In the federal income tax world, there are effectively two functions within the Internal Revenue Service (“IRS”). First, the IRS examines tax years and tax returns to determine whether the taxpayer has reported the correct amount of tax liability. In this so-called “assessment phase,” the IRS may propose additional income tax owed beyond the amount reported on the taxpayer’s tax return.
Second, if the taxpayer and the IRS agree on the amount of taxes owed or the taxpayer can no longer challenge the amount of tax, the IRS may engage in actions to collect the federal income taxes that are due and not paid. In this so-called “collection phase,” the IRS may file notices of federal tax lien or propose levies to try to collect the unpaid tax debts.
Congress also recognizes the distinction between the assessment phase and the collection phase in the Internal Revenue Code (the “Code”). With respect to the assessment phase, Congress permits the IRS, as a very general