We welcome back Megan Brackney for part three in her three-part series discussing penalties imposed on foreign information returns. Today, she brings of stories of clients who have faced these penalties demonstrating the problems caused by the manner in which the penalties are being imposed and she brings suggestions of how to improve the system. Keith
The Gifts That Keep on Giving
Two young people moved to the U.S. as students. They met in graduate school and married. After graduation, they were offered jobs and were sponsored by their employers so that they could stay in the U.S. While they were students, their parents from their home country sent them money to help pay for their expenses in the U.S. After they became U.S. taxpayers, they received a few more gifts, totaling more than $100,000. They told their CPA about these gifts, and even showed him copies of their bank statements so that he could see the wire transfers from their parents’ non-U.S. accounts. The CPA told them that because these were gifts and not subject to taxation, they did not need to be reported. The CPA did not advise them of the Form 3520 filing requirement for gifts from foreign persons that exceed $100,000 in the aggregate during the tax year. Neither of the taxpayers had any knowledge of the Form 3520, and genuinely believed that they were filing their returns correctly.
A few years later, the taxpayers switched to a new CPA and again mentioned the gift issue, and she told them that they should have been filing Forms 3520 after they became U.S. taxpayers. She prepared three Forms 3520 with statements explaining their reasonable cause, and the taxpayers filed them. There was no audit or inquiry by the IRS and no tax due as a result of the error, and other than this understandable omission, they have a perfect compliance history. The CPA was not aware of the Delinquent International Information Return Submission Procedures, but the taxpayers’ submission nevertheless substantially complied with the requirements for that procedure.
Soon after their good faith attempt to self-correct, the IRS assessed the maximum amount of penalties on both taxpayers pursuant to I.R.C. § 6039F – 25% of the amount of the gifts they had received. The IRS issued separate notices for the three years so that there were three different deadlines for the appeals, and thus three separate appeals.
These notices were entitled “Notice of Penalty Charge.” The Notices stated merely that “you have been charged a penalty under Section 6039F of the Internal Revenue Code for Failure to File Form 3520 to Report Receipt of Certain Gifts” and did not provide any other information or explanation. As the word “charge” does not appear in the Code or Regulations, a lay person would not know from this notice whether there has actually been an assessment of the penalty.
The only information provided about how to challenge the penalty was to state that the taxpayer could submit a written request for appeal within 30 days from the date of the notice which, “should reflect all facts that you contend are reasonable cause for not asserting this penalty.”
The notice does not contain any information about collection while the appeal is pending but contains the following statement: “If you do not wish to appeal this penalty, there is nothing you need to do at this time. You may later dispute the penalty by paying the penalty and then filing a claim.” A reasonable layperson could interpret this to mean that the taxpayer does not have to pay the penalty until after his or her appeal. And, indeed, as noted in the previous column, Internal Revenue Manual 220.127.116.11 states that taxpayers are afforded pre-payment appeals. The notice does not explain any of this, however, and yet the IRS will only suspend collection activity if the taxpayer separately notifies Collections that he or she has filed an appeal (and frequently not even then).
Moreover, from the notice, there is no indication that the IRS obtained managerial approval of the penalty, as is required by I.R.C. § 6751(b), and no indication that the IRS considered the reasonable cause defense submitted along with the Forms 3520.
The taxpayers timely submitted an appeal to each penalty, explaining again that they had reasonable cause for failure to file foreign information returns, i.e., that that they retained a competent CPA to prepare their returns, that they gave him full and complete information, and they reasonably relied on his advice that nothing needed to be done to report the gifts from their parents.
Despite the timely appeals, the IRS has continued sending collection notices. In response to Notice CP504, the taxpayers requested that the IRS place a hold on collection pending the appeal. The IRS did not respond, but moved forward with issuing the notice of intent to levy on one tax year. The taxpayers were forced to file a CDP request to prevent enforced collection while Appeals considers their reasonable cause defense. The taxpayers are frightened that the IRS will file a notice of federal tax lien, which would be devastating as they are trying to buy a house right now.
In the meantime, for one of the tax years, the IRS sent the taxpayers a notice stating that it was rerouting the taxpayers’ correspondence (the timely filed appeal) to the Frivolous Correspondence Department. The taxpayers promptly responded with a letter explaining that their appeal was not frivolous, and that they had a right to Appeals review, and that the IRS cannot refuse to forward their protest to Appeals. They have received no further communications regarding the appeal.
For another tax year, the taxpayers received a cryptic letter from the Service Center, responding to their correspondence (with the same date as the appeal for that year), by stating “We reviewed the information you provided and determined that no action is necessary on your account.”
