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 5% penalty.
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. 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.
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.
Form 3520–A Penalty, On March 30, 2020.
The key to successfully having these penalties abated,
more so today than ever before, is to hire an
Experienced Tax Attorney, to develop the facts and distinguish adverse case law, especially when requesting penalty abatement based upon "Reasonable Cause".
Penalties for Late Filing or Failure to File Form 3520
IRC section 6677 provides for stiff penalties if Form 3520 is not timely filed or is incomplete or incorrect. The initial penalty is the greater of $10,000 or—
- 35% of the gross value of any property transferred to a foreign trust if a U.S. person fails to report the creation of or transfer to a foreign trust;
- 35% of the gross value of the distributions received from a foreign trust by a U.S. person who fails to report receipt of the distribution; and
- 5% of the gross value of all of a foreign trust’s assets treated as owned by a U.S. person under the grantor trust rules (IRC sections 671–679) if the U.S. owner fails to report required information. The owner is also subject to an additional 5% penalty if the foreign trust itself fails to file a timely Form 3520-A [“Annual Information Return of Foreign Trust With a U.S. Owner”; see IRC section 6048(b)], does not provide all required information, or provides incorrect information.
Penalties for Late Filing or Failure to File Form 3520-A
The U.S. owner is subject to an initial penalty equal to the greater of $10,000 or 5% of the gross value of the portion of the trust's assets treated as owned by the U.S. person at the close of that tax year if the foreign trust (a) fails to file a timely Form 3520-A, or (b) does not furnish all of the information required by section 6048(b) or includes incorrect information. Criminal penalties may be imposed under sections 7203, 7206, and 7207 for failure to file on time and for filing a false or fraudulent return.
for a Late Form 3520 or 3520-A?
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Wilson, No. 19-cv-5037 (BMC) (E.D.N.Y. 11/18/19)