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 file IRS Form 3520 and/or Form 3520-A or incorrectly filing one of these returns can be substantial. The Form 3520 and Form 3520-A (collectively known as 3520 penalties) are 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 a Form 3520 and Form 3520-A is incredibly complicated or many taxpayers do not know they are required to file one of these forms has not deterred the IRS from aggressively penalizing taxpayers who do not correctly file a Form 3520 or 3520-A or file one of these forms late. As a matter of fact, the IRS has recently announced that it would automatically assess penalties against anyone who filed a Form 3520 or 3520-A late- regardless of the reason. These penalties are no joke. They can easily be in the hundreds of thousands of dollars. Many tax practitioners have grown comfortable with sending the IRS a letter stating that a 3520 penalty should be forgiven because reasonable cause can be demonstrated. These penalties are usually only forgiven or abated when a practitioner or individual assessed 3520 penalties can best marsal facts and make a persuasive argument for leniency. The problem is there is a dearth of causes applying the reasonable cause defense to a 3520 penalty. As a result, the IRS has not been overly generous in forgiving 3520 penalties through reasonable cause defenses.
The main problem with the reasonable cause defense is that the focus is typically on the actions of the individual assessing the penalty rather than the IRS procedures in assessing the penalty. With that said, recent litigation of Internal Revenue Code Section 6751 penalty procedures has scrutinized IRS procedures for assessing penalties. This may provide an opportunity to individuals who have been assessed a 3520 penalty to contest the penalty on technical grounds.
Utilizing Internal Revenue Code Section 6751 to Contest a Section 3520 Penalty
Internal Revenue Code Section 6751 requires the IRS to follow two procedural requirements when assessing monetary penalties against taxpayers. First, a taxpayer must receive notice of the penalty and how the penalty is computed. In the ase of 3520 penalties, this requirement is usually satisfied by the IRS when a taxpayer receives a notice of assessment. Second, the “initial determination” to assess the penalty must be approved “in writing” by the “immediate supervisor” or an approved higher official. If either of these two requirements are not met in assessing a penalty, the penalty must be removed. It is this second requirement of Section 6751 that has resulted in recent litigation.
Internal Revenue Code Section 6751(b) provides that all penalties assessed by the IRS must comply with the procedural requirements unless they meet the specified exceptions listed. These specific exceptions include failure to file and failure to pay penalties as well as failure to make estimated tax payments. It also includes “any other penalty automatically calculated through electronic means.” According to the IRS Internal Revenue Manual, the requirements of Section 6751 do not apply if“no Service human employee makes an independent judgment with respect to the applicability of the penalty.” See IRM 20.1.1.2.3(5).
Where there is any judgment regarding the applicability of whether or not a penalty exists, Section 6751(b)(1) must be satisfied. This is the case even for penalties the IRS has taken the position are not actually penalties. For example, the IRS has long argued that, despite the designation as penalties in the statute, liability under Section 6672 of the Internal Revenue Code are actually taxes. See Questioning IRS Approval of Penalties Under Code Sec. 6751, Journal of Tax Practice & Procedure, Spring 2021, Joshua D. Smeltzer. Under Section 6672, money deducted from the employee’s wages is held in trust and paid to the IRS in quarterly payments on the employee’s behalf. This arrangement shifts liability for the failure to remit these taxes from the employee to the employer to protect the IRS from revenue losses. Because the liability is reimbursing the IRS for lost withholding tax revenues, and not more, the IRS has argued that it is “essentially” a tax. The courts have accepted this argument in several cases; however, the Tax Court disagreed for purposes of Section 6751.
In Chadwick v. Commissioner, 154 TC 84 (2020) the United States Tax Court found that “from the person sanctioned” these are “penalties” as stated in the Internal Revenue Code and “in the ordinary sense of the word.” The Tax Court decided that, as a penalty, it was subject to the requirements of Section 6751(b) requiring written approval of the immediate supervisor at the time of the initial determination. Consequently, this broad interpretation of penalties appears to indicate that, unless this exception clearly applies, all penalties will need to meet the requirements of Section 6751. This includes 3520 penalties.
