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. There are a number of defenses to these penalties such as the reasonable cause defense. This article will discuss the reasonable cause and other procedural defenses available to contest penalties associated with the failure to timely file a Form 3520 (hereinafter “3520 penalty” or “3520 penalties”).
Reasonable Cause Defense
Once the IRS assesses a 3520 penalty, the most commonly cited defense is the reasonable cause defense. In order to obtain an abatement of the penalties associated with a Form 3520 penalty, it must be established that the individual that was assessed a penalty did not only act with “reasonable cause,” but also lacked “willful neglect.” Whether both “reasonable cause” and lack of “willful neglect” exist is a question of fact. The term “willful neglect” was defined by the United States Supreme Court in United States v. Boyle, 469 U.S. 241, 246 (1985) as a conscious, intentional failure or reckless indifference.” The IRS has interpreted the Boyle decision in its regulations to define “reasonable cause” and lack of “willful neglect” as the taxpayer exercised “ordinary business care and prudence.” See Treas. Reg. Section 301.6651-1(c)(1). Thus, if a taxpayer can show that he exercised ordinary business care and prudence, he may have a reasonable cause for a 3520 penalty. Of course, the question then becomes, what constitutes ordinary business care and prudence? In the past, the IRS considered the following examples to constitute reasonable cause for the purpose of a delinquent filing penalty.
1. A return mailed in time but returned for insufficient postage.
2. A return filed timely but in the wrong district with the Regional Commissioner or Commissioner of Internal Revenue.
3. Erroneous information from an IRS official.
4. Death or serious illness of the taxpayer or someone in his or her immediate family.
5. Unavoidable absence of the taxpayer.
6. Destruction of a business or business records by fire or other casualty.
7. A request proper for returns not timely furnished by the IRS.
8. An effort to obtain assistance or information necessary to complete the return by a personal appearance at an IRS office that was unsuccessful because the taxpayer, through no fault of his or her own, was unable to see an IRS representative.
Thus, if an individual who was assessed a 3520 penalty can show he exercised ordinary business care and prudence under any of the examples listed above, this individual may have a reasonable cause defense to a 3520 penalty. Case law has also carved out a reasonable cause defense to a 3520 penalty based on the advice of a qualified tax advisor. To be clear, the failure to timely filing of a Form 3520 is not excused by an individual’s reliance on a tax professional. Such reliance is not ‘reasonable cause’ for purposes of a 3520 penalty. Reliance on a tax professional who is expected to attend to the matter, even reasonably so, does not relieve an individual with a Form 3520 filing obligation and is not a defense to a 3520 penalty.
With that said, a distinction is drawn between reliance on the act of a tax professional and reliance on the advice of a tax advisor. In Haywood Lumber & Mining Co. v. Commissioner, 172 F2d 769, 771 (2d Cir. 1950), the court said: “When a corporate taxpayer selects a competent tax expert, supplies him with all necessary information, and requests him to prepare proper tax returns, we think the taxpayer has done all that ordinary business care and prudence can reasonably demand.” Consequently, advice sought and received in good faith from a competent adviser constitutes reasonable cause for failure to file a Form 3520. Finally, in certain limited cases, ignorance of law may be considered reasonable cause if other factors support this contention, such as the individual being a first-time 3520 filer or the individual required to file a Form 3520 is not fluent in english.
Once it is determined whether or not a reasonable case defense exists for a 3520 penalty, the next step is to notify the IRS in writing as to why a reasonable cause defense exists in a particular case. Unfortunately, lately, the IRS’s assessment of 3520 penalties can be best described as ‘assess penalties first and ask questions later’ approach. This means that individuals filing a Form 3520 after the deadline cannot likely attach a reasonable cause statement to the return and hope that the IRS will not assess a 3520 penalty. Any correspondences describing reasonable cause should only be sent to the IRS only after a 3520 penalty is assessed. With that said, anyone attempting to convince the IRS to remove or abate these penalties under a theory of reasonable cause will likely be in for a frustrating uphill battle, regardless of the facts and circumstances of the case. Many times the IRS does not even respond to letters requesting an abatement or removal of a Form 3520 penalty. And when the IRS does respond to a written request to remove or abate a Form 3520 penalty, the response times to such requests have been extremely slow. In the meantime, unless proper steps are not taken with the IRS such as negotiating holds on enforced collection activities, the IRS is free to collect a 3520 penalty assessment through levies on wages and assets. Given what is a stake in many 3520 penalty assessments, simply sending a letter to the IRS stating reasonable cause exists or even requesting administrative hearing within the IRS may not be enough. In some cases, particularly when the 3520 penalty is large, litigation may be needed to contest a 3520 penalty. The rules governing the litigation of a 3520 are complicated and full of traps for the unwary. Why go through the hassle of litigating a 3520 penalty? Because litigation or even the threat of litigation may convince the IRS to settle or a Form 3520 penalty. In other cases, the IRS may refuse to abate a 3520 penalty and judicial intervention is necessary.
