the flush language of Sec. 6677(a) states that a person "shall pay a penalty" (emphasis added), the IRS could only assess one penalty under Sec. 6048 for Wilson's violations. The Second Circuit, to the contrary, concluded that, construed in its statutory context, the phrase "a penalty" did not mean that the IRS could only impose one penalty if a taxpayer violates multiple Sec. 6048 filing requirements.
Forms 3520 and 3520-A: The instructions to Part III of Form 3520 state:
If you received an amount from a portion of a foreign trust of which you are treated as the owner and you have correctly reported any information required on Part II [to be completed by the trust owner] and the trust has filed a Form 3520-A with the IRS, do not separately disclose distributions again in Part III.
The district court had found, accepting Wilson's estate's arguments, that based on this language, because a trust owner who received a distribution and reported it on the trust's Form 3520-A is not required to otherwise report the distribution on Form 3520, Form 3520 disregards the beneficiary status of the trust owner in favor of his or her owner status, at least for the limited purpose of tracking distributions to the owner. The Second Circuit, however, concluded that there were two problems with this reasoning.
First, the court stated that Sec. 6048 provides the taxpayer's actual disclosure requirements and does not deal with the form on which the required disclosures must be made. Thus, filing a Form 3520 without providing all the information required by Sec. 6048 is still a violation of the statute. Further, the court determined that the option provided by the instructions to disclose distributions from a trust to an owner does not "favor" owner status. Rather, as the IRS argued, the instructions simply provide, in a case where a foreign trust filed a Form 3520-A reporting all the trust's distributions (which Wilson's trust did not), that the trust owner is not required to fill out Part III of Form 3520 if he or she attaches his or her ownership statement to the return and checks a box in Part II of Form 3520 that indicates a Form 3520-A has been filed by the trust.
Wilson's estate also asserted that Form 3520-A (the annual return for the trust) includes separate subsections to report distributions to owners and beneficiaries, and the instructions for the form indicate that the IRS did not consider a distribution to the trust owner to be reported as a distribution to a trust beneficiary. The Second Circuit disagreed, finding that the form and its instructions carried "no such implications" and that the separate reporting required of owners and beneficiaries did not erase a trust owner's concurrent status as a trust beneficiary for purposes of Sec. 6048(c). According to the court, even if the forms and their instructions caused some ambiguity on the point, the only role that materials outside the text of the statute can properly play is to clear up ambiguity about a statute's meaning, not create ambiguity about its meaning.
Wilson (and now his estate) pays what could arguably be considered an unfairly large penalty for his failure to file the required forms for his foreign trust. However, apparently Congress believed that a large penalty for the failure to report distributions from foreign trusts was the appropriate mechanism to make certain that taxpayers timely and fully comply with this requirement. Because Wilson did not properly follow the information reporting rules for foreign trusts, his scheme to keep his money out of his ex-wife's hands ended up putting a large portion of that money in the IRS's hands.
Wilson, No. 20-603 (2d Cir. 7/28/21)