By Anthony Diosdi
Under Internal Revenue Code Section 6677(a), if any United States Person beneficiary receives (directly or indirectly) a distribution from a foreign trust, that person is required to make a return with respect to such a trust using Internal Revenue Service (“IRS”) Form 3520, and show thereon the name of the trust, the amount of the aggregate distribution received, and any other data the IRS may require. A foreign gift, bequest, or inheritance that exceeds $100,000 must also be disclosed on a Form 3520. The IRS may assess an annual penalty equal to 35 percent of the gross value of the trust or 35 percent of the gross value of the property transferred from the trust if a Form 3520 is not timely filed. The IRS may also assess a penalty under Internal Revenue Code Section 6039F equal to 25 percent of a foreign gift if it is not timely disclosed on a Form 3520. Finally, the IRS may assess an annual penalty of $10,000 or 5 percent of the gross reportable amount of a foreign trust (whichever is greater) on an individual required to file an IRS Form 3520-A.
It goes without saying that the penalties associated with failing to timely IRS Form 3520 and/or Form 3520-A or incorrectly filing one of these returns can be substantial. These returns can be incredibly complicated and many taxpayers do not even know they have to file one of these forms until it’s too late. The fact that in certain cases a Form 3520 and Form 3520-A can be incredibly complicated has not deterred the IRS from aggressively penalizing taxpayers. Given the complexities of these forms, one would think that the IRS would be lenient and only assess penalties in egregious cases. Unfortunately, the exact opposite has taken place. Over the past year or so, the IRS has been automatically assessing penalties against taxpayers who file a Form 3520 or Form 3520-A late. (regardless of the reason). In our experience, these penalties are most often assessed when an individual files a late Form 3520 disclosing a previous undisclosed foreign gift. These penalties are no joke. Penalties for failing to timely file a Form 3520 or 3520-A (hereinafter “3520 penalty” or “3520 penalties”) can easily be in the tens of thousands or even hundreds of thousands range. Although the IRS has administrative procedures to remove 3520 penalties, the IRS has not been overly generous in removing 3520 penalties once they have been assessed.
To make matters worse, 3520 penalties are what is known as assessable penalties. In other words, 3520 penalties can be assessed by the IRS once it determines that the penalty is appropriate and should be assessed. Assessable penalties are not subject to deficiency procedures. Which means that a 3520 penalty can be assessed by the IRS without issuing a notice of deficiency and providing a prepayment judicial forum to dispute the penalty. Typically, this means once a 3520 penalty is assessed and finalized by the IRS, an individual’s only option to contest this penalty is limited to paying it in full and filing a tax refund suit in either a United States district court or the Court of Federal Claims. The problem in these cases is usually the size of the penalty. As discussed above, it is not uncommon for the IRS to assess 3520 penalties that are in the hundreds and thousands of dollar range. In many cases, the individual assessed the penalty does not have the means to pay it in order to contest it.
Fortunately, in certain cases, there is a mechanism to obtain judicial review of a 3520 penalty by the United States Tax Court without having to pay the penalty in full. The ability to contest a 3520 penalty in court may offer an individual the ability to present defenses he or she could not raise before the IRS. This article discusses the procedure involved in bringing a 3520 penalty case to Tax Court and the benefits of bringing a 3520 penalty case to Tax Court. .
Defenses to the 3520 Penalty
There are two main defenses to a 3520 penalty. The first defense is that an individual demonstrates that he or she exercised ‘ordinary business care and prudence’ but nevertheless was unable to file a Form 3520 or 3520-A within the prescribed time or filed an incorrect return. The second defense is that the IRS failed to follow certain procedural requirements of Internal Revenue Code Section 6751. We will discuss these defenses in more detail below.
