By Anthony Diosdi
Most tax penalties and other civil sanctions for noncompliance with internal revenue laws are located in Chapter 68 of the Internal Revenue Code. Chapter 68 authorizes the assessment of civil sanctions for fraud, negligence, and delinquency penalties. These civil sanctions are subject to the deficiency process. This means that a taxpayer is afforded the opportunity of judicial review by the United States Tax Court before these penalties can be assessed and collected by the IRS. On the other hand, the authority to assess most international penalties is embedded in Chapter 61 of the Internal Revenue Code. Notwithstanding these differences in geography, all international penalties are “assessable penalties,” meaning that they may be assessed and collected without the IRS having to resort to providing an individual an opportunity to prepayment judicial review by the Tax Court.
A prime example of an international penalty assessable under Chapter 61 is provided in Internal Revenue Code Section 6677(a). 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.
The penalties associated with failing to timely IRS Form 3520 and/or Form 3520-A can be substantial. With that said, there are a number of defenses to these penalties. The problem is the penalties associated with failing to timely file Form 3520 or Form 3520-A are “assessable penalties” meaning that the IRS can assess and collect these penalties without providing an individual an opportunity for prepayment Tax Court judicial review. The tax law seems to indicate that if an individual does not agree with an IRS penalty assessment associated with the failure to timely file an IRs Form 3520 or 3520-A his or her only option would be to pay the penalty in full, file administrative refund claims with the IRS, and sue the government for a refund of the penalty in either a United States district court or Court of Federal Claims. This solution is easier said than done for many.
Although the Internal Revenue Code implies that an “assessable penalty” such as a penalty for failing to timely file a Form 3520 or Form 3520-A can only be judicially reviewed in refund litigation before a United States district court or Court of Federal Claims, in certain cases, a penalty assessed by the IRS for filing to timely file a Form 3520 or Form 3520-A can be judicially reviewed in a prepaid forum such as the Tax Court. Below are the criteria that must be met in order for a penalty associated with a Form 3520 or Form 3520-A to be reviewed by the Tax Court.
Once a Form 3520 or Form 3520-A Penalty is Assessed, if the Penalty is Not Satisfied, the IRS will Issue a Number of Notices
Once the IRS assesses a penalty associated with a Form 3520 and/or Form 3520-A, the IRS will demand payment of the penalty. If the penalty is not paid, the IRS will commence enforced collection actions by issuing approximately three notices reminding the individual of the assessed penalty and accumulating interest. If the IRS does not receive payment in response to these letters, the IRS will issue a notice to the individual assessed a penalty concerning his or her right to a Collection Due Process Hearing under Internal Revenue Section 6330 or 6320. This letter is typically 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.” However, sometimes the IRS issues notices which inconspicuously inform the individual of an opportunity to a Collection Due Process hearing. Anyone who wishes to attempt to contest a Form 3520 and/or Form 3520-A penalty in court without having to pay the penalty in full should not ignore or dismiss this correspondence. This correspondence not only provides an individual an opportunity to contest a penalty in an administrative hearing known as a “Collection Due Process Hearing,” requesting a Collection Due Process Hearing is a prerequisite to judicial review of the international penalty by the Tax Court.
The request for a Collection Due Process Hearing must be made within 30 days of the date of the final notice. An individual can must request a Collection Due Process Hearing 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 the reason for contesting the international penalty in detail.
The Collection Due Process Hearing
Once the IRS receives the Form 12153, it will schedule the Collection Due Process Hearing with the IRS Office of Appeals. This hearing is usually conducted telephonically with an Appeals Officer. During the hearing, the individual will be provided an opportunity to argue the issues raised on the Form 12153. Shortly after the conclusion of the Collection Due Process Hearing, the IRS Office of Appeals will issue a so-called Notice of Determination.” If the Notice of Determination does not favorably resolve the international penalty, the individual who was assessed the penalty has the right to seek judicial review of the determination by filing a petition with the United States Tax Court. The petition must be filed within 30 days after the date stated on the determination letter. Judicial review may only be raised as to the issues that were raised in the Collection Due Process Hearing.