The taxpayers have not received any further communications from Appeals. We have tried to find someone at the IRS who has this file, but have had no luck. Although the Service Center told me that their case is assigned to the field, no one at that office has specific responsibility over it. As of the date of publication of this column, the taxpayers have been waiting for over a year for an Appeals conference. Meanwhile, the IRS collection machinery rolls on, without regard to the fact that the taxpayers have never had any Appeals review of the assessments.
Welcome to the Machine
This taxpayer is a non-U.S. Person who is the sole shareholder of several U.S. real estate holding companies. Due to some serious health issues, including dementia and loss of hearing, he fell behind on filing returns. His son began taking over the business, discovered that returns had not been filed, and starting filing Forms 1120, which included Forms 5472, and a reasonable cause statement explaining his father’s health problems and his inability to file returns on time. The entities filed the Forms 5472 for years which there was no tax due and owing pursuant to the Delinquent International Information Return Submission Procedures. For the years in which tax was due, the entities filed the returns in the ordinary course but attached reasonable cause statements.
The IRS’s response to these various filings has been haphazard. For many of the Forms 5472, no penalties were imposed at all. There is no discernible pattern – sometimes tax was due, sometimes it was not; sometimes the year at issue was the first year of correction, sometimes it was a later year. The taxpayers have no complaints about not getting penalties on these years, but it does make one wonder whether the IRS just failed to catch them, or if someone evaluated the reasonable cause defense and agreed that penalties would not be appropriate, and if this is the case, why penalties were imposed for other tax years with identical facts.
For the rest of the Forms 5472, the IRS sent out notices assessing penalties for $10,000 per form for each of late-filed Forms 5472. The Tax Cuts and Jobs Act of 2017 (“TCJA”) increased this penalty to $25,000 for each late-filed or incomplete Form 5472. On almost all of the notices, the tax year was mistakenly stated. The entities are fiscal year taxpayers, with their tax years ending on different dates, such as June 30, or September 31. The U.S. companies’ fiscal year, was, of course, stated on the front of the Forms 1120, and thus that information was available to the IRS. However, the IRS identified the penalty period for all years as ending on December 31.
In any event, the notices of penalty were on a different form than those issued to the taxpayers described above. These notices had a heading stating, “We Charged You A Penalty.” This notice provided thirty days to notify the IRS if “you don’t agree with the penalty assessment,” and provided instructions on presenting a reasonable cause statement under penalties of perjury. The notice does not explain whether this submission would be an appeal or a request for abatement. Like the notice to the other taxpayers, this notice does not provide any information about collection or indicate whether managerial approval has been obtained or acknowledge that the taxpayer had already submitted a statement of reasonable cause under penalty of perjury. And again, there is no concept of a “charge” under the Internal Revenue Code, and it would not be clear to a lay person trying to interpret this notice what this meant.
In response to these notices, the entities requested abatement of penalties on the ground of reasonable cause, and the IRS granted several of these requests, with no explanation. It is possible that for some of these penalties, the IRS was applying a concept of First Time Abatement, since they were the first tax years with non-compliance. The First Time Abatement provisions of the Internal Revenue Manual do not refer to foreign information return penalties, but I suspect that this relief may have been granted for these entities, and I have heard, anecdotally, from other practitioners, that their clients have received this relief.
For the penalties on which the IRS denied the request for abatement, the IRS provided an explanation for the denial and obtained proper managerial approval under I.R.C. § 6751(b). In the letter denying the abatements, the IRS stated that the taxpayer could appeal the decision. It is unclear why these taxpayers were provided with a two-step procedure – request abatement, and then appeal of the denial of the abatement request — while the taxpayers described above were told to go directly to Appeals. In any event, the IRS provided these entities with 60 days in which to submit an appeal, and the entities have done so, but several months later, they still have not heard from Appeals.
In the meantime, on all of the remaining penalties, the IRS has sent collection notices, and each time, the entity responded with a request a hold on collection pending its appeal. The IRS did not directly respond to any of this correspondence, but for some of the entities, the IRS seems to have stopped sending notices. For other entities, the IRS issued final notices of intent to levy. Despite already having one appeal pending, these entities were forced to submit CDP requests to avoid levy.
In addition, for several of the penalty assessments, the IRS filed notices of federal tax lien. As noted, the Code section that authorizes the penalty for failure to file the Form 5472 is I.R.C. § 6038A. However, on several of the notices, the IRS stated that the penalty had been assessed under I.R.C. § 6038. This is close, but not quite right – this is the penalty for failure to file Form 5471. On one of the notices of federal tax lien, the IRS did not even get close, but identified the penalty as being assessed pursuant to I.R.C. § 6721 (trust fund recovery penalties). And, as noted above, the IRS assessed the penalties for tax years ending December 31, even though the entities’ tax years do not end on December 31, but at the close of their fiscal year. As these notices were improper and inaccurate, and the taxpayer’s Appeals had not been heard, the entities had to file CDP requests challenging the federal tax lien filings.