1. Reasonable Cause
Reasonable cause provides an escape hatch to the 3520 penalty. However, the term “reasonable cause” is nowhere defined in the Internal Revenue Code or in regulations interpreting it. That phrase, however, appears repeatedly through the Internal Revenue Code and its regulations. Internal Revenue Code Section 6677(d), which is applicable to the reporting of foreign trusts, prohibits penalties for “any failure which is shown to be due to reasonable cause and not due to willful neglect. Another statute, applicable to individual income tax returns, prohibits monthly penalties for failing to file tax returns where “such failure is due to reasonable cause and not due to willful neglect.” See IRC Section 6651(a)(1). In 1985, the Supreme Court noted that the meaning of the terms “reasonable cause” and “willful neglect” “ha[d] become clear over the near-70 years of their presence in the statutes.” See United States v. Boyle, 469 U.S. 241, 245 (1985). It also noted that regulations defined “reasonable cause” for purposes of Section 6651(a)(1). (“[T]he relevant Treasury Regulation calls on the taxpayer to demonstrate that he exercised ‘ordinary business care and prudence’ but nevertheless was ‘unable to file the return within the prescribed time.”).
Establishing “reasonable cause” is determined on a case-by-case basis. Probably the best way to determine if an individual acted with “reasonable cause” through testimony. Unfortunately, the IRS does not allow taxpayers the ability to offer testimony in a 3520 penalty case. Instead, a taxpayer or her representative reasonable cause defense is limited to a letter which attempts to marshal the facts most favorably in her case. IRS responses to these letters are often terse. A IRS response to a 3520 penalty abatement based on reasonable case typically goes as follows:
Dear Taxpayer:
I have completed my review of your request to adjust the penalty(s) assessed against you. Based on the facts presented, including additional information you submitted. I find that no basis for abatement of the penalty(s) is warranted within the protective framework of reasonable cause.
Fundamentally, all taxpayers should be entitled to at least some level of reasoned explanation from the IRS as to the basis for the rejection. As demonstrated above, this typically does not take place when requesting a 3520 penalty abatement based on reasonable cause. The IRS appears to be taking an efficiency position when it comes to assessing 3520 penalties and elaborating whether or not reasonable cause exists to remove a 3520 penalty. This IRS efficiency practice does not blend well to cases involving substantial monetary penalties. This practice makes it difficult to know if the agent reviewing the request for penalty relief is considering the arguments raised in a penalty abatement letter or if the agent has even read the letter.
2. Section 6751
Another defense to the 3520 penalty is Section 6751. According to Internal Revenue 6771(b), all penalties (including 3520 penalties) must comply with certain procedural requirements. Section 6751 requires the IRS to follow two procedural requirements when imposing penalties on taxpayers. First, an individual must receive notice of the penalty, the section of the Internal Revenue Code that imposes the penalty, and how the penalty is computed. This requirement is usually easily satisfied. Second, the “initial determination” to assess the penalty must be approved “in writing” by an “immediate supervisor” or an “approved higher official.” See IRC Section 6751(b). The IRS has a long history of not complying with Section 6751.
The IRS has assigned to it’s Ogden, Utah campus the task of assessing 3520 penalties. The Ogden campus has assessed hundreds, if not thousands, of 3520 penalties against individual taxpayers globally in the past year. Section 6751 states that these penalties must have been approved “in writing” by an “immediate supervisor” or an “approved higher official.” It is difficult to imagine the IRS having the resources to satisfy the statutory requirements of Section 6751. In this author’s experience, the IRS has not complied with Section 6751 in a substantial number of 3520 penalty cases. Any failure to comply with Section 6751 should result in the automatic removal of a Section 3520 penalty. This raises two questions. First, how does an individual assessed a 3520 penalty obtain verification that the IRS complied with Section 6751? An individual assessed a 3520 penalty can request proof that the IRS complied with Section 6751 through a Freedom of Information Act (“FOIA”) request.
The second issue related to Section 6751 is how does an individual administratively utilize Section 6751 to contest a 3520 penalty. After a 3520 penalty is assessed by the IRS, the IRS only invites taxpayers to submit letters requesting an abatement on penalties based on reasonable cause. The IRS does not ask nor does it desire that taxpayers submit letters stating that its process of assessing 3520 penalties violated Section 6751. As such, it is unknown if the IRS would voluntarily remove a 3520 penalty if it was notified that its process of assessing penalties violated the procedural requirements of Section 6751.
