The Failure-to-File Form 3520 and 3520A Penalty Assessment

Failure-to-File Form 3520 and 3520-A Penalties

At the end of February 2023, there was a very important tax ruling in the US tax court in the case of Fairbank, which we have summarized here and here. The reason why this case is so important for US taxpayers who have foreign trusts and gifts to report is that the penalties for failing to report foreign trusts can be staggering. In addition, the Faribank court also held that if a taxpayer fails to file the proper international tax form – for example, files Form 5471 instead of Form 3520 – they can be on the hook for extensive fines and penalties despite the fact that they initially thought they timely filed the form they believed they were required to report. Moreover, in accordance with 26 USC 6501(c)(8), the statute of limitation does not begin to run if the form is not filed. This is the case, even in a situation in which the tax return was filed timely but the international reporting form was not.  A few years back, the Internal Revenue Service produced a practice unit guide involving Form 3520 and 3520-A on matters involving trusts. Let’s revisit that practice unit for a moment.

Here are key excerpts from the Practice Guide

Form 3520 Statute of Limitations

• • • “The statute of limitations for assessing IRC §6677(a) and IRC §6677(b) penalties ends three years after a complete and accurate Form 3520 and/or 3520-A is filed.”

Form 3520 Penalty Structure

• • • • “If Form 3520 is not filed on or before the due date (including extensions) of the USP’s income tax return or the Form 3520-A is not filed on or before the 15th day of the 3rd month after the end of trust’s year (including extensions), or if the applicable form does not include all the information required or includes incorrect information, then Initial and Continuation Penalties may be applicable as follows:

    • Initial Penalty for filings due before 01/01/2010

      • • • Form 3520-A = 5% of Gross Reportable amount

          • Form 3520 = 35% of Gross Reportable amount (for Parts I and III)

• • • Initial Penalty for filings due after 12/31/2009

      • • • Form 3520 = Greater of $10,000 or 35% of Gross Reportable amount (for Parts I and III)

          • Form 3520 = Greater of $10,000 or 5% of Gross Reportable amount (for Part II)

          • Form 3520-A = Greater of $10,000 or 5% of Gross Reportable amount

• • • Continuation Penalty (applicable to tax years after December 31, 1995)

      • • • $10,000 every 30 days (or fraction thereof), starting 90 days after notice.

          • Max penalty is the reportable amount (if known).

    • After 12/31/2009, if penalty amount collected exceeds the gross reportable amount, the excess must be refunded

      • • • Continuation penalty computation is same for Form 3520 and Form 3520-A. Note: An Initial Penalty can be asserted by the examiner without advance notification, however, it is best for examiners inform the taxpayer prior to assessing the penalty.”

Reasonable Cause Exception

• • • No penalty shall be imposed under IRC §6677 for any failure which is shown to be due to reasonable cause and not due to willful neglect. The fact that a foreign jurisdiction would impose a civil or criminal penalty on the taxpayer (or any other person) for disclosing the required information is not reasonable cause.

    • As previously discussed, there are two different penalties: the Initial Penalty and the Continuation Penalty. While both penalties are described within IRC §6677(a), two different sets of facts for a reasonable cause argument should be considered when considering these penalty cases. While one set of facts will apply to the Initial Penalty, separate facts may apply to Continuation Penalty as it can only be assessed 90 days after the Notice Letter. The taxpayer’s actions subsequent to receiving notice should be carefully considered in determining the applicability of Continuation Penalties.

    •  Once it is determined the taxpayer is in full compliance for all open years, consider any reasonable cause statements provided by the taxpayer. These statements must be in writing. These statements should be evaluated in conjunction with the guidelines, principles relating to reasonable cause based on the facts and circumstances. Reasonable cause statements provided by the taxpayer must include a declaration, “Under penalties of perjury, I declare…..” See page 4 of Letter 3804 for the required language.

    • If a representative prepares and signs the statement, Form 3804 contains substitute language the representative must include on the statement. See page 4 of Letter 3804 for the required language.

Form 3520/3520-A  Statute of Limitations for Penalty Assessment Can be Extended

Regarding the code sections and IRS forms identified above, if the taxpayer does not file the form, the three-year statute of limitations does not begin to run. This may result in a Taxpayer being severely penalized several years after the statute limitations would have already expired for a timely filed return – if the return had been filed by the taxpayer. Noting, if the taxpayers are able to show reasonable cause and not willful neglect, they may be able to avoid penalties.

Fairbank Case

In the recent tax court case of Fairbank, Section 6501(c)(8) was front and center on the issue of the statute of limitations for filing Form 3520/3520-A for an entity in which another international reporting form was already filed.

Let’s take a look at how the court ruled:

• • • “Now we turn to section 6048(b) and (c) to determine the statutory reporting obligations of Mrs. Fairbank as the United States owner and beneficiary of Xavana Establishment and whether petitioners have furnished the information required to be reported under that section. Section 6048(b), entitled “United States Owner of foreign trust,” provides that each United States person treated as the owner of any portion of a foreign trust shall be responsible to ensure that (A) the trust makes a return for the year which sets forth a full and complete accounting of all trust activities and operations for the year, the name of the United States agent for such trust, and such other information as the Secretary may prescribe and (B) the trust furnishes such information as the Secretary may prescribe to each United States person (i) who is treated as the owner of any portion of the trust or (ii) who [*23] 24 [*24] receives (directly or indirectly) any distribution from the trust. I.R.C. § 6048(b)(1).