The entities have not received any response to their appeals, many of which have been pending for more than a year.
Perfection is the Enemy of Good
The next taxpayer is a high net worth individual who is the grantor of a foreign trust with significant assets. Since the formation of the trust, he has always timely filed Forms 3520 and Forms 3520-A and reported all income related to the trust. At some point, the country codes stating where the trust was administered and what law applied were not included on the Form 3520, although that information is included in other parts of the form. The IRS caught this error on the Form 3520 for one year and assessed a multimillion-dollar penalty pursuant to I.R.C. § 6677. There was no tax non-compliance related to this error – it was a minor and inconsequential technical error on a timely filed return. The taxpayer did not notice this minor error during his review of his returns and he certainly did not instruct his CPA not to fill out these items on the form. Other than this minor foot-fault, the taxpayer has an excellent compliance history.
The notice was entitled “Notice of Penalty” charge, and provided for 30 days to appeal or request abatement and directed the taxpayer to correct the errors within 90 days or be subjected to additional penalties. The language of the notice was unclear as to whether the taxpayer would be able to appeal if the request for abatement was denied. To be on the safe side, the taxpayer submitted an appeal to the IRS explaining that the taxpayer had reasonable cause for the error based on reliance on his CPA, and that penalties were not appropriate because he substantially complied with the Form 3520 filing requirement.
There is no indication from the notice that the IRS obtained managerial approval under I.R.C. § 6751, and the notice did not provide any information about suspending collection. Before the 30-day deadline for the appeal, the IRS sent Notice CP504, taking the first steps toward enforced collection action, despite the fact that the taxpayer’s time to appeal had not yet elapsed. The Appeal is pending, unless the IRS changes its practices, despite the timely appeal, which should be successful, the taxpayer may have a federal tax lien filed against him and may receive a notice of intent to levy and be forced to submit a second appeal through CDP.
Suggestions for Improving Penalty Enforcement Procedures
Below are a few simple suggestions for the IRS that would go a long way toward fair and efficient administration of the Internal Revenue Code penalty provisions.
1. Stop systematically assessing these penalties. These are significant penalties and it is important that they only be assessed in appropriate cases.
2. Consider that a taxpayer voluntarily self-corrected. Instead of encouraging voluntary compliance, the IRS is severely penalizing taxpayers without any proper purpose. The message that the IRS is sending to taxpayers is not to attempt to resolve issues voluntarily and self-correct, as the IRS treats taxpayers who come forward to correct past non-compliance in the same manner – as harshly as possible – as those whom the IRS identifies as non-compliant.
3. Apply concepts of substantial compliance. Missing a line on a form should not warrant the highest level of penalty assessment where there is no tax due or other harm to the government.
4. Formally adopt a First Time Abatement policy for foreign information return penalties that is applied consistently among taxpayers.
5. Find a way to follow the Internal Revenue Manual. Wait until the time has elapsed for filing an appeal before commencing collection action, and upon receipt of the appeal, immediately stop collection. If there is no system in place to cause this to happen automatically, create one, or, at a minimum, add a line to the notice telling the taxpayer that if they receive a collection notice, they should notify the office that sent the notice that they have timely filed an appeal of the penalty. Then, instruct Collections to suspend collection activity once they receive notification that an appeal has been filed.
6. Train IRS personnel in the Service Center and Collection about these penalties, so that they know what they are and how the procedures are different than those that may apply to the usual situations they see with taxpayers who have income tax liabilities so that they are able to respond to taxpayers who call for assistance.
7. Use consistent language in the penalty notices. There is no reason for there to be different versions of the notices that taxpayers receive when foreign information penalties are assessed.
8. Use language that tracks the statute. There is no such thing as a penalty “charge” in the Internal Revenue Code or Treasury Regulations. It is an assessment, and it is misleading to call it something else.
9. Clearly describe how the taxpayers may submit their reasonable cause defenses to the IRS, and state that if the IRS denies abatement, they may request an appeal.
10. Notify taxpayers that they can request additional time to appeal and explain the process for doing so, or provide a longer time period and make it consistent for all taxpayers.
At this point, there have been very few court decisions addressing reasonable cause and other defenses to foreign information return penalties, and none addressing the IRS’s procedures. This may be because the increase in systematic assessments is fairly recent, and it also may be because for Forms 5471, 8938, and Forms 5472 (until the TCJA increased it), the penalty of $10,000 per form did not warrant the cost of federal litigation. The IRS should not take advantage of the fact that most people will not go to court to challenge these penalties, but should take immediate action to ensure that they are being applied in an appropriate manner, and that taxpayer’s right to challenge the IRS’s position and be heard, the right to appeal an IRS decision in an independent forum, and the right to a fair and just tax system are being honored and protected. As can be seen by the cases discussed in today’s post, the IRS is not taking steps to protect these rights.