Mind your foreign trust – the IRS is getting aggressive in asserting draconian penalties

February 2020  |  SPOTLIGHT  |  CORPORATE TAX

Financier Worldwide Magazine

February 2020 Issue

Many individuals who are US persons – residents or citizens – continue to have foreign financial connections, including foreign trusts. What many of these people forget, including their accountants, is that the Internal Revenue Service (IRS) requires special forms to be filed in a timely way to report various trust activities. Those forms are the 3520-A and 3520.

Following on the heels of the IRS’s success in pursuing civil penalties resulting from both wilful and non-wilful failures of US persons to timely disclose foreign financial accounts, the IRS has recently 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. While rougher treatment by the IRS may lie ahead for delinquent Form 3520-A and Form 3520 filers, at least one court has now provided some measure of relief.

Form 3520-A is the annual information return of a foreign trust with at least one US owner. This form provides information about the foreign trust, its US beneficiaries and any US person who is treated as an owner of any portion of the foreign trust under the grantor trust rules – Internal Revenue Code (IRC) sections 671 through 679. 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.

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: (i) a formal voluntary disclosure; (ii) streamlined procedures for non-wilful violations; and (iii) delinquent submission procedures. Taxpayers who do not need to use either the formal disclosure programme 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 international disclosure forms including Forms 3520-A and 3520, should consider filing the delinquent forms according to the instructions, along with a statement of all facts establishing reasonable cause for the failure to file.

For taxpayers with reasonable cause who do not need to use the other filing procedures, the Delinquent International Information Return Submission Procedures (DISP) is arguably intended to allow the taxpayer to achieve compliance without the automatic assessment of severe penalties. However, recent experience has shown that there is a systemic problem within the IRS in following this procedure when it comes to Form 3520-A and 3520 penalties. The issue seems to be that the reasonable cause statements being submitted as part of the DISP are not being considered by agents and penalties are being automatically assessed. 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, if not the letter, of the DISP.

The district court in Wilson to the rescue

In Wilson v. United States, the IRS’s aggressive assertion of penalties was met with rejection when the US District Court for the Eastern District of New York held that the IRS went too far in imposing a 35 percent penalty, rather than a 5 percent penalty, for the delinquent filing of a Form 3520. IRC section 6048 requires a US person who is the owner of a foreign trust to report the activities and operations of the trust for the taxable year and a US 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 IRC section 6677, a US beneficiary who fails to timely file Form 3520 can be assessed a penalty equal to 35 percent of the amount distributed during the year and a US owner of a foreign trust who fails to timely file can be assessed a penalty equal to 5 percent of the total assets in the trust at the end of the taxable year.

Wilson involved a taxpayer who set up a foreign trust in 2003 and funded it with $9m in US Treasury bills. Each year Mr Wilson reported the trust assets and related income on his US tax returns. In 2007, he terminated the trust and transferred all the assets to his accounts in the US. The total transferred was $9.203m. The IRS assessed a penalty equal to 35 percent of the amount transferred, or $3,221,183, against him for late filing of a Form 3520. After paying the penalty, Mr Wilson filed a claim for a refund and when the IRS failed to grant his claim, he sued the US in district court asserting that as the trust’s owner he was only liable for the 5 percent penalty for late filing and for judgment on the pleadings. The court agreed and granted Wilson’s motion for partial summary judgment.

According to the Court, the material facts were undisputed: Mr Wilson was the sole owner and sole beneficiary of the trust, during 2007, he transferred all the trust’s assets, $9.203m, to his US bank accounts and he filed Form 3520 late. That left the court to only decide the legal issue raised by the IRS’s pursuit of the 35 percent penalty. The court turned to IRC section 6677 which is clear on its face that where a person is both the owner and beneficiary of a foreign trust, he is only required to file one Form 3520 and the appropriate penalty for a delinquent filing of such a form is thereafter controlled by not subsection (a) but rather subsection (b) of that statute. Subsection (a) imposes a penalty of up to 35 percent of the amount distributed on a beneficiary who fails to timely report the distribution. Subsection (b), however, provides that in the case of the owner of a foreign trust, 5 percent is substituted for 35 percent. The court reasoned that the statutory language mandated that where a person is a trust owner, only a 5 percent penalty can be imposed. The court rejected the government’s argument that both a 5 percent and a 35 percent penalty can be applied to a person who is both an owner and a beneficiary.

The court further noted that under section 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. The penalty assessed by the IRS – $3.221m – clearly exceeded the amount that could be lawfully assessed.

The court granted Wilson’s motion to find that as owner of the trust he is liable for a 5 percent penalty on the amount of the trust’s assets at the close of 2007 – zero.

The Wilson decision is a good reminder of how aggressive the IRS has become in asserting foreign trust penalties and how judicial intervention may be necessary when the IRS goes too far.

Steven Toscher and Sandra Brown are principals at Hochman Salkin Toscher Perez P.C. Mr Toscher can be contacted on +1 (310) 281 3200 or by email: toscher@taxlitigator.com. Ms Brown can be contacted on +1 (310) 281 3200 or by email: brown@taxlitigator.com.

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Steven Toscher and Sandra Brown

Hochman Salkin Toscher Perez P.C.

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