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Foreign Trusts: IRS Penalty Notices For Late Forms 3520-A Traumatize Many Innocent Taxpayers!



It was early on a Monday morning, and I dragged myself in after a long weekend of reg. buzzing and Code section perusing. I was not looking forward to the day. I played a message on my answering machine that made me want to return home and crawl back into bed. It was left in the middle of the previous night by a crazed and panicked client living in Norway. She had just gotten a CP15 Notice from the IRS that said she had been charged a penalty in the amount of $10,000 under Section 6677 of the Internal Revenue Code (IRC) for failure to file Form 3520-A, under the requirements of IRC Section 6048(b).

The client was the owner of a foreign trust, and I knew we had properly filed Form 3520, “Annual Return to Report Transactions With Foreign Trusts and Receipt of Certain Foreign Gifts.” Foreign trusts with U.S. owners have the responsibility to file Form 3520-A, “Annual Information Return of Foreign Trust With a U.S. Owner,” which few of them do. So since IRC Section 6048(b) requires the owner of a foreign trust to ensure that this happens, we attached “substitute” Form 3520-A to Form 3520, in accordance with the instructions to Form 3520. Form 3520 and the attached substitute Form 3520-A were filed in August, but we had filed an automatic extension for the client’s tax return, which, according to the instructions to Form 3520, also extended the filing date for Form 3520.

It’s Cool

I called the client back with the confidence of a guy who thought he knew what he was talking about. I consoled and cajoled her with the promise that this was simply a terrible mistake on the part of the IRS. We had filed the Form 3520 with substitute Form 3520-A attached, and had filed Form 4868 to give us till October 15 to file these forms. I could sense her blood pressure returning to near normal levels. She asked if she should call the IRS, just to make sure. I said please don’t – I would call and get it straightened out.

The day got away from me and I didn’t get the call made. I figured since early morning was the best time to get through to the IRS, I would call early Tuesday. I went home that night and got lost in a great article on PFICs I had been meaning to read.

It’s Not Cool

Tuesday morning I felt like Bill Murray’s character in “Groundhog Day” – it was Monday morning all over again. I was greeted with a frantic phone message and two or three nasty e-mails. She had called the IRS.

The lady at the IRS assured her that the notice was not a mistake, and that she had better pay up. The IRS lady referred her to the instructions to Form 3520-A, which clearly state that Form 3520-A must be filed by the 15th day of the 3rd month after the end of the trust’s tax year, and that an extension of time to file Form 3520-A may be granted by filing Form 7004, “Application for Automatic Extension of Time To File Certain Business Income Tax, Information, and Other Returns.” Had she or her preparer filed Form 7004, the IRS lady asked? If not, the IRS lady explained, her Form 3520-A was late and the $10,000 penalty indeed applied.

Nooooo!!! Why hadn’t I told her about Form 7004?, she screamed into the phone. She called me a few things I won’t repeat, and my own blood pressure now had the “Check Engine” light flashing. Had I been wrong about this? Was I supposed to file Form 7004 by March 15? Was I really just a hack with a lot of letters after my name? Maybe I should just sell the practice and find a job delivering pizza. “Wait a minute,” I thought. “Get a hold of yourself. This can’t possibly be right.”

So Who’s Right?

IRC Section 6048(b) requires a U.S. person who is treated as owning a foreign trust under the grantor trust rules of Sections 671 through 679 to report information with respect to the trust (file Form 3520). Such person must also “ensure that the such trust makes a return for such year which sets forth a full and complete accounting of all trust activities . . .” (files Form 3520-A). (Sec. 6048(b)(1)(A).)

The Code section does not explain how an owner is to “ensure” that Form 3520-A is filed, and regulations under Section 6048 are non-existent. However, the instructions to Form 3520 instruct a U.S. owner of a foreign trust who has not received a Foreign Grantor Trust Owner Statement from the foreign trust to complete a substitute Form 3520-A to the best of his/her ability and attach it to his/her Form 3520. (See also CCA 201150029 – “Information With Respect to Certain Foreign Trusts.”)

