By Anthony Diosdi
Some tax professionals believe that international penalties such as penalties associated with the late filing of Internal Revenue Service or IRS Form 5471, Form 5472, or Form 3520 can be abated or removed through an administrative procedure often referred to as “first-time penalty abatement program.” Requests for relief of a penalty may be made in writing or by calling directly at 1-866-860-4259. This article discusses if it is possible to abate or request a refund of an international penalty through the first-time penalty abatement program.
What Are Form 5471, Form 5472, and Form 3520 Penalties?
Chapter 61 of the Internal Revenue Code contains countless reporting requirements regarding foreign information filing obligations. Many of the sections under Chapter 61 impose significant penalties for the failure to comply with the reporting requirements. The more well known reporting requirements and penalties are found in Chapter 61 and are as follows:
The Internal Revenue Code requires certain persons to provide the Internal Revenue Service or IRS with information regarding foreign corporations. This information is typically provided on Form 5471, Information Return of U.S. Persons With Respect to Certain Foreign Corporations. The Form 5471 and schedules are used to satisfy the reporting requirements of Internal Revenue Code Section 6038 and 6046 along with the applicable regulations. Substantively, Form 5471 backstops various international provisions of the Internal Revenue Code such as Sections 901/904 (Foreign Tax Credit), Section 951(a) (Subpart F and Section 956), Section 951A (GILTI), Section 965 (transition Tax), Section 163(j) (interest deduction limitation), and Section 482 (transfer pricing). International information returns that often are associated with Form 5471s include Form 926 (Return by a U.S. Transferor of Property to a Foreign Corporation), Form 5713 (International Boycott Report), Form 8621 (PFIC), Form 8990 (Limitation on Business Interest Expense), and Forms 1116/1118 (Foreign Tax Credit).
In the Form 5471, at a minimum, the reporting agent must provide the following information regarding a foreign corporation:
i) Stock ownership, including current year acquisition and dispositions,
ii) The names of U.S. shareholders,
iii) GAAP income statement and balance sheet,
iv) An accounting of foreign taxes accrued and paid,
v) Current and accumulated earnings and profits, including any actual dividend distributions during the corporation’s taxable year,
vi) An accounting of each U.S. shareholder’s pro rata share of GILTI and Subpart F income, and
vii) Disclosure of any transactions between the foreign corporation and its shareholders or related persons.
The Form 5471 is ordinarily attached to a U.S. person’s federal income tax return.
The penalty for failure to file, or for delinquent, incomplete or materially incorrect filing is a reduction of foreign tax credits by ten percent and a penalty of $10,000, as well as a reduction in the taxpayer’s foreign tax credit. An additional $10,000 continuation penalty may be assessed for each 30 day period that noncompliance continues up to $60,000 per return, per year.
Similarly, Internal Revenue Code Section 6038A requires 25 percent foreign-owned domestic corporations and limited liability companies to report specified information as an attachment to a corporate tax return. This is done on Form 5471, Information Return of a 25% Foreign-Owned U.S. Corporation or a Foreign Corporation Engaged in a U.S. Trade or Business. In filing a Form 5472, the filer must provide information regarding its foreign shareholders, certain other related parties, and the dollar amounts of transactions that it entered into during the taxable year with foreign related parties. A separate Form 5472 is filed for each foreign or domestic related party with which the reporting entity engaged in reportable transactions during the year. The practical importance of the Form 5472 is that the IRS often uses this form as a starting point for beginning transfer pricing audits. Any reporting corporation or limited liability company that fails to file Form 5472 may be subject to a penalty of $25,000. If the failure continues for more than 90 days after notification by the IRS, there is an additional penalty of $25,000 for each 30 day period or fraction. There is no upper limit on this penalty.
Another well known provision in Chapter 61 is Section 6039F. Section 1905 of the 1996 Tax Act created new reporting requirements under Section 6039F for U.S. persons (other than certain exempt organizations) that receive large gifts (including bequests) from foreign persons. The information reporting provisions require U.S. donees to provide information concerning the receipt of large amounts that the donees treat as foreign gifts, giving the IRS an opportunity to review the characterization of these payments and determine whether they are properly treated as gifts. Donees are currently required to report certain information about such foreign gifts on Part IV of Form 3520.
Section 6039F(b) generally defines the term foreign gift as any amount received from a person other than a U.S. person that the recipient treats as a gift or bequest. However, a foreign gift does not include a qualified transfer (within the meaning of Section 2503(e)(2)) or any distribution from a foreign trust. A distribution from a foreign trust must be reported as a distribution under Section 6048(c)(discussed below) and not as a gift under Section 6039F.
Section 6039F(c) provides that if a U.S. person fails, without reasonable cause, to report a foreign gift as required by Section 6039F, then (i) the tax consequences of the receipt of the gift will be determined by the Secretary and ii) the U.S. person will be subject to a penalty equal to 5 percent of the amount for the gift for each month the failure to report the foreign gift continues, with the total penalty not to exceed 25 percent of such amount. Under Sections 6039F(a) and (b), reporting is required for aggregate foreign gifts in excess of $100,000 during a taxable year. Once the $100,000 threshold has been met, the U.S. donee is required to file a Form 3520 with the IRS.