The penalties associated with Form 3520 are classified as “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 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 3520 penalty 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 3520 penalty to be contested in the Tax Court.
Once a Form 3520 Penalty is Assessed, if the Penalty is Not Satisfied, the IRS will Issue a Number of Notices
Once the IRS assesses a 3520 penalty, it 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 that was assessed the 3520 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 for 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 3520 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 a 3520 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 a 3520 Penalty in order to obtain a De Novo Standard of Review as to Whether he or she Acted with Reasonable Cause
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).
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 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 a 3520 penalty and the hearing is granted, an individual cannot contest a 3520 penalty, at least not under a reasonable cause standard. 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 under a de novo standard. See IRC Section 6330(c)(2)(B).
The most common defense for challenging the existence or amount of a 3520 penalty is probably whether or not the individual assessed the penalty acted with reasonable cause. Although reasonable cause may be the most common defense to a 3520 penalty, it may not always be the best defense to the penalty. An individual can also challenge a 3520 penalty under Section 6751 in a de novo proceeding. lesser known but probably more important defense than reasonable cause
Section 6751 of the Internal Revenue Code requires the IRS to follow two procedural requirements when imposing penalties against taxpayers. First, an individual must receive notice of the penalty and how that penalty is computed. In 3520 penalty cases. This requirement is usually easily satisfied in a 3520 penalty case. Second, the “initial determination” to assess a penalty must be approved “in writing” by the “immediate supervisor” or an “approved higher official.” According to Internal Revenue Code Section 6751(b), all penalties (with the exception of Section 6651, 6654, and 6655 penalties) must comply with certain procedural requirements. They also include “any other penalty automatically calculated through electronic means.” See IRC Section 6751(b)(2)(B). According to the IRS, this means “no Service human employee makes an independent judgment with respect to the applicability of the penalty.” See IRM 18.104.22.168.3(5). Essentially, if a computer makes the determination, then the supervisory approval probably is not required. However, where any judgment regarding the applicability of the penalty exists, Section 6751 must be satisfied. See Journal of Tax Practice & Procedure, Spring 2021, Questioning IRS Approval of Penalties Under Code Sec. 6751, by Joshua D. Smeltzer. This is the case even for penalties the IRS for many years has argued are not actually penalties but instead are taxes.
For example, under Internal Revenue Code Section 6672, a 100 percent penalty (equal to the amount of the tax that should have been withheld and paid to the IRS) is imposed on a person responsible for willfully failing to collect and pay over the withholding taxes. Because the penalty is assessed to reimburse the government for lost withholding tax revenues, and not more, the IRS has argued that it is “essentially” a tax. In Chadwick v. Commissioner, 154 T.C. 84 (2020), decided that “from the person sanctioned” a Section 6672 liability are “penalties” under the Internal Revenue Code and “in the ordinary sense of the word.” The Tax Court also determined that, as a penalty, Section 6672 was subject to the statutory requirements of Section 6751(b). Under this broad interpretation of a penalty , unless a statutory exception exists, all penalties found in the Internal Revenue Code are subject to the requirements of Section 6751. This includes 3520 penalties.
Consequently, if the IRS failed to comply with Section 6751 when assessing a 3520 penalty, the penalty can be successfully challenged in a Tax Court de novo proceeding. Given the fact that most 3520 penalties were not assessed in a traditional audit, the IRS may not have adequately complied with provisions of Section 6751. Anyone considering this defense should make a proper request for their administrative file under the Freedom of Information Act (“FOIA”) to determine if the statutory requirements of Section 6751 were met.
b. Tax Court Jurisdiction based on an Abuse of Discretion Standard
Even if an individual cannot challenge a 3520 penalty under de novo standard, does not mean all avenues to prepayment litigation are foreclosed. An individual can potentially attack a 3520 penalty under an abuse of discretion theory. 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 the 3520 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 through a FOIA. 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 a 3520 penalty should begin preparing right after the penalty is assessed. Preparation should include investigating any possible defenses to the 3520 penalty and obtaining their administrative file from the IRS. Finally, anyone considering contesting a 3520 penalty must seriously consider the pros and cons of requesting any administrative appeal other than a Collection Due Process Hearing.
Anthony Diosdi is tax 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. As a tax attorney, Anthony Diosdi regularly represents clients in 3520 penalty disputes. The tax attorneys at Diosdi Ching & Liu, LLP advise and represent clients throughout the United States, Asia, Europe, Australia, Canada, and South America. Anthony Diosdi may be reached at (415) 318-3990 or by email: email@example.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.