If the trust owner fails to file Form 3520 when required by IRC Section 6048(b), or the foreign trust that is treated as owned by the U.S. person fails to file Form 3520-A and that person does not file a substitute Form 3520-A, the U.S. person will owe a penalty under IRC Section 6677(b) equal to the greater of $10,000 or 5 percent of the value of the foreign trust’s assets that are treated as owned by the U.S. person at the end of the year. (IRC Section 6677(c)(2)).

The critical point of contention here is: When is the stupid substitute Form 3520-A due, and how can the due date be extended? After all, this is not the Form 3520-A required of the foreign trust. This is a “substitute” form, which is filed as an attachment to the trust owner’s Form 3520.

The due date to file Form 3520 is the 15th day of the 4th month following the end of the U.S. person’s tax year. The instructions to Form 3520 explain that if the U.S. person is granted an extension of time to file Form 1040, the due date for filing Form 3520 is the 15th day of the 10th month following the end of the U.S. person’s tax year. (Also see IRM 21.8.2.19.2.) In other words, Form 4868 extends the time to file Form 3520 along with Form 1040.

It seems logical that the due date for an attachment to Form 3520 would be the same as Form 3520 itself, and the Internal Revenue Manual happens to agree. Buried deep within the IRM is this:

If the foreign trust does not file Form 3520-A, but the U.S. owner completes and attaches a substitute Form 3520-A for the foreign trust to the U.S. owner’s timely filed Form 3520 in accordance with the instructions for Form 3520, the U.S. owner will not be subject to the penalty for failure to file Form 3520-A.

(IRM 21.8.2.19.3.7.)

Resolution? 

I called the IRS, made my point, and was told to submit a formal protest letter. The letter was submitted. I called again after 30 days, was told the protest letter was lost and to submit it again. Still we wait for a response from the IRS after nearly four months after the second protest submission.

In the meantime, four additional clients have received the exact penalty letter under the exact same circumstance. We are in the process of protesting all of these penalties, but have yet to resolve any of them.

Devious Means? 

In such a high stakes game created by outrageous penalties imposed by Congress for a late filed information return, it seems that either Congress or the IRS would make it perfectly clear, to both IRS personnel and to taxpayers, when a “substitute” Form 3520-A is due. However, neither the due date for this form, nor the means of extending the due date, is mentioned in the Form 3520 instructions. If our small client base has received five of these penalty notices, imagine how many thousands of notices have been mailed. Imagine how many taxpayers have paid the bogus penalty just to get the IRS off their backs.

Hey, wait a minute. Isn’t that what scammers do – send out bogus tax notices to get people to send them money? I can imagine the conversation:

Some High Ranking IRS Official #1: “I’ve got a great idea. We send out $10,000 penalty notices to everyone who filed a Form 3520 with substitute Form 3520-A attached and tell them they filed late.”

Some High Ranking IRS Official #2: “But that’s not really honest is it?”

Some High Ranking IRS Official #1: “Of course not. But think about all the revenue we can raise with such little effort. It’s the perfect scam.”

Some High Ranking IRS Official #2: “But aren’t we supposed to be warning taxpayers to beware of scammers?”

Some High Ranking IRS Official #1: “Well sure, beware of scammers pretending to be the IRS, but we ARE the IRS. It’s perfect!”

Just kidding, of course. That’s not our IRS. Or is it . . .?

Have a question? Contact Gary Carter.

 

 

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Gary Carter, President of GW Carter, Ltd., was a tax professor at the University of Minnesota’s Carlson School of Management and the Associate Director of the Carlson School’s Master of Business Taxation Program until June, 2010. He received a B.A. in accounting from Eastern Washington University in 1977, a Master of Taxation degree from the University of Denver in 1980, and a Ph.D. in taxation from the University of Texas at Austin in 1985. Early in his career he worked as a revenue agent for the State of Alaska, and later in public accounting for both a regional CPA firm and a Big Four Firm. His current practice was started in 1999. He has conducted tax seminars on various tax topics and has published several books on taxation.

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13 thoughts on “Foreign Trusts: IRS Penalty Notices For Late Forms 3520-A Traumatize Many Innocent Taxpayers!

