Today’s guest post is the first of a two-part series by Megan L. Brackney. These posts raise important questions about practitioners’ ethical responsibilities when confronting clients’ potential exposure to penalties for failing to file foreign information returns. Megan previously wrote a terrific series of posts considering problems with the IRS’s administration of these penalties, and in today and tomorrow’s posts Megan situates how these problems raise challenges for practitioners wanting to effectively and ethically represent their clients.
Megan is a partner at Kostelanetz LLP in New York who focuses her practice in civil and criminal tax controversies. She would like to thank Grace Hall for her assistance in researching this series. Grace was a paralegal in the D.C. office of the firm and is now attending the University of Virginia Law School. Les
The IRS’s practice of assessing penalties against taxpayers who voluntarily attempt to get into compliance with their filing of foreign information returns puts tax practitioners in a difficult position. Most practitioners understand that they have an obligation to the tax system and genuinely strive to comply with that obligation to assist their clients with compliance. And, indeed, most taxpayers believe in tax compliance. See Comprehensive Taxpayer Attitude Survey, 2017 Executive Report, Practitioners also have duties to their clients to ensure that they are not recommending actions that will cause them to unnecessarily incur penalties. In the past several years, as the IRS continues to impose the maximum level of penalties against taxpayers who file untimely or incomplete foreign information returns, it is getting harder for practitioners to recommend that clients should self-correct, as the outcome is the same if they do not self-correct and are later audited.
Most of us would agree, for instance, that a young person who received a reportable (but nontaxable) gift from a foreign relative for the first time and who prepared her own return and did not know about the Form 3520 requirement at the time of filing, but then filed it 6 months after learning about the filing requirement should not have to pay a penalty of 25% of the foreign gift to the IRS. The IRS, however, would assess this penalty without a second thought – and indeed does so with regularity.
Considering the example above, assume that your client has come to you for advice before she files the late Form 3520. The client she tells you that she received the gift 5 years ago but has heard that the IRS could still assess penalties, and that she has limited financial resources such that a large penalty would be financially devastating to her. If she asks whether you recommend filing the Form 3520 reporting the foreign gift now, knowing that this will immediately result in a penalty of 25% of the amount of the gift, and that if the client likely would not be able to satisfy the IRS’s interpretation of the standard for reasonable cause and thus would likely be unsuccessful in challenging a penalty, what is your advice? Do you have an ethical duty to advise the client to file the delinquent Form 3520 despite knowing what the outcome will be? How do you balance your duty to tax system and ethical obligations under Circular 230 with your duty to obtain the best possible outcome for your client And can you consider the likelihood that the client will be audited in giving advice as to whether she should file the late Form 3520?
Before discussing the practitioner’s ethical duties, we will briefly review the common foreign information return filing requirements and penalties to provide context for this discussion.
Basic Background on Foreign Information Return Penalties – Types and Amounts of Penalties
Foreign information return penalties include penalties for failure to file a host of forms that report U.S. taxpayer’s foreign assets and transactions. The forms for which we most commonly see the assessment of penalties are Form 5471 (Information Return of U.S. Persons with Respect to Certain Foreign Corporations), Form 5472 (Information Return of a 25% Foreign-Owned U.S. Corporation or a Foreign Corporation Engaged in a U.S. Trade or Business), Form 3520 (Annual Return to Report Transactions with Foreign Trusts and Receipt of Certain Foreign Gifts), and Form 3520-A (Annual Information Return of Foreign Trust with U.S. Owner), and other forms. Forms 3520 and 3520-A were the subject of an IRS Large Business and International “Campaign,” which the IRS discontinued on February 28, 2022. (We note that there are several other foreign information returns, but this article focuses on the forms for which we see the most IRS penalty action.
This post focuses only on the Title 26 foreign information return penalties and does not address the IRS’s enforcement of penalties for failure to file FinCen Form 114 (the “FBAR”), as those are not assessed under Title 26 (the Internal Revenue Code), but Title 31 (the Bank Secrecy Act). The rules for assessment and collection of FBAR penalties are contained in 31 U.S.C. § 5321..Failure to file Form 8938 (Statement of Specified Foreign Financial Assets) is also subject to penalties, but we have not seen the same level of enforcement of penalties as with the forms listed above. This may change in the future, however, as the Treasury Inspector General for Tax Administration has criticized the IRS for its lack of enforcement in this area. Additional Actions Are Needed to Address Non-Filing and Non-Reporting Compliance Under the Foreign Account Tax Compliance Act
The penalties for not filing Forms 5471 and 8938 are $10,000 for the initial failure to file the form, and an additional $10,000 for every 30-day period, or part thereof, after the IRS has notified the taxpayer of the failure to file, up to a maximum of $50,000, meaning that the IRS can assess penalties of up to $60,000 for each form. Beginning with the 2018 tax years, the penalty for failure to file Forms 5472 increased to $25,000 per failure, an additional $25,000 with every 30-day period, or part thereof, after the IRS has mailed a notice of failure, with no outer limits. See I.R.C. §§ 6038, 6038A, 6038B, 6038C, 6039F, 6677
The penalty for not reporting a transaction with a foreign trust on Form 3520 is 35% of the “gross reportable amount,” increasing by $10,000 for every thirty days for which the failure to report continues up to the “gross reportable amount.” As per Section 6677(c), the “gross reportable amount” is the transfer of any money or property (directly or indirectly) to a foreign trust by a U.S. person, or the aggregate amount of the distributions so received from such trust during such taxable year.
