June 7, 2020 – New York, United States
How Joseph Wilson, Damsel in Distress, Escaped the Clutches of the Villainous IRS and Its Assessment of Form 3520 Penalties
If you are a classic film buff, or even if you are not, you may recall the classic damsel in distress film genre from the silent era. A villain decked out in a curly ‘Q’ mustache kidnaps a pretty woman, the significant other of his arch enemy, ties her up and binds her to the railroad tracks. As the train comes clickety clacking down the track, the arch enemy, a handsome man on a white horse, rescues the damsel in the nick of time, captures the villain, and then saves the day. The field of international tax recently released its own production of the classic damsel in distress genre via the case of Wilson v. United States, (E.D.N.Y. 11/17/19). The villain was played by the IRS, the damsel in distress was Joseph Wilson, and the hero was the district court.
The court in Wilson decided that the IRS overstepped its authority in imposing a 35% penalty for the filing of a late Form 3520. If you are unfamiliar with form 3520, it is an informational form created as a result of IRC Section 6048. The regulation stipulates that a US person who is the owner of a foreign trust must report activities and transactions of the trust for the taxable year, and a US beneficiary of a foreign trust who received a distribution must likewise report the distribution. Both owners and beneficiaries are required to file the form. IRS Section 6677 imposes a penalty equal to 35% of the amount distributed upon the beneficiary for failing to timely file. Further, the regulation imposes a 5% penalty on the value of the assets at the end of the year on the owner for the foreign trust for failing to timely file.
In the case at hand, Joseph Wilson was the sole owner and beneficiary of the trust, which was created in anticipation of a divorce. Wilson desired to protect these assets in an offshore account to avoid having the funds equitably distributed between himself and his soon to be ex-wife. Upon divorce settlement, he repatriated the assets, which was $9.203 million. He filed the 3520 form late. The IRS imposed a 35% penalty to the tune of $3,221,183 that Wilson paid and subsequently filed a claim for refund.
Wilson asserted that his late filing was due to reasonable cause, and that as a sole owner of the trust, the IRS at best could only impose the 5% penalty. The IRS motioned for dismissal of the claim for refund based on the premise that the claim did not apprise the Service of the exact basis for the claim. The court ruled in favor of Wilson upon denial of the motion for dismissal stating the IRS had sufficient information alerting them to the claim and to compute the correct penalty.
In citing it reasoning, the Court reviewed the language of IRC Section 6677. Pursuant to statute, should the owner and the beneficiary of the trust be one and the same person, only one form 3520 is required. Section (b) of the statute provides that in such an instance wherein the owner and beneficiary are the same, the 5% penalty is substituted for the 35% penalty. The Court rejected the IRS claim that both penalties should be imposed.
The court also stated that under section 6677(a)(1), penalties assessed may not exceed “the gross reportable amount”. As trust owner, the gross reportable amount for Wilson at the end of the year was zero. The penalty assessment was far in excess of the amount that could be assessed. The Court also granted Wilson’s motion to find that as owner of the trust, he is liable for a 5% penalty on the amount of the trust assets at the end of 2007, which was zero.
The main reason this case erupted as it did in the first place is because the IRS automatically applies these penalties. However, this practice stands in opposition to Delinquent International Information Return Filing Procedures (DIF). This is because a taxpayer with reasonable cause should be allowed to make such a statement prospectively and not be subject to an automatic assessment of penalties. In practice, however, agents at the Service were not considering these reasonable cause statements. As a result, they were automatically assessing the penalties without any communication or dialogue between the Service and the taxpayer before the assessment. Such practice flies in the face of the spirit of delinquent filing procedures posted on the IRS website, which states in part:
“Information returns filed with amended returns will not be automatically subject to audit but may be selected for audit through the existing audit selection processes that are in place for any tax or information returns”.
For the past decade, the IRS has been successfully running programs to allow taxpayers to disclose their foreign assets. These programs have been collectively referred to as Offshore Voluntary Disclosure Programs (OVDP). In September 2018, the window of opportunity for disclosure ended, and with that, taxpayers have been limited as far as compliance options for previous non-compliance. Further, the end of this OVDP era has allowed for the IRS to step in and be aggressive in its pursuit of the imposition of penalties for late filings as with the instant case involving Form 3520. An environment wherein the IRS is aggressively pursuing collections lends itself to practices otherwise deemed unfair and prejudicial. These practices include not even considering reasonable cause statements before assessment. Seemingly, the Court in Wilson became wise to such practices and in its interpretation of the statute, provided the taxpayer justifiable and equitable relief.
This case is a red alert for taxpayers and international tax practitioners alike to be on the lookout for the imposition of civil penalties for a late filed Form 3520. A heavy tax bill will be met with less consternation knowing that a statement for reasonable cause was in all probability overlooked by the Service. This is because many agents do not have a working familiarity with the intricacies of applicable statutes in an evolving area of law that is Form 3520 practice. It then behooves a tax filer and their associated representative to know the ins and outs of these laws, the law’s applicability to the facts of the case, and the mechanics of relevant trust provisions. By accomplishing this, any questions or concerns expressed by an IRS agent will be met with satisfactory responses. In effect, time-consuming tax litigation as experienced by the claimant in the case of Wilson will be deemed unnecessary and effectively avoided.
About the Author
Alicea Castellanos is the CEO and Founder of Global Taxes LLC. Alicea provides personalized U.S. tax advisory and compliance services to high net worth families and their advisors. Alicea has more than 17 years of experience. Prior to forming Global Taxes, Alicea founded and oversaw operations at a boutique tax firm, worked at a prestigious global law firm and CPA firm. Alicea specializes in U.S. tax planning and compliance for non-U.S. families with global wealth and asset protection structures which include non-U.S. trusts, estates and foundations that have a U.S. connection.
Alicea also specializes in foreign investment in U.S. real estate property, and other U.S. assets, pre-immigration tax planning, U.S. expatriation matters, U.S. persons in receipt of foreign gifts and inheritances, foreign accounts and assets compliance, offshore voluntary disclosures/tax amnesties, FATCA registration, and foreign companies wanting to do business in the U.S. Alicea is fluent in Spanish and has a working knowledge of Portuguese.
Alicea is an active member of the Society of Trusts & Estates Practitioners (STEP), the New York City Bar, the New York State Society of Certified Public Accountants (NYSSCPAs), the American Institute of Certified Public Accountants (AICPA) and the International Fiscal Association (IFA). She is the New York/Northeast Regional Representative of the Women of IFA Network (WIN). Distinctly, in 2020, Alicea was awarded with a prestigious NYSSCPA Forty Under 40 Award. She was selected as someone that has notable skills and is visibly making a difference in the accounting profession.
Please note: This content is intended for informational purposes only and is not a replacement for professional accounting or tax preparatory services. Consult your own accounting, tax, and legal professionals for advice related to your individual situation. Any copy or reproduction of our presentation is expressly prohibited. Any names or situations have been made up for illustrative purposes — any similarities found in real life are purely coincidental.