A recent taxpayer-friendly court decision from New York is worth reviewing for practitioners who handle late-filed Forms 3520, Annual Return to Report Transactions With Foreign Trusts and Receipt of Certain Foreign Gifts, for offshore trusts. The federal district court struck down the IRS's imposition of a 35% civil penalty for failing to timely file a Form 3520 — an information return used to report, among other things, transactions with foreign trusts — and limited the penalty to a much smaller amount, 5%.
Moreover, the court ruled that the penalty must be computed based upon the year-end value of the trust's bank account, which meant that the penalty amount was zero and not $3,221,183, as the IRS asserted. The ruling is a clear taxpayer victory and provides much needed guidance by a federal district court on the application of the civil penalties for unfiled Forms 3520 for foreign trusts.
In Wilson, No. 19-cv-5037 (BMC) (E.D.N.Y. 11/18/19), the U.S. District Court for the Eastern District of New York ruled that the IRS could assess only a 5% penalty (not both a 5% penalty and a 35% penalty) for an individual's untimely filing of a 2007 Form 3520.
The Wilson case sheds light on the highly complex and technical information reporting penalties for unfiled information returns — returns that provide information as opposed to self-assessing a balance due. Wilson illustrates that practitioners should carefully review IRS penalty computations and not merely take them for granted.
Information return penalty cases, and particularly unfiled Form 3520 cases, are relatively new to IRS field agents, even the most seasoned IRS agents, and there are only a handful of reported cases that agents can look to for guidance. An agent working an offshore trust case may not fully understand the workings of two complex Code sections — Secs. 6677 and 6048 — that must be read in conjunction to determine the penalties accurately. When faced with a technically challenging issue, an agent should reach out for technical assistance to, for example, IRS Counsel, for field advice, but this does not always occur. The agent may, in good faith, believe that he or she got it right, assess the penalty, and close the case.
A reasonable cause exception exists for unfiled information returns, such as Form 3520 or even a Form 5471, Information Return of U.S. Persons With Respect to Certain Foreign Corporations, and this may be a valid defense in most situations. Under Sec. 6677(d), no penalty is imposed "on any failure which is shown to be due to reasonable cause and not due to willful neglect."
However, as taxpayers face more and more steep information return penalties, it is prudent to do more than assert that reasonable cause exists for the untimely filed form to mount a strong defense. Practitioners must understand how the IRS computed the penalty, and as in the Wilson case, determine whether the IRS got it right. This could be a golden nugget in the hands of a taxpayer that significantly reduces the penalty amount and provides needed financial relief.
Facts of the case
Joseph Wilson established an overseas trust in 2003, naming himself the grantor of the trust and its sole owner and beneficiary. The trust's purpose was to place assets beyond the reach of his then-wife, who, he had reason to believe, was preparing to file for a divorce. Wilson funded the trust with approximately $9 million in U.S. Treasury bills.
In 2007, upon the conclusion of the divorce proceedings, Wilson terminated the trust and transferred the assets back to his bank accounts in the United States.
Wilson was late in filing his Form 3520 for the calendar year 2007. Form 3520 is an annual report disclosing distributions from a foreign trust, with different requirements for trust grantors/owners and trust beneficiaries. After Wilson filed his 2007 Form 3520, the IRS assessed a late penalty of $3,221,183, representing 35% of the distributions from the trust during the 2007 calendar year.
Wilson paid the penalty and filed a claim for refund with the IRS. Wilson died while waiting for the refund claim to be resolved, and his estate filed a complaint with the federal district court seeking a refund. Wilson's estate asserted that only a 5% penalty under Sec. 6048(b) applied to Wilson's late filing of the Form 3520 for the calendar year 2007.
The government contended that the 35% penalty and the 5% penalty are separate penalties and could be applied independently against Wilson for untimely filing Form 3520. The court rejected the government's position and ruled in the taxpayer's favor.
There was no doubt that Wilson was liable for the 5% penalty under Sec. 6048(b) because he was the owner of the foreign trust. But Wilson was also a beneficiary of the foreign trust (the only beneficiary). So, the issue was whether he could be independently penalized under Sec. 6048(c) as a beneficiary for untimely filing Form 3520, as the government asserted. The court disagreed.
The court held that "[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)." The statute mandated substituting 5% for 35%, whenever a trust owner is required to file a Form 3520.
Moreover, the court ruled that the government's position, if accepted, would result in "irreconcilable textual conflict" because Sec. 6677(a) provides that any penalty shall not exceed the "gross reportable amount." The court clarified that "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."