    • Section 6048(c), entitled “Reporting by United States beneficiaries of foreign trusts,” provides that any United States person who receives (directly or indirectly) during any taxable year of the person any distribution from a foreign trust shall make a return with respect to that trust for the year which includes (A) the name of the trust, (B) the aggregate amount of the distributions so received from the trust during the taxable year, and (C) the other information as the Secretary may prescribe. I.R.C. § 6048(c)(1). Petitioners’ citation of section 6501(c)(8) and their argument on brief that the period of limitations has run is incomplete.31 Section 6501(c)(8) refers the reader to the requirements under section 6048; therefore, a detailed analysis of a taxpayer’s statutory obligations under section 6048 is necessary.

    • We conclude that Mrs. Fairbank, as the deemed U.S. owner of Xavana Establishment, has failed to provide any written return to respondent setting forth a full and complete accounting of Xavana Establishment’s activities for the years at issue. See I.R.C. § 6048(b)(1). Similarly, we conclude that Mrs. Fairbank, as Xavana Establishment’s U.S. beneficiary, has failed to make any return that includes the name Xavana Establishment and which outlines the aggregate amount of distributions she received during each of the tax years at issue from Xavana Establishment. See I.R.C. § 6048(c)(1).

    • Finding that petitioners have not complied with section 6048(b) and (c), we similarly find that the period of limitations has not expired under section 6501(c)(8). Our conclusion is consistent with those of other courts that have considered this issue. See Rost, 44 F.4th at 298; Wilson, 6 F.4th at 434. Accordingly, we are constrained to conclude that the period of limitations has not expired for the tax years at issue since petitioners neither filed IRS Form 3520–A or Form 3520 nor satisfied their reporting obligations under section 6048, assuming those obligations could be satisfied without the filing of the forms prescribed by the IRS.32 Consequently, we find respondent’s notice of deficiency in this case was timely issued.”

Always Try to Show Reasonable Cause

Practitioners should keep in mind that the court made a specific note that taxpayers did not make a sufficient claim for reasonable cause. Thus, Taxpayers may have been able to avoid the penalties if they could show reasonable cause:

• • • “In a 2010 amendment to section 6501(c)(8), Congress added a reasonable cause exception for failure to furnish the information required under this section, effective for returns filed after March 18, 2010. Petitioners did not adequately raise the issue of reasonable cause for their failure to comply with the reporting obligations under section 6048.”

Current Year vs Prior Year Non-Compliance

Once a taxpayer missed the tax and reporting (such as FBAR and FATCA) requirements for prior years, they will want to be careful before submitting their information to the IRS in the current year. That is because they may risk making a quiet disclosure if they just begin filing forward in the current year and/or mass filing previous year forms without doing so under one of the approved IRS offshore submission procedures. Before filing prior untimely foreign reporting forms, taxpayers should consider speaking with a Board-Certified Tax Law Specialist that specializes exclusively in these types of offshore disclosure matters.

Avoid False Offshore Disclosure Submissions (Willful vs Non-Willful)

In recent years, the IRS has increased the level of scrutiny for certain streamlined procedure submissions. When a person is non-willful, they have an excellent chance of making a successful submission to Streamlined Procedures. If they are willful, they would submit to the IRS Voluntary Disclosure Program instead. But, if a willful Taxpayer submits an intentionally false narrative under the Streamlined Procedures (and gets caught), they may become subject to significant fines and penalties. 

Golding & Golding: About Our International Tax Law Firm

Golding & Golding specializes exclusively in international tax, specifically IRS offshore disclosure. 

Contact our firm today for assistance.

Current Year vs Prior Year Non-Compliance

Once a taxpayer missed the tax and reporting (such as FBAR and FATCA) requirements for prior years, they will want to be careful before submitting their information to the IRS in the current year. That is because they may risk making a quiet disclosure if they just begin filing forward in the current year and/or mass filing previous year forms without doing so under one of the approved IRS offshore submission procedures. Before filing prior untimely foreign reporting forms, taxpayers should consider speaking with a Board-Certified Tax Law Specialist that specializes exclusively in these types of offshore disclosure matters.

Avoid False Offshore Disclosure Submissions (Willful vs Non-Willful)

In recent years, the IRS has increased the level of scrutiny for certain streamlined procedure submissions. When a person is non-willful, they have an excellent chance of making a successful submission to Streamlined Procedures. If they are willful, they would submit to the IRS Voluntary Disclosure Program instead. But, if a willful Taxpayer submits an intentionally false narrative under the Streamlined Procedures (and gets caught), they may become subject to significant fines and penalties. 

Golding & Golding: About Our International Tax Law Firm

Golding & Golding specializes exclusively in international tax, specifically IRS offshore disclosure. 

Contact our firm today for assistance.