The penalty for failure to file Form 3520-A, results in penalties of 5% of the “gross reportable amount.” The gross reportable amount for this penalty is “the gross value of the portion of the trust’s assets at the close of the year treated as owned by the United States person.” If the IRS notifies a taxpayer of a failure to file the Form 3520-A, and the taxpayer does not file the form within the next 90 days, there is an additional penalty of $10,000 for each 30-day period (or fraction thereof) during which the failure to file continues, up to the gross reportable amount. I.R.C. §§ 6048(b); 6667(b), (c).
These penalties are related to the failure to file, or the incomplete filing, of these foreign information returns, and are not related to any tax deficiency. Accordingly, the IRS can – and frequently does – assess these penalties even where there is no tax due as a result of the failure to file or the incomplete form. Despite the policy statement in the Internal Revenue Manual that penalties should “be objectively proportioned to the offense,”( see IRM 126.96.36.199.1 (11-25-2011)) the IRS routinely assesses the maximum amount of foreign information return penalties even for short delays and where there is no tax due as a result of the late filing.
For all of the foreign information return penalties, reasonable cause is a defense.. The IRS applies the same standards for reasonable cause for failure to file income tax returns under I.R.C. § 6651 to failure to file foreign information returns, i.e., the exercise of ordinary business care and prudence. See e.g., Chief Counsel Advisory200748006. Many clients simply cannot meet this standard (at least as the IRS interprets it). These are taxpayers who were not willful and who did not intend to evade tax (and in many cases, there is no tax liability related to the late filing of the foreign information returns), but who may have been negligent or could have made a better effort at understanding their filing obligations.
In Notice 2022-36, the IRS recently provided some limited relief to taxpayers who had not filed, or had already been assessed penalties for late filing of, several different forms, including Forms 3520, 3520-A, and some Forms 5471. This relief is limited to the 2019 and 2020 tax years, and penalties “assessed by the campus assessment program” with respect to Forms 3520 and 3520-A (Annual Information Return of Foreign Trust with U.S. Owner). The IRS also limited relief to taxpayers who were able to file their delinquent returns within the 37-day period between August 24, 2022, the date that IRS announced Notice 2022-36, and the September 30, 2022, deadline. In addition, Notice 2002-36 stated that the IRS will cancel penalty charges for those forms and years, and issue refunds, as appropriate.
Notice 2002-36 provided cold comfort as it did not provide relief for earlier years and applied to a limited category of forms, and did not guarantee that the IRS would not assess penalties, only that they would not systematically assess them. It is noteworthy that this limited relief was in no way a recognition of the harsh consequences to taxpayers from the systematic assessment of penalties. The only stated reason for the relief was that there are better uses of IRS resources given its backlog after the pandemic and budget constraints, stating “[t]he Treasury Department and the IRS have determined that the penalty relief described in this notice will allow the IRS to focus its resources more effectively, as well as provide relief to taxpayers affected by the COVID-19 pandemic.” Notice 2022-36 did not come close to alleviating the burdens on taxpayers who want to be compliant by filing delinquent foreign information returns.
There are no other programs or procedures available for a taxpayer who has not understated their income to file a delinquent foreign information return without being subject to penalties. Other than Notice 2022-36, which was of limited utility, the IRS has not offered a method of self-correcting with reduced penalties. Instead, the only option for a taxpayer who wants to come into compliance is to file late and incur penalties. Theoretically, a taxpayer could make a voluntary disclosure, but the penalty of 50% of the unreported offshore asset makes this option untenable, and the voluntary disclosure procedure is intended to apply in situations where the taxpayer has acted willfully and has concern about criminal liability, which is not the case where a taxpayer missed a filing deadline but does not owe any additional tax.
The IRS’s Streamlined Filing procedures are not available for taxpayers who do not owe any additional tax related to their non-compliance. This is an oddity of the current system – that a U.S. taxpayer who lives in the U.S., and has not reported income from a foreign asset is offered an opportunity to self-correct in exchange for payment of the tax and a reduced penalty of 5% of the value of the unreported foreign asset, while a taxpayers who lives in the U.S. and has not underreported their income will be subject to the maximum amount of penalties.
It is also important to note, as Les discussed in Tax Court To Consider IRS Procedure For Imposing Information Reporting Penalties, that foreign information return penalties are “assessable penalties,” meaning that they are “paid upon notice and demand” and are not subject to the deficiency procedures, and thus cannot be challenged in Tax Court (with one narrow exception under Collection Due Process if the taxpayer is not offered review by the IRS Independent Office of Appeals).Despite the IRM allowing for pre-payment review, the IRS sometimes initiates enforced collection before the taxpayers have completed their appeal, and frequently sends collection notices, including notices of intent to levy, before the taxpayers’ deadlines to submit a protest has even passed. This means that the taxpayer will receive a notice and demand for the payment and will not have any pre-assessment right to challenge the penalty or raise any defenses. The taxpayer should receive Appeals review, and also has a right to pay the penalty and bring a claim for refund, and then bring a suit in district court or the federal court of claims if the IRS denies the refund. Full payment and the Flora rule can impose a significant barrier. Moreover, these procedures are burdensome, and also may not be successful, as the taxpayer will have the burden of providing reasonable cause, which is the only defense available if the penalty was otherwise properly assessed.
This article does not discuss these procedures or likelihood of success, but merely notes, for the purposes of the issue under discussion (i) other than the returns filed under Notice 2022-36, the IRS frequently systematically assesses penalties for late filing of certain foreign information returns; (ii) the burden is on the taxpayer to challenge the penalty and raise any defenses; (iii) it is unlikely that the IRS or Appeals will abate the penalty without a strong showing of reasonable cause; and (iv) for most taxpayers, the only possibility for judicial review will be after they pay the penalty in full and file a refund claim.
In tomorrow’s post, we will discuss the ethical standards that practitioners must address when faced with a client’s failure to comply with the information reporting obligations discussed today.