Getting a 3520 Penalty Case Before the Tax Court
Now since we have discussed the two most common defenses to the 3520 penalty, we will now discuss how a case can be brought before the Tax Court and the benefits of bringing a 3520 penalty case before the Tax Court. There are two distinct procedures available to individuals who wish to contest a 3520 penalty before the Tax Court. First, an individual may challenge the validity of a 3520 penalty and ask the court to review an IRS’s penalty assessment de novo. Second, an individual may take the position that the IRS’s decision to assess a 3520 penalty was an abuse of discretion. We will discuss these two standards in more detail below.
1. Tax Court De Novo Review of a 3520 Penalty
5 U.S.C.A. Section 706(2)(f) provides that courts may invalidate agency action that is “unwarranted by the facts to the extent that the facts are subject to trial de novo by the reviewing court. (5 U.S.C.A. Section 706 governs Administrative Procedure (“APA”) Cases. Although the Tax Court has held that the APA does not govern its review of agency actions, in practice the Tax Court’s review of the IRS is similar to that of the APA). When engaging in de novo review, a court can make its own independent finding of facts in addition to examining the record developed by the agency. Under this standard, the Tax Court has the ability to review an IRS 3520 penalty assessment. Unfortunately, an individual assessed a 3520 penalty may not simply just bring a case before the Tax Court and request de novo review of the penalty. There are a number of prerequisites to this sort of de novo review by the Tax Court. The first prerequisite to Tax Court de novo review is the filing of a Collection Due Process Hearing (“CDP”). Through a CDP, an individual can challenge the existence of a Section 3520 penalty based on the fact that he or she acted with reasonable cause or the IRS did not follow Section 6751 procedures, and/or the IRS abused its discretion in assessing 3520 penalties. Should the IRS improperly reject a 3520 penalty challenge in a CDP hearing, the taxpayer can request judicial review of the IRS’s penalty assessment and/or the IRS’s decision not to remove the 3520 penalty. The taxpayer then can challenge the existence of the underlying 3520 penalty in a CDP and before the United States Tax Court without first having to pay the penalty.
As is typically the case in controversy matters, contesting a 3520 penalty through a CDP is all about timing. There is a very small window of time in which a taxpayer can contest a 3520 penalty. An individual contesting a 3520 penalty must wait for the IRS to issue a correspondence entitled “Final Notice of Intent to Levy and Notice of Your Right to a Hearing” or “Notice of Federal Tax Lien Filing and Your Right to a Hearing” before requesting a CDP. Once a taxpayer receives a correspondence entitled “Final Notice of Intent to Levy and Notice of Your Right to a Hearing” or “Notice of Federal Tax Lien Filing and Your Right to a Hearing,” he or she will have thirty days from the date of the letter to request a CDP. The request for a CDP must be made on an IRS Form 12153, Request for a Collection Due Process or Equivalent Hearing. The Form 12153 must be completed in its entirety and must state in detail the reason for contesting the 3520 penalty.
If more than 30 days lapses from the date of a “Final Notice of Intent to Levy and Notice of Your Right to a Hearing” or “Notice of Federal Tax Lien Filing and Your Right to a Hearing,” an individual will be foreclosed from using this process. A prematurely filed protest will also prevent a taxpayer’s ability to challenge a 3520 penalty through a CDP. If an individual files a protest with the IRS before receiving letters entitled “Final Notice of Intent to Levy and Notice of Your Right to a Hearing” or “Notice of Federal Tax Lien Filing and Your Right to a Hearing,” it will also probably prevent the taxpayer from challenging a 3520 penalty through a CDP.