The Types of Tax Court Jurisdiction and Judicial Remedies Available
The Tax Court can offer an individual two types of review: de novo review or abuse of discretion review. The Tax Court can offer an individual de novo judicial review. This review is used to question how the IRS applied or interpreted the law in assessing an international penalty. Basically, the Tax Court starts from the beginning and reviews the facts along with the evidence of the case. The Tax Court will typically conduct a trial to determine whether the assessment of an individual is liable for the international penalty asserted by the IRS. A de novo review provides an individual the best opportunity to contest an international penalty. All other international penalty cases brought before the Tax Court through a Collection Due Process Hearing are reviewed under an abuse of discretion standard. The Tax Court will not disturb an international penalty assessment unless it is arbitrary, capricious, clearly unlawful, or without sound basis in fact or law.
a. A Litigant Cannot have Had a Prior Opportunity to Contest an International Penalty in order to obtain a De Novo Standard of Review
An individual may raise a Collection Due Process Hearing challenge to the existence or amount of an international penalty only if he or she “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.
As assessable penalties, international 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 taxpayer “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 the 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, a taxpayer 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 Tax Court will not have jurisdiction to review an international penalty under a de novo standard. Thus, if an individual requests an administrative hearing (other than a Collection Due Process Hearing) to contest an international penalty and the hearing is granted, an individual cannot contest an international penalty under a de novo standard. Even if an individual did not request an administrative hearing with the IRS to contest an international penalty, if the IRS provided a taxpayer with an opportunity to contest an international 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 an international penalty under a de novo standard. See IRC Section 6330(c)(2)(B).
b. Tax Court Jurisdiction based on an Abuse of Discretion Standard
Where there is or can be no challenge to the amount of an individual’s underlying penalty liability under the de novo standard, the United States Tax Court will review the IRS determination of an “international penalty” for abuse of discretion only. An abuse of discretion is measured by the arbitrary or capricious standard. To determine if the IRS acted arbitrarily or capriciously or in abuse of its discretion, the Tax Court will presume that the IRS acted correctly in assessing an assessable penalty and is not permitted to substitute its judgment for the IRS’. The Tax Court should be certain that the IRS acted within the scope of its authority in assessing an international penalty, and it should determine whether the “decision was based on a consideration of relevant factors and whether there has been a clear error of judgment.” See Ocean Advocates v. Army Corps of Engineers, 361 F.3d 1108, 1118 (9th Cir. 2004) (explaining review under Section 706(2)(A) of the Administrative Procedure Act).
In order to satisfy the abuse of discretion standard in regards to the assessment of an international penalty, the IRS’ record should contain an explanation as to why the international penalty was assessed. There must also be a rational connection between the facts found and the reason for the assessment of the penalty. The IRS announced recently that they will begin to automatically assess penalty for the delinquent filing of Form 3520s and Form 3520-A. Given that the IRS is now essentially automatically assessing penalties associated (without considering the individual facts and circumstances of each case) with untimely filed Form 3520s and Form 3520-As, these penalty assessments are subject to attack under the abuse of discretion standard. With that said, just because the IRS has assessed a penalty without properly considering the facts and circumstances of each case, does not mean that the Tax Court will have the ability to reconsider an international penalty on a de novo basis. Instead, in these circumstances, the Tax Court will likely remand the matter 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).
The remedy for abuse of discretion is typically a remand of the case back to the IRS to reconsider the assessment of the international penalty. Although this remedy is not as compelling as a trial de novo, at least it offers the individual an opportunity to contest the penalty before the IRS with the supervision of the Tax Court. Anyone considering raising an abuse of discretion argument before the Tax Court should understand that the burden of proof will be on them. This means the individual should obtain the IRS’ administrative record as to the reason for the assessment of the international penalty the IRS issues a Final Notice of Intent to Levy Notice. This permits this argument adequate time to develop before it reaches the Tax Court.
The IRS has recently begun to automatically assess penalties associated with not timely filing Form 3520s and Form 3520-As. These penalties can be significant. For many, paying these penalties is not an option. In certain cases, individuals can petition the United States Tax Court to contest penalties associated with not timely filing Forms 3520 and/or Forms 3520-A without having to pay these penalties. Anyone considering petitioning the Tax Court to contest an international penalty should begin preparing right after the penalty is assessed. Preparation should include investigating any possible defenses to the international penal and obtaining their administrative file from the IRS. Finally, anyone considering contesting an international penalty must seriously consider the pros and cons of requesting any administrative appeal other than a Collection Due Process Hearing.
Anthony Diosdi is a partner and attorney at Diosdi Ching & Liu, LLP located in San Francisco, California. Diosdi Ching & Liu, LLP also has offices in Pleasanton, California and Fort Lauderdale, Florida. Anthony Diosdi advises clients in tax matters domestically and internationally throughout the United States, Asia, Europe, Australia, Canada, and South America. Anthony Diosdi may be reached at (415) 318-3990 or by email: firstname.lastname@example.org.
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.