We welcome guest blogger Megan L. Brackney who is a partner at Kostelanetz & Fink, LLP in New York City, and focuses her practice in civil and criminal tax controversies. Over the past couple of years, she and her colleagues have seen a significant influx in foreign information reporting penalties and have represented hundreds of taxpayers against the IRS on these issues. She provides us with the wisdom gained from her experience. Megan and I serve together as vice chairs of the ABA Tax Section. I can tell from the experience of working with her what a great lawyer and counselor she is. Keith
The IRS has been assessing more and more foreign information return penalties on taxpayers. It is difficult to find statistics on this point, as the IRS’s reports on tax penalties lump all “nonreturn” penalties into one category, which includes failure to file Forms 1099, 8300, and other information returns, along with foreign information return penalties. Even without the statistics, tax controversy practitioners know this to be true, as we have clients coming in with these assessments every day. Many of these penalties are being systematically assessed, meaning that a penalty is automatically issued whenever there is a late-filed form or a form is missing information, without regard to the individual circumstances of the taxpayer. In many cases, the penalties are wildly disproportionate to the taxpayer’s mistake, and serve no purpose other than to discourage taxpayers from voluntary compliance.
The increase in penalty assessments has also increased the workload of IRS Appeals and there are significant delays in resolution. As will be discussed below, while these appeals languish without any response or action, the IRS continues to move forward with enforced collection. This is a waste of the taxpayer’s resources to be constantly receiving notices and attempting to call and correspond with the IRS, and sometimes filing multiple appeals because they have to resort to Collection Due Process (“CDP”) to stop the IRS from levying on their assets before their appeals are heard. This is also a waste of resources for the IRS, and further burdens Appeals, as more CDP requests come in on cases that are already assigned to Appeals.
The IRS has caused this chaos from overreacting to taxpayers who have filed late or incomplete foreign information returns while at the same time, not allocating additional resources to Appeals to deal with the additional volume, or instructing Collections and Service Center personnel as to how to handle these cases. There are some very simple administrative fixes to these issues, which I will recommend at the end of this column.
To provide some context, and hopefully to bring some order to the chaos, this column tells the stories of three taxpayers who have faced assessment of devastating foreign information return penalties and have been unable to get the IRS to consider their defenses, followed by ten recommendations for improvement.
Background on Foreign Information Return Penalties
Before talking about these three illustrative cases, below is some basic information about foreign information return penalties.
Types and Amounts of Penalties
Foreign information return penalties include penalties for failure to file:
- 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 8938 (Statement of Specified Foreign Financial Assets)
- Form 8858 (Information Return of U.S. Persons With Respect to Foreign Disregarded Entities (FDEs) and Foreign Branches (FBs))
- Form 926 (Return by a U.S. Transferor of Property to a Foreign Corporation); Form 8865 (Return of U.S. Persons With Respect to Certain Foreign Partnerships)
- Form 3520 (Annual Return to Report Transactions with Foreign Trusts and Receipt of Certain Foreign Gifts)
- Form 3520-A (Annual Information Return of Foreign Trust with U.S. Owner), and other forms. (Note that Penalties for failure to file FinCen Form 114 (the “FBAR”) are not assessed under Title 26 (the Internal Revenue Code), but Title 31 (the Bank Secrecy Act). See 31 U.S.C. § 5321. The rules for assessment and collection of FBAR penalties are contained in 31 U.S.C. § 5321. This column focuses only on the Title 26 foreign information return penalties and does not address the IRS’s enforcement of FBAR penalties.)
- See I.R.C. §§ 6038(c)(4)(B), 6038A, 6038B, 6038D(d), 6039F(c), 6677. 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.
The penalties for not filing Forms 5471, 8938, 8858, and 8865 (to report ownership in a foreign partnership) 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 have been 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.
The penalty for failure to report a transfer to a foreign corporation on Form 926, or failure to report a transfer to a foreign partnership on Form 8865, is 10% of the fair market value of the transferred property, up to $100,000.
The penalties for failure to file Form 3520-A to report a gift from a foreign person or inheritance from a foreign estate is 5% of the amount of such foreign gift/inheritance for each month for which the failure to report continues up to 25% of the foreign gift/inheritance.
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.” 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. I.R.C. § 6677(c).
As with all penalties, the IRS is supposed to obtain proper managerial approval before assessment. I.R.C. § 6751(a)(2) (“no penalty under this title shall be assessed unless the initial determination of such assessment is personally approved (in writing) by the immediate supervisor of the individual making such determination or such higher level official as the Secretary may designate.”)