For a U.S. owner of a foreign trust, the gross reportable amount is the value of the portion of the trust's assets at the close of the year (Sec. 6677(c)(2)). Since Wilson had withdrawn the trust's assets before the year end, the gross reportable amount was zero. Therefore, any additional penalty above zero would violate the statute. Since the government sought a $3,221,183 penalty, this violated the statute.
Consequently, the court concluded that the "IRS could, therefore, assess only the 5% penalty under 26 U.S.C. § 6677 — not both or either the 5% and/or 35% penalty — for Wilson's untimely filing of his 2007 Form 3520."
Finally, the court ruled that the 5% penalty should be based on the amount of the trust's account balance, if any, at the close of 2007, under Sec. 6677(c)(2). Given that Wilson had withdrawn the trust assets before the end of the year, this presumably made the penalty amount zero.
A few lessons from the Wilson case:
- Identify the trust owner and beneficiary. Key to the Wilson case was the fact that the taxpayer was both the owner of the foreign trust and the sole beneficiary. Determine the trust owner and the beneficiary(ies). If the taxpayer is both the grantor/owner of the trust and a beneficiary, the IRS cannot assess the more substantial 35% penalty and is limited to the 5% penalty under Sec. 6677. Take the time to read and review Secs. 6671 and 6048 to fully understand how the two sections operate in conjunction with one another.
- Does the case involve an asset protection trust? Look to see if the case involves an asset protection trust, which the taxpayer established in a foreign jurisdiction to guard against creditors. If so, the facts of the case may be like Wilson, and the penalty limited to 5%. Obtain a copy of the trust document and review it.
- Check penalty computation. Confirm that the IRS correctly computed the civil penalty based on the account balance at the close of the year. If the taxpayer terminated the trust and transferred the assets back to his bank accounts in the United States before the end of the year, the penalty would be zero. This presumably was the result in the Wilson case. The IRS field agent probably reviewed the taxpayer's bank statements to compute the penalty amount. So, taxpayers should carefully review the IRS penalty statements and determine how the IRS calculated the penalty.
- File a FOIA request. If it is difficult to ascertain how the IRS computed the penalty based on the IRS penalty notice, file a Freedom of Information Act request to obtain a copy of the administrative file. This file presumably should contain the agent's working papers, which show how the agent computed the penalty during the field audit.
Procedural options to fix the case
The best course of action is to file a written protest with the IRS Appeals office. A taxpayer is given a right to appeal an IRS Notice CP15, Notice of Penalty Charge, and the appeal must be filed within 30 days. Details on filing an appeal are found on the back of the notice.
If the appeal period, which is very short, has expired, a taxpayer may still have options to handle the civil penalty. For example:
- CDP hearing. File a request for a Collection Due Process hearing in response to an IRS notice of intent to levy (Sec. 6330(a)). This is essentially a pre-levy administrative hearing where a taxpayer has a right to a fair hearing with an impartial hearing officer (Sec. 6330(b)). A taxpayer may petition the Tax Court for review of the determination (the Tax Court has jurisdiction on those matters) (Sec. 6330(d)). The ability to have a judicial review of the IRS's determination is an added level of comfort.
- Offer in compromise. File an offer in compromise based upon doubt as to liability and assert that the IRS incorrectly calculated the penalty (Sec. 7122).
- Audit reconsideration. File a request for an audit reconsideration. See IRS Publication 3598, What You Should Know About the Audit Reconsideration Process (Rev. 2-2015), for details.
Civil penalties for late-filed Forms 3520 is an evolving area of the law and taxpayers should be prepared that the agent assigned to the case may not be thoroughly familiar with the intricacies of the Code, especially since there are few published cases. The tax professional should be ready to answer the agent's questions on the law and the facts (particularly, the mechanics of the foreign trust). The IRS's mission is to apply the tax law with integrity and fairness to all. In complex cases, the best results are often reached when both sides work together collaboratively.
A taxpayer who has received an IRS Notice CP 15 for an unfiled Form 3520 involving a foreign trust would be wise to contact a competent tax counsel, who can review the facts of the case, explain the options, and formulate a defensible position.
— Steven L. Walker, J.D., LL.M., is a tax attorney with the Law Offices of Steven L. Walker PLC in San José, Calif., who specializes in civil and criminal tax controversy involving both federal and state tax agencies, as well as estate and business planning. He is also an Adjunct Professor of Law at the University of San Francisco School of Law (LLM Taxation) program. For more information, see www.walk-law.com. To comment on this article or to suggest an idea for another article, please contact Sally Schreiber, senior editor, at Sally.Schreiber@aicpa-cima.com.