This raises the question of how an individual assessed a 3520 penalty can obtain information and evidence regarding managerial approval of a 3520 penalty. The best way for an individual assessed a 3520 penalty to obtain this information is to file a request for documentation related to the assessment of the 3520 penalty under a procedure known as the Freedom of Information Act (“FOIA”). In the late 1960s and throughout the 1970s, Congress passed a number of Acts aimed at increasing the openness with which federal agencies such as the IRS carried out their regulatory responsibilities. The most important of these was FOIA. It and its subsequent amendments, establish a liberal disclosure policy regarding public access to information obtained, generated and held by the government. “Any person” is entitled to request and receive identifiable records held by a federal agency, unless the records in question fall within one of the Act’s nine exemptions. See 5 U.S.C.A. Section 552(a)(3). Disclosure is the norm. A requester’s motives or relation to the information she seeks to acquire are irrelevant. A federal agency’s refusal to disclose requested information is subject to de novo judicial review and the government has the burden of proving that the information it seeks to withhold is, in fact, exempt from disclosure. See 5 U.S.C.A. Section 552(a)(4)(B).
A taxpayer assessed a 3520 penalty should request his or her administrative file from the IRS through a FOIA right after receiving the notice of the penalty. The IRS has delegated the duty of assessing 3520 penalties to Ogden, Utah. It is unclear if an actual IRS human employee is making an independent judgment with respect to these penalties and if an IRS “immediate supervisor” or “approved higher official” is approving the assessment of 3520 penalties. This is why obtaining the IRS administrative record for the individual assessed the 3520 penalty is so important. If the IRS administrative record does not provide evidence of “immediate supervisor” or “approved higher official” approval, the IRS might be convinced to concede the 3520 penalty. If the IRS refuses to concede a 3520 penalty even after being provided evidence that the penalty was not legally authorized, the individual may have other procedural options to contest the 3520 penalty such as litigation.
Can a 3520 Penalty Assessment be Attacked on Due Process Grounds?
In certain cases, 3520 penalties may also be attacked on Due Process grounds. In order to argue that the IRS violated the Due Process Clause of the United States Constitution, it must be established that the IRS acted arbitrarily or capriciously or in abuse of its discretion in assessing the penalty. To determine if the IRS acted arbitrarily or capriciously or in abuse of its discretion, a review of the administrative record should be made. If the administrative record is devoid of any explanation of the IRS’s reasons for imposing a maximum 3520 penalty, the IRS may have acted arbitrarily or capriciously or in abuse of its discretion in assessing the penalty.
At this point, very few know the procedure the IRS is using to assess 3520 penalties. One thing is certain, the IRS is assessing 3520 penalties in mass. It appears that the IRS is automatically assessing 3520 penalties on anyone who files a late Form 3520 or 3520-A. Under this standard, other than the receipt of a late filed 3520, it is unlikely that the IRS administrative record of those who have been assessed a 3520 penalty will provide any explanation of the ultimate decision to impose a 3520 penalty. In appropriate cases, the lack of an explanation for the assessment of a 3520 penalty may result in a finding that the IRS’s actions were arbitrary and capricious.
Conclusion
If you have been assessed a 3520 penalty, it is extremely important to review all correspondences from the IRS to determine your appeal rights and the deadlines to appeal this penalty. A copy of your administrative file must be obtained from the IRS through a FOIA right after you receive notice of the 3520 penalty. Contesting a 3520 penalty requires a detailed understanding of the tax law, administrative law, international tax law, and tax litigation. If you are assessed a 3520 penalty, you must carefully select a tax lawyer to represent you. We have substantial experience in 3520 penalty defense.
Anthony Diosdi is one of several tax attorneys and international tax attorneys at Diosdi Ching & Liu, LLP. As a domestic tax attorney 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 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.