For example, let’s assume that in 2017 Tom received a foreign gift in the amount $1,000,000 from his uncle, a citizen of China. Unbeknownst to Tom, he was required to disclose the $1,000,000 foreign gift on a Form 3520. In 2019, Tom visits Phil, a CPA. Phil tells him about the 3520 filing requirement and files a late 3520 with the IRS on behalf of Tom. In 2020, the IRS mails Tom a letter advising Tom that the IRS has assessed a $250,000 3520 penalty against him. Tom retains Steve, a tax attorney to contest the 3520 penalty. Unfortunately for Tom, Steve knows nothing about the CDP process. Steve immediately challenges the 3520 penalty by filing a protest with the IRS before Tom received correspondence entitled “Final Notice of Intent to Levy and Notice of Your Right to a Hearing” or “Notice of Federal Tax Lien Filing and Your Right to a Hearing” The IRS rejects the protest letter but offers Steve the opportunity to submit an appeal to the IRS Appeals Office. Steve files an appeal with the IRS Appeals Office. The Appeals Office subsequently rejects the appeal. Because Steve prematurely filed a protest letter and was granted an appeal before Tom was issued a correspondence entitled “Final Notice of Intent to Levy and Notice of Your Right to a Hearing” or “Notice of Federal Tax Lien Filing and Your Right to a Hearing,” Tom can no longer contest the 3520 penalties in a CDP or before the Tax Court. This is because Tom availed himself of a prior opportunity to challenge the 3520 penalties through Steve’s protest and appeal. In order to understand why Tom cannot challenge a 3520 penalty in a CDP, we will need to take a deeper dive into the procedural rules governing CDP penalty.
An individual may raise a CDP challenge to the existence or amount of his underlying tax liability only if he “did not receive any statutory notice of deficiency for such tax liability or did not otherwise have an opportunity to dispute such tax liability.” See IRC Section 6330(c)(2)(B). In determining whether the taxpayer had a prior opportunity to dispute his liability, the regulations distinguish between liabilities that are subject to deficiency procedures and those that are not. For liabilities subject to deficiency procedures, an opportunity for a post-examination conference with an IRS Appeals Office does not bar the taxpayer (in appropriate circumstances) from contesting his liability in a later CDP proceeding. See 301.6330-1(e)(3), Q&A-E2, Proceed. & Admin. Regs. On the other hand, where a liability is not subject to deficiency procedures, “[a]n opportunity to dispute the underlying liability includes a prior opportunity for a conference with Appeals that was offered either before or after the assessment of the liability.”
As assessable penalties, 3520 penalties are not subject to deficiency procedures. See Smith v. Commissioner, 133 T.C. 424, 428-430 (2009). Notwithstanding the absence of a notice of deficiency, a taxpayer may be able to dispute international penalties (without paying them first) by resisting IRS collection efforts through the Collection Due Process Hearing and then seeking review in the United States Tax Court. See Williams v. Commissioner, 131 T.C. 54, 58 (2008); Gardner v. Commissioner, 145 T.C. 161 (2015)(upholding Tax Court jurisdiction to review penalties in the Collection Due Process context). But this route to prepayment judicial review is available only if the individual “did not otherwise have an opportunity to dispute such tax liability.” See IRC Section 6330(c)(2)(B).
For example, in Yari v. Commissioner, 143 T.C. 157 (2014), aff’d,___F. App’x___, 2016 WL 5940054 (9th Cir. Oct. 13, 2016), the IRS assessed an “assessable penalty” against a taxpayer and issued him a notice of intent to levy. After receiving a notice of determination sustaining the levy, the taxpayer petitioned the United States Tax Court. There was no evidence in the record that the taxpayer had received notice of the assessment, that he had been offered the opportunity to protest the assessment, or (if so) that he had taken advantage of that opportunity. Under these circumstances, the Tax Court allowed the taxpayer to contest the amount of the penalty because he had not had a prior opportunity to dispute it.
