Court Agrees on IRS Assessment of Double Penalties for the Failure To Report the Ownership and Distributions from a Foreign Trust

September 09, 2021

By Brent Lipschultz and Ragini Subramanian

On July 28, 2021, the U.S. Court of Appeals for the 2nd Circuit, vacating and remanding a district court decision, ruled in favor of the IRS that the foreign trust owner/beneficiary is liable for a 35% penalty for the failure to report trust distributions and that the penalty is not limited to 5% for failure to report foreign trust ownership. That was a whopping 35% on a $9.2 million distribution from the trust, in addition to 5% on the gross value of the trust at the end of the relevant tax year.

What does this mean for U.S. owners and beneficiaries of foreign trusts?

The Facts

Joseph Wilson was the sole owner and beneficiary of a foreign trust which was established by him in 2003 with an approximate value of $9 million with principal that was previously taxed in the U.S. The sole purpose of the trust was to “place assets beyond the reach of his then-wife, who was contemplating a divorce action.” From 2003-2007, Wilson timely filed all the required information returns related to this foreign trust. In 2007, upon conclusion of the divorce proceedings, Wilson terminated the trust and transferred the assets – then at $9,203,381– back to his U.S. bank accounts. At the end of 2007, the value of the trust was $0. Wilson filed Form 3520 and Form 3520-A for tax year 2007, BUT LATE! The IRS assessed a late penalty of $3,221,183 ($9,203,381 x 35%). Wilson paid this amount and two months later submitted a Claim for Refund to the IRS for 30% of the penalty. Wilson filed a complaint in the U.S. Court of Federal Claims. The Court of Federal Claims dismissed the case for “lack of jurisdiction” without prejudice and asked Wilson to re-file a claim for refund, wait for six months and then file a new complaint if the claim was rejected. Immediately Wilson filed an Amended Claim for Refund. Wilson died while the Amended Claim for Refund was pending. The executor of Wilson’s estate filed a complaint with the United States District Court Eastern District of New York, claiming that Wilson’s estate is entitled to the refund on two grounds:

  1. That “reasonable cause” existed in Wilson’s untimely filing of Form 3520, and
  2. That Wilson as the owner of the foreign trust is responsible for untimely filing of Form 3520-A which is subject only to 5% penalty under IRC Sec. 6048(b). The IRS’s position that the beneficiary of the trust was subject to 35% penalty, under IRC Sec. 6048(a), on the amount of trust distribution on untimely filed Form 3520, is erroneous.

Wilson originally argued that the 5% penalty should apply to the 2007 “trust distribution” ($9,203,381) but later changed his position that the penalty is 0 or 5% of the “trust assets” at the close of 2007. The IRS moved to dismiss the second ground for the refund and objected to Wilson’s change of stance on the amount on which the 5% penalty should be assessed. The District Court agreed with Wilson – “The IRS can assess only the 5% penalty on the amount of the trust’s account balance, if any, at the close of 2007.” A BIG DISTRICT COURT WIN BY WILSON!

The IRS appealed, arguing that the district court erred in its construction of the Internal Revenue Code. The U.S. Appeals Court agreed and held that the 5% penalty does not supplant the 35% penalty. “A penalty” does not mean the government may impose only a single penalty even if the taxpayer violates multiple filing requirements under relevant IRC sections.

The Applicable Tax Law in the Year at Issue in Wilson’s Case

The year at issue in Wilson is 2007, when foreign trust and it is U.S. owner’s information reporting requirement were governed by IRC Secs. 6048(b) and 6048(c), and the governing penalty sections were IRC Secs. 6677(b) and 6677(a) as follows (“the Applicable Code Sections”).

  U.S. Owner of a Foreign Trust  U.S. Beneficiary of a Foreign Trust
Reporting requirement

IRC Sec. 6048(b):

File annual return using Form 3520-A

IRC Sec. 6048(a) and (c):
File Form 3520 in the year distribution received from the foreign trust or transactions with the foreign trust
Applicable penalty for failure to comply with the reporting requirement IRC Sec. 6677(a):
Failure to timely file penalty – 5% of the gross value of the trust asset that the U.S. owner is considered owner of, at the end of the tax year.
IRC Sec. 6677(b):
Penalty for failure to timely file Form 3520 and report as stated above - 35% of the amount of the distribution.

