Are You an Owner or Beneficiary of a Foreign Trust or Receive a Foreign Gift or Bequest?

The Government is pressing taxpayers with large civil penalties for late-filed Forms 3520.  The IRS may assert the penalty in the context of a foreign trust or if you are a U.S. person who received foreign gifts of money or other property.  This is an evolving and complex area of the law, and there is a recent, taxpayer-friendly case from New York that is worth reading.

The Wilson Case

In Wilson v. United States, 2019 US Dist. LEXIS 199902 (ED NY. Nov. 18, 2019), the United States District Court for the Eastern District of New York ruled that the IRS could only assess a 5% penalty (not both a 5% penalty and a 35% penalty) for an individual’s untimely fling of a 2007 Form 3520.

Joseph Wilson established an overseas trust in 2003.  Wilson named himself the grantor of the trust and was 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 a divorce action against him.  Wilson funded the trust with approximately $9 million in US 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.  The IRS assessed a large civil penalty for the late-filed form.

The federal district court struck down the IRS 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 asserted by the IRS.  The ruling is a clear taxpayer victory and provides well-needed guidance by a federal district court on the application of the civil penalties to unfiled Form 3520s for foreign trusts.

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 at face value.

Reasonable Cause Exception

A reasonable cause exception exits for unfiled information returns, such as Form 3520 or even a Form 5417, and this may be a valid defense in most situations.  26 U.S.C. § 6677(d) (no penalty shall be imposed “on any failure which is shown to be due to reasonable cause and not due to willful neglect.”)  However, it is prudent to do more than assert that reasonable cause exists for the untimely filed form to mount a strong defense.  Fully understand how the IRS computed the penalty, and determine whether the IRS got it right.

Taxpayer’s Options to Resolve a Penalty Case

IRS civil penalties for late-filed Form 3520 are known as “assessable penalties”, which means that the penalty is assessed at the audit level. Once the IRS assesses the penalty and send a notice to the taxpayer, the taxpayer is liable for the penalty.  This is different than an income tax audit, where the taxpayer has a right to administrative appeal and can even file a petition in Tax Court to context the IRS’ proposed determination, before it goes final.  Despite the fact that Form 3520 penalties are assessable penalties, a taxpayer has procedural options to fix the case, as detailed below:

Option #1: Written Protest with the Appeals Office of the IRS – The best course of action is to prepare and file a written protest with the IRS Office of Appeals.  A taxpayer is given a right to appeal an IRS Notice CP 15, and the appeal period is 30 days.  Details on filing an appeal are found on the backside of the Notice CP 15.  A critical aspect of the written appeal is showing that the taxpayer’s failure to timely file the form is due to reasonable cause and not due to wilfull neglect.  This requires a careful review of the relevant case law and a thorough understanding of the facts of the case.  For further information, see Publication 5 (Rev. 11-2019).  This publication tells you how to appeal your tax case, if you don’t agree with the IRS Findings.

Option #2: Collection Due Process Hearing  – File a request for a Collection Due Process Hearing in response to an IRS notice of intent to levy.  26 U.S.C. 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.  26 U.S.C. 6330(b).  The taxpayer may be able to raise the Form 3520 penalty at the hearing and seek relief.  If things do not work out at the hearing, a taxpayer may petition the Tax Court for review of the determination (the Tax Court has jurisdiction with respect to such matter).  26 U.S.C. 6330(d).  The ability to have a judicial review of the IRS’ determination is an added level of comfort with the Collection Due Process Hearing process.

Option #3: Offer in Compromise – File an offer in compromise based upon doubt as to liability and assert that the IRS incorrectly calculated the penalty.  26 U.S.C. § 7122.

Option #4: Audit Reconsideration – File a request for an audit reconsideration. See IRS Publication 3598 (Rev. 2-2015) for details.

Deciding which option is best for a case often depends on the facts of the case.  Not all options may work for a particular case, and individuals should consult with tax counsel.

Foreign Gifts and IRS Streamlined Filing Compliance Procedures

If you are a U.S. person who received foreign gifts of money or other property, you may be required to report the foreign gift or bequest on a Form 3520. Gifts or bequests valued at more than $100,000 from a nonresident alien individual or foreign estate must be reported. There is a procedure in place for handling delinquent Forms 3520, and it called the IRS Streamlined Filing Compliance Procedures.  It is not recommended to file delinquent forms outside the program because there is a risk of triggering civil penalties. Taxpayers should work with tax counsel, if they are interested in participating in the IRS Program. DIY is not advised.

Assistance of Tax Attorney

Civil penalties for late-filed Forms 3520s 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 Internal Revenue Code and the developing case law.  This is especially true since there few published cases.  The tax professional should be ready to answer the agent’s questions on the law and the facts of the case.  The IRS 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.

Taxpayers who have received an IRS Notice CP 15, Notice of Penalty Charge, for a late-filed Form 3520, would be wise to contact tax counsel, who can review the facts of their case, explain the options, and formulate a defensible position.