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.
Originally, 3520 and 3520-A penalties (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. However, recently, the IRS began a systemic assessment of international penalties associated with the late filing of a Form 3520 (or Form 3520-A). International penalties 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.
Reasonable Cause Defense
It is common for taxpayers who have been assessed an international penalty to send the IRS a protest letter claiming they acted with “reasonable cause” and request the removal of the penalty. This is easier said than done. In order to obtain an abatement or removal of an international penalty, the individual assessed an international penalty must establish he or she acted with “reasonable cause.” Whether an individual or entity acted with “reasonable cause” is a question of fact. See Treas. Reg. Section 301.6651-1(c)(1). For example, reliance on a professional tax return preparer (such as a CPA or attorney) as to whether or not to file a Form 3520 should constitute “reasonable cause” for purposes of removing an international penalty.
Thus, in theory, if an individual assessed a 3520 penalty can show that he or she exercised reasonable cause, a 3520 penalty should not be assessed. The problem is for purposes of abating or removing an international penalty, the IRS has recently taken a very narrow view as to what constitutes “reasonable cause.” It is extremely difficult to convince the IRS to remove an international penalty on reasonable cause grounds.
Does the IRS Have the Authority to Assess and Collect an International Penalty?
If a taxpayer disagrees with an international penalty assessment, he or she has the option to pay the international penalty in full, file an administrative refund claim, 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 often easier said than done. In many cases, individuals assessed an international penalty do not have the financial ability to fully pay the penalty. In addition, there is a great deal of uncertainty if the federal courts will more generously apply the “reasonable cause” standard than the IRS for purposes of removing an international penalty.
Fortunately, individuals or entities that have been assessed international penalties may have another option to contest international penalties. That is, in the view of the National Taxpayer Advocate and others, international penalties are not the type that may be systematically assessed by the IRS. To better understand this argument, we will need to take a deeper dive into how the IRS is permitted to assess penalties under the Internal Revenue Code.
The authority to summarily assess a penalty related to international penalties is found in Chapter 68, Subchapter B, of the Internal Revenue Code titled “Assessable Penalties.” Chapter 68 permits the IRS to assess and collect penalties “in the same manner as taxes” without first sending a notice of deficiency to an individual or business assessed a penalty. See IRC Section 6671(a). According to Chapter 68 of the Internal Revenue Code, summary assessments are made without a deficiency determination and “shall be paid upon notice and demand…and collected in the same manner as taxes.” Chapter 68, Subchapter A of the Internal Revenue Code permits the IRS to assess penalties for the failure to file or pay tax, understatements or underpayments of tax, and assess civil fraud penalties. However, in the view of the National Taxpayer Advocate, penalties associated with international information returns (such as Forms 3520 and 3520-A) are not located in Chapter 68 of the Internal Revenue Code and therefore cannot be assessed and collected by the IRS. See The IRS’s Assessment of International Penalties Under IRC Sections 6038 and 6038A Is Not Supported by Statute, and Systemic Assessments Burden Both Taxpayers and the IRS Taxpayer Advocate Service- 2020 Annual Report to Congress. Since assessment of international penalties are not authorized in Chapter 68 of the Internal Revenue Code, the IRS is not authorized to assess and collect international penalties. If Congress wanted the IRS to have the ability to assess and collect international penalties it certainly would have authorized the IRS to do so in the Internal Revenue Code. But this is not the case.
A number of highly respected legal commentators have questioned the IRS’s assessment and collection of international penalties. For example, on July 9, 2018, Tax Notes, published an article by Erin Collins and Garrett Hahn. See Collins and Hahn, “Foreign Information Reporting Penalties: Assessable or Not?” Tax Notes, July 9, 2018, p. 211. In their view, the IRS does not have the authority to collect international penalties discussed in Internal Revenue Code Sections 6038 and 6038A. The only way that the IRS can collect a foreign information reporting penalty is by authorizing the United States Department of Justice to sue an individual or entity to collect the penalty in a district court. Collins and Han also raise the possibility that the ten year assessment period is legally dubious and subject to challenge.
In November 2018, Frank Agostino and Phillip J. Colasanto published an article suggesting that international penalties should be subject to the deficiency procedures. See Agostino and Colasanto, “The International Information Reporting Penalties: Is the IRS’s Failure to Embrace a One-Stop Shopping Paradigm Inefficient and Statutorily Deficient? Agostino & Associates (Nov. 2018). On January 31, 2019, Tax Notes published an article by Robert Horwitz arguing that the IRS that international penalties are not a tax and are not therefore collected in the same way as a tax. Thus, the IRS is not authorized to assess international penalties and the IRS cannot file tax liens or collect them through a levy. See Robert Horwitz, Can the IRS Assess or Collect Information Reporting Penalties? Tax Notes Today (Jan. 31, 2019) 301-305.
Although each of these legal commentators follow slightly different analytical paths, they all arrive at the same conclusion- the IRS lacks the legal authority to assess and collect most if not all international penalties. See The IRS’s Assessment of International Penalties Under IRC Sections 6038 and 6038A Is Not Supported by Statute, and Systemic Assessments Burden Both Taxpayers and the IRS Taxpayer Advocate Service- 2020 Annual Report to Congress. “ To sum it up, the argument is very simple to these types of penalties, “if it ain’t in the [Internal Revenue Code], it doesn’t exist.” Consequently, it appears that the IRS has been illegally using its collection powers for quite some time to automatically assess a penalty that has not been granted to it by the Internal Revenue Code. See Information Return Penalty Assessment Fight Coming to a Head, Tax Notes, November 28, 2022. The fact that the IRS has been illegally using its powers to assess and collect international penalties provides taxpayers assessed these penalties a very real possibility to challenge these assessments.
Unfortunately, challenging the IRS’s legal authority to assess an international penalty cannot be done through a simple protest letter. Taxpayers facing an international penalty will probably need to litigate these penalties in court. In some cases, this may impose an unreasonable burden on taxpayers. The only “good news” – if you want to call it good news- is that in many cases taxpayers assessed an international penalty will not need to pay the penalty in full before challenging the IRS’s legal authority to contest the penalty.
The IRS has recently begun to automatically assess penalties associated with not timely filing a Form 3520 and/or Form 3520-A. These penalties are stiff and can range from a few thousand dollars to several million dollars. For many, paying these penalties is not an option. In certain cases, individuals and entities can attempt to challenge the IRS’s legal authority to assess international penalties in a federal court. Anyone considering petitioning a federal 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 penalty.
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 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.
By Anthony Diosdi