  1. Thanks for this – great post. The 3520 and 3520A rules are some of the most ridiculous and outraegous rules in the Internal Revenue Code, when applied to the day-to-day activities of Americans abroad.

    Of course these problems arise only if you are dealing with something that meets the definition of a trust. It is difficult to see why/how many tax-deferred accounts (Canadian TFSAs and the equivalent in other countries) qualify as trusts to begin with. Yet, it is the view of many in the tax compliance indusity that one is “better safe than sorry” and to (as a matter of caution) treat things as Foreign trusts that are likely not.

    Your post demonstrates how “over compliance” (I am not saying that the example in your case was not a trust) can be FAR MORE dangerous than just taking a principled approach based on the law that something is not a trust. After all, the penalty imposed for not filing the 3520A is because the person filed the 3520. The person filed the 3520 because somebody decided there was a “foreign trust”.

    The starting question: Is you dealing with a trust at all?

    Thanks again for sharing this!

    • Avatar Gary Carter says:

      Good points John. Hence forth we will not be recommending the filing of Form 3520/substitute 3520-A unless the trustee is unequivocally a “fiduciary” and declares to be so. The cautionary strategy of filing Form 3520 when there is doubt is not a winning strategy. With the dearth of specific guidance from the IRS on how to classify a foreign trust, agents are not likely to take this question on. We have never received a notice from the IRS asking why Form 3520 was not filed. Only when the client tries to do the right thing in filing Form 3520 do the problems with the IRS arise.

  2. Avatar Lee Shaffer says:

    How ironic. I filed my forms, my accountant did not fill in (1) number, I got a letter for the IRS for the number, I sent it off and they claim they never got it so the fined me$10000.00 US. They are total assholes. I am 100 % compliant on my tax returns since 1978 and I am 100% in compliance to the 965 Transition tax with 2 payments and they still stick it to me. I am not ever going back to the US do they can drop dead. American citizen and they treat us like shit.

  3. Avatar Kat Jennings says:

    Gary, this is a perfect example why taxpayers need the help of an intelligent Tax Expert like you!

  4. Not familiar with this area, yet absolutely shocking. I think you should contact the Taxpayer Advocate Nina Olson’s office (she retired of course) because this sounds like a protocol issue that will impact thousands of taxpayers.

    • Avatar Gary Carter says:

      That’s exactly what I had in mind for the next step William, if we can’t get these cases resolved soon. I know Nina was a contributor to this blog. Perhaps the new TA will jump in.

  5. I think you should contact and inform the Taxpayer Advocate’s office because this issue is likely impacting several thousand taxpayers, annually.

  6. Avatar Kat Jennings says:

    I have contacted the National Taxpayer Advocate as they have been wonderful to work with helping taxpayers and tax professionals who have approached us over the years for help.

    Gary Carters article has attracted a lot of attention globally. We want to get this matter to the attention of the NTA per William Byrnes wonderful suggestion.

  7. Avatar Gary Carter says:

    Thanks for your help with this Kat. Connections have been made. We’ll see what happens!

    • Avatar Suzanne says:

      I have reported your article to Laura Snyder with the Tax Advisory Panel which addresses systemic problems like this. She had told me that they will advance it. Thanks for the article. We haven’t yet received a notice, and hopefully won’t.

  8. Avatar Metoo says:

    Thanks for sharing your experience and the response that you sent to the IRS Gary. Appreciate you shining a light on this awful and traumatising development. I’ve just received a $10,000 penalty notice too. I have only ever tried to do the right thing. I now live in fear, not just about whether I have submitted & ticked all the right boxes for this form, but about remaining in compliance. Until know there seemed to be an obviously naive belief in forums and blogs that duals and/or “expats” would not be targeted in such a cavalier and brutal way. I’ve contacted my preparer but I feel despondent that the IRS would act in this way and that those impacted, some far worse than me, will have to live In uncertainty and fear for so long, possibly, it seems, up to a year.

  9. Avatar Gary Carter says:

    HI Metoo – Good luck in getting this resolved. Definitely call the Taxpayer Advocate office and share your frustration. You should also contact your Congressional representative and tell them about the egregious penalties Congress has enacted for very minor infractions. Lawmakers must be made aware of this.

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