The Analysis

The District Court concluded that when a U.S. person is both an owner and the beneficiary of a foreign trust, that owner’s failure to timely report a distribution violates only the owner’s obligation under IRC Sec. 6048(b) and subject only to the 5% penalty (essentially eliminating or supplanting the 35% penalty). Secondly, the district court asserted that under the applicable code sections, a penalty should not exceed the “gross reportable amount” and “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.” Because the value of the trust asset at the end of 2007 (after distributions) was $0, the penalty of $3,221,183 was more than the “gross reportable amount” ($0).

The appeals court on the other hand concluded that the plain language of the reporting and penalty provisions of the applicable code sections represent two distinct obligations of a U.S. person when that person is both an owner and a beneficiary of a foreign trust. Accordingly, no part of IRC Secs. 6048 or 6677 diminishes or eliminates the applicability of 35% penalty where the U.S. beneficiary fails to report foreign trust distributions.

Essentially, according to the Appeals Court, a U.S. person, who owns a foreign trust and who is also the beneficiary of the same trust, must comply with the two distinct reporting sections or face the consequences.

Conclusion

In 2010, Congress amended IRC Sec. 6048(b) to provide that the U.S. owner of a foreign trust is also required to provide any information required by the IRS. A minimum $10,000 penalty was added to IRC Sec. 6677 for failure to report the foreign trust’s ownership, or transfers to, or distributions from the trust. With the 2010 amendments to the IRC and the Appeals court decision, the current U.S. owners and/or beneficiaries are subject to both 5% penalty and 35% penalty for failure to timely report as shown in the table below.

 
  U.S. Owner of a Foreign Trust U.S. Beneficiary of a Foreign Trust
Reporting requirement

IRC Sec. 6048(b):

File annual return using Form 3520-A and provide information as required by the IRS

IRC Secs. 6048(a) and (c):

File Form 3520 in the year distribution received from the foreign trust or transactions with the foreign trust

Applicable penalty for failure to comply with the reporting requirement

IRC Sec. 6677(a):
Failure to timely file penalty – 5% of the gross value of the trust asset that the U.S. owner is considered owner of, at the end of the tax year (with a minimum penalty of $10,000)

IRC Sec. 6677(b):
Penalty for failure to timely file Form 3520 and report as stated above - 35% of the amount of the distribution.

With so much at risk, it is ever more important that the U.S. owners or beneficiaries of foreign trusts are vigilant about their filing requirements and timely file their Form 3520 and/or 3520-A. Note that a delay in filing of Form 3520 and 3520-A caused Wilson $3.2million. The IRS has automatic penalty issuance procedures when the information returns are filed late. The taxpayer is at the mercy of the IRS for a hearing on the reasonable cause defense to penalty abatement.

The Wilson case is especially important for the U.S. citizens who live overseas and participate in their overseas employer’s pension plans. These individuals should carefully review terms and conditions of employer pension plans to understand whether these plans are considered a foreign trust under U.S. tax laws. If yes, and unless treaty provides otherwise, or exception is available under Rev. Proc. 2020-17, the U.S. citizen should annually file Form 3520-A with their U.S. income tax return and, when necessary, Form 3520.

The taxpayers should note the filing deadlines for these two forms. While Form 3520 is due April 15, with available six-month extension (October 15), which is automatic with the filing of the extension for the personal tax return, Form 3520-A is due March 15, requiring filing of a separate Form 7004 to obtain a six-month extension (September 15).


Tax Controversy and Dispute Resolution - Q3 2021

About Brent Lipschultz

Brent Lipschultz is a Partner in the Personal Wealth Advisors Group with over 25 years of experience, and a leader in the International Wealth Planning team.

About Ragini Subramanian

Ragini Subramanian is a Tax Senior Manager in the Personal Wealth Advisors Group.

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