Under this framework, an individual in a Collection Due Process Hearing case is entitled to challenge his or her underlying “assessable penalty” only if he or she did not have a prior opportunity to dispute it. For this purpose, a prior opportunity includes “a prior opportunity for a conference with Appeals.” See Treas. Reg. Section 301.6330-1(e)(3), Q&A-E2, Proced. & Admin. Regs. The United States Tax Court has sustained the validity of this regulation even though the taxpayer had no right to judicial review of the prior Appeals Office determination. See Lewis v. Commissioner, 128 T.C. 48, 60-61 (2007). Since Lewis, the United States Tax Court has consistently precluded an individual from raising a liability challenge in a “assessable penalty” case when he had an opportunity to present that challenge to the Appeals Office before the IRS commenced collection action.
This means if an individual had, and availed himself of, a prior opportunity of contesting an “assessable penalty” by filing a protest with IRS before a Collection Due Process Hearing was conducted, the IRS through a CDP and the Tax Court will not have jurisdiction to review a 3520 penalty under a de novo standard. In other words, an individual may raise a challenge to the existence or amount of his or her 3520 penalty liability under either a theory of reasonable cause and/or the IRS did not adhere to the 6751 rules. This is the case even if an individual did not request an administrative hearing with the IRS to contest a 3520 penalty, if the IRS provided a taxpayer with an opportunity to contest the penalty through some resemblance of an appeals conference and the individual refused to participate in the hearing, this may deprive the individual of the ability to contest a 3520 penalty. See IRC Section 6330(c)(2)(B).
In the example above, Tom availed himself a prior opportunity to challenge the 3520 penalties as a result of Steve’s protest with the IRS. Tom was then offered, and Steve an opportunity to appeal (within the IRS) the 3520 penalty. This process unquestionably afforded Tom “a meaningful opportunity to dispute * * * the 3520 penalty. Thus, Tom is precluded from disputing the 3520 penalties during the CDP hearing. And because Tom could not challenge his liability from the penalties at the CDP hearing, he is likewise precluded from disputing the penalties before the Tax Court. See Giamelli v. Commissioner, 129 T.C. (2007). Where there is or can be no challenge to the amount of the 3520 liability. However, the Tax Court may still review the IRS determination for abuse of discretion which is discussed in more detail below.
Asking the Tax Court to review a 3520 penalty de novo offers an individual a number of advantages as compared to an IRS administrative request (a letter asking for penalty relief) to remove a 3520 penalty. The Tax Court affords individuals the opportunity to expand the record well beyond what he or she could have presented in a written correspondence. Typically, individuals are precluded from offering testimony as to why they acted reasonably. Litigants contesting a 3520 penalty in a de novo setting can offer testimony of their reasonable attempts to comply with the 3520 requirements such as reliance on tax professionals or computer software. Litigants can also offer testimony regarding limitations that prevented them from complying with the 3520 filing requirements such as the inability to write or comprehend the English language. If necessary, litigants can also place the IRS’s administrative record into evidence challenging the very procedure used to assess the 3520 penalty. Finally, through a de novo proceeding, the individual assessed a 3520 penalty is assured their case will be heard by a neutral third party. It is difficult to imagine a scenario in which a de novo review of a 3520 penalty would not benefit a taxpayer. The problem is that it is not always possible for an individual that wishes to contest a 3520 penalty in Tax Court to satisfy the procedural requirements to get the case before the Tax Court. In many cases, the IRS will offer a taxpayer opportunity to contest a 3520 penalty by inviting the taxpayer to submit a letter to contest the 3520 penalty. Just because a taxpayer was provided an opportunity to contest a 3520 penalty or appealed a 3520 penalty through a written correspondence does not mean that the taxpayer is foreclosed from Tax Court judicial review. In this case, the taxpayer will be foreclosed from Tax Court de novo review. However, the taxpayer may ask the Tax Court to review the 3520 penalty for abuse of discretion.