Originally, penalties associated with Form 5471, Form 5472, and Form 3520 (hereinafter “international penalties”) were assessed manually on individuals and entities whose missing filings were discovered during an audit. The IRS is still assessing international penalties during audits. Several years ago the IRS began a systemic assessment of international penalties associated with the late filing of these returns. The systemic assessment of international penalties is controversial. Many taxpayers are unaware of their international reporting obligations and learn of their filing obligations after the due date of the filing obligation has already passed. Many of these same taxpayers often try to comply with their international filing obligations by filing an international informational return (i.e. Form 5471, Form 5472, and Form 3520) late. The IRS typically rewards these same taxpayers “trying to do the right thing” by automatically assessing international penalties against them. These penalties can range from a minimum of $10,000 to several million dollars. The policy of automatically assessing international penalties discourages compliance.
First Time Penalty Abatement Administrative Program
A number of tax professionals tout the first time penalty policy that is supposedly offered by the IRS. A request for a penalty abatement under the first time penalty abatement policy is often requested by phone. The IRS’s first time abatement policy provides an avenue for penalty relief if the following criteria are met:
1) The individual assessed the penalty has not been required to file the same return, or no tax modules for the same return are delinquent, for the three years preceding the penalized tax period;
2) If required to file the same return during the preceding three years, there are no unreversed penalties (except an estimated tax penalty) or penalties manually suppressed or reversed using the first time penalty abatement procedure or tolerance criteria;
3) The individual assessed the penalty has paid, or arranged to pay, any tax currently. See IRM 20.1.1.3.3.2.1 (10/19/20), First Time Abate (FTA).
The first time penalty abatement procedure is generally automatic.
However, the policy provides an opportunity to abate a very limited number of penalties. According to the IRS’s website, the first time abatement policy or procedure is limited to the following penalties:
Failure to file returns when the penalty assessed by the IRS relates to individual tax returns under Section 6651(a)(1), partnership returns under Section 6698(a)(1), S corporate returns under Section 6699(a)(1), or a failure to make a deposit under Section 6656. Penalties assessed under Sections 6038A and 6039F for failure to timely file Forms 5471, 5472, and 3520 are notably absent from the list of penalties that qualify for first time abatement relief.
As a general matter, the first time penalty abatement procedures do not apply to event-based filing requirements, such as a Form 5471, Form 5472, or Form 3520. In other words, penalties associated with the late filing of Forms 5471, 5472, and 3520 do not qualify for relief under the first time penalty relief procedures. With that said, an argument can be made that the IRS Internal Revenue Manual or IRM provides the authority to remove international penalties through the first time penalty abatement procedures under reasonable cause. That is, if the following criteria are met:
1) The failure-to-file penalty on the related tax return was not assessed as a result of an outstanding tax liability.
2) The individual assessed the penalty had no similar penalties in the three prior periods; and
3) There were no late filing penalties assessed in the three prior periods. See IRM Section 20.1.9.5.5 (1/29/21), Reasonable Cause.
The problem is even if one satisfies these elements, the IRS is under no duty to remove an international penalty. In other words, a request for first time penalty relief of an international penalty may amount to nothing more than a waste of time and in some cases, the waste of client’s money. Obviously, in most cases, there is no harm in calling the IRS and asking for relief from an international penalty through the first time abatement policy over the phone. A limited number of taxpayers or their representatives may even “get lucky” and have a penalty abated or removed. However, most requests through the first time abatement policy will probably be denied. In other cases, taxpayers or their representatives may be told over the phone that their request to abate an international penalty has been granted only to find out later the penalty was never removed. This can be extremely frustrating for both the individual requesting relief and their representatives.
Anyone considering calling the IRS and requesting relief under the first time abatement policy should understand that this merely a policy created by the IRS within its Internal Revenue Manual and as a result, it does not grant taxpayers any legal rights.
Thus, if the IRS fails to remove a penalty under the first time abatement policy, legally speaking, there is little if anything that can be done. If a decision is made to request an abatement of an international penalty through the first time abatement policy over phone, a proper written request to remove an international penalty should also always be sent to the IRS. If done correctly, this will not only greatly increase the probability that the penalty will actually be removed, it will also protect one’s rights to contest the penalty under the statute of limitations.
We have substantial experience advising clients ranging from small entrepreneurs to major multinational corporations in foreign tax planning and compliance. We have also provided assistance to many accounting and law firms (both large and small) in all areas of international taxation.
Anthony Diosdi is one of several tax attorneys and international tax attorneys at Diosdi Ching & Liu, LLP. Anthony focuses his practice on domestic and international tax planning for multinational companies, closely held businesses, and individuals. Anthony has written numerous articles on international tax planning and frequently provides continuing educational programs to other tax professionals.
He has assisted companies with a number of international tax issues, including Subpart F, GILTI, and FDII planning, foreign tax credit planning, and tax-efficient cash repatriation strategies. Anthony also regularly advises foreign individuals on tax efficient mechanisms for doing business in the United States, investing in U.S. real estate, and pre-immigration planning. Anthony is a member of the California and Florida bars. He can be reached at 415-318-3990 or adiosdi@sftaxcounsel.com.