The Internal Revenue Service has instituted a new program aimed at examining the failure to file somewhat esoteric information-reporting tax forms related to a U.S. person's transactions with foreign trusts. A U.S. taxpayer faced with this particular examination risks the imposition of massive penalties, which can be as much as 100 percent of the value of the transaction not timely reported, even if there is no unreported income attributable to the transaction.
The program, Forms 3520/3520-A Non-Compliance and Campus Assessed Penalties, is conducted by the Withholding & International Individual Compliance IRS practice area. The so-called campaign will take a "multifaceted approach" to improving compliance with respect to the timely and accurate filing of information returns reporting ownership of and transactions with foreign trusts. The IRS will address noncompliance through a variety of "treatment streams" including, but not limited to, examinations and penalties when the forms are received late or are incomplete.
Form 3520, Annual Return to Report Transactions with Foreign Trusts and Receipts of Certain Foreign Gifts, must be filed by U.S. persons who engage in transactions with foreign trusts. Form 3520-A, Annual Information Return of Foreign Trust with a U.S. Owner, must be filed annually by the U.S. person who is treated as the owner of a foreign trust. Both forms are informational only and do not report tax liability. Nevertheless, the failure to file one or the other carry with it substantial penalties, often perceived as substantially disproportionate to the taxpayer behavior being penalized. See discussion below under "The Penalties."
The IRS Letter
The IRS will inform a U.S. person of its belief that the person had a filing requirement by issuing a letter stating in part that the person may have been required to file a variety of forms including Forms 3520 and/or 3520-A. The IRS letter goes on to explain the filing requirements with respect to these and other forms and closes with: "Failure to timely file a complete and accurate return could result in penalties."
If a form is not timely filed or is incomplete, the penalties are as follows:
Generally, the initial penalty is equal to the greater of $10,000 or the following (as applicable):
- 35 percent of the gross value of any property transferred to a foreign trust by a U.S. person
- 35 percent of the gross value of the distributions received from a foreign trust by a U.S. person
- 5 percent of the gross value of the portion of the foreign trust's assets treated as owned by a U.S. person under the grantor trust rules
- An additional separate 5 percent penalty (or $10,000 if greater), if the U.S. person:
(a) Fails to ensure that the foreign trust files a timely Form 3520-A and furnishes the required annual statements to its U.S. owners and U.S. beneficiaries, or
(b) Does not furnish all of the information required by section 6048(b) or includes incorrect information.
The U.S. owner of a foreign trust is subject to an initial penalty equal to the greater of $10,000 or 5 percent of the gross value of the portion of the trust's assets treated as being owned by the U.S. person at the close of that tax year if the foreign trust (a) fails to file a timely Form 3520-A or (b) does not furnish all of the information required by section 6048(b) or includes incorrect information.
The U.S. owner is subject to an additional separate penalty equal to the greater of $10,000 or 5 percent of the gross value of the portion of the trust's assets treated as owned by the U.S. person at the close of that tax year if the U.S. owner (a) fails to file a timely Form 3520 (Part II) or (b) fails to furnish all of the information required by section 6048(b) or includes incorrect information. See section 6677(a) through (c) and the Instructions for Form 3520.
Additional penalties ($10,000 every 30 days until the gross reportable amount is reached) will be imposed if the noncompliance (failure to file Forms 3520/3520-A) continues for more than 90 days after the IRS mails a notice of failure to comply with the required reporting.
What to Do
First, do not ignore the IRS letter. Have your situation reviewed by a qualified tax professional who is experienced in these issues.
Second, the Forms 3520/3520-A filing requirements are very complex. So much so that there are instances where the IRS itself has incorrectly imposed these massive penalties. If the IRS cannot get it right, why should a layperson be expected to know about these forms? Fortunately, the penalties may be avoided or abated if the U.S. person can show that the failure to file the forms was due to "reasonable cause." Establishing reasonable cause is often not an easy task and requires professional assistance.
Finally, understand that this process of determining whether filing was required and, if it was, whether penalties are or are not applicable takes time. It may be a two-year (or more) ordeal to achieve a resolution, likely at the IRS Office of Appeals.
For More Information
If you have any questions, please contact Thomas W. Ostrander, the author of this Alert; Hope P. Krebs in Philadelphia; Jon Grouf in New York; Anthony D. Martin in Boston; William D. Rohrer or Jennifer Migliori in Miami; any of the attorneys in our Tax Group; Michael A. Gillen of the Tax Accounting Group; or the attorney in the firm with whom you are regularly in contact.
Disclaimer: This Alert has been prepared and published for informational purposes only and is not offered, nor should be construed, as legal advice. For more information, please see the firm's full disclaimer.