Challenging a 3520 Penalty on Grounds that the IRS Acted Arbitrarily, Capriciously or Abused Its Discretion in Assessing the Penalty
Where there is or can be no challenge to the amount of a 3520 penalty under a de novo standard discussed above, the Tax Court will review a 3520 penalty for abuse of discretion only. An abuse of discretion may be set aside only if they are found to be “arbitrary, capricious, an abuse of discretion or otherwise not in accordance with law.” For example, in carrying out its adjudicatory duties, the IRS makes findings of fact. Under this standard, the Tax Court can set aside an IRS penalty assessment if the penalty is premised on facts “unsupported by substantial evidence.” See 5 U.S.C.A. Section 706(2)E).
The abuse of discretion standard may be appropriate when the IRS assesses a 3520 penalty, but the administrative record contains no explanation of the IRS’s decision to impose penalties. The abuse of discretion standard may also be brought in cases where the IRS failed to follow Section 6751. Successfully bringing an abuse of discretion case requires obtaining the IRS administrative record regarding the assessment of the 3520 penalty. Once the administrative record is obtained, the record should provide a rational connection between the facts found by the IRS and the reason for the assessment of the penalty. If the record does not contain a rational connection between the facts found by the IRS and the reason for the assessment of a 3520 penalty or the record is completely void as to why a penalty was assessed, the 3520 penalty may be attacking on grounds that the IRS acted arbitrarily, capriciously, or abused its discretion in assessing the penalty. The same is true if the record does not provide evidence of a “writing” indicating that an “immediate supervisor” or “approved higher official” approved the 3520 penalty.
Although an abuse of discretion standard can be used to attack a 3520 penalty, the remedy offered by the abuse of discretion standard is not as sweeping as the above discussed de novo standard. Under the de novo standard, the Tax Court can order the IRS to remove a 3520 penalty. Under the abuse of discretion standard, the Tax Court can only remand the case back to the IRS for further consideration. For example, the United States Supreme Court has stated:
“If the record before the agency does not support the agency action, if the agency has not considered all relevant factors, or if the reviewing court simply cannot evaluate the challenged agency action on the basis of the record before it, the proper court, except in rare circumstances, is to remand to the agency for additional investigation or explanation. The reviewing court is not generally empowered to conduct a de novo injury into the matter being reviewed and to reach its own conclusions based on such an inquiry.” See Florida Power & Light Co. v. Lorion, 470 U.S. 729, 744 (1985).
Although the remedies available to individuals are not as broad under the abuse of discretion standard, a remand to the IRS for further consideration may prove to be very useful in facilitating a successful resolution to a 3520 penalty. A remand will likely be under the supervision of the Tax Court. At a minimum, a remand should provide the individual contesting a 3520 penalty a more fair process and it may even invite an IRS concession of a 3520 penalty or a favorable settlement. Finally, if the IRS violated Section 6751 when assessing a 3520 penalty, the Tax Court may compel the IRS to concede the penalty.
Conclusion
All taxpayers should be entitled a fair process and some reasoned explanation from the IRS as to the basis when significant penalties are being assessed against them. The current process that the IRS has used to assess 3520 penalties is not only unfair, but it also encourages individuals to hide foreign assets if an individual discovers they did not timely disclose a foreign asset or foreign gift. Litigating a 3520 controversy before the Tax Court will not only assure that the IRS adheres to the Internal Revenue Code and its regulations, it will also increase the probability of a fair and just result.
Anthony Diosdi is one of several tax attorneys and international tax attorneys at Diosdi Ching & Liu, LLP. As a domestic and international tax attorney, Anthony Diosdi provides international tax advice to individuals, closely held entities, and publicly traded corporations. Diosdi Ching & Liu, LLP has offices in San Francisco, California, Pleasanton, California and Fort Lauderdale, Florida. Anthony Diosdi advises clients in international tax matters throughout the United States. Anthony Diosdi is a frequent speaker at international tax seminars. Anthony Diosdi may be reached at (415) 318-3990 or by email: adiosdi@sftaxcounsel.com.
This article is not legal or tax advice. If you are in need of legal or tax advice, you should immediately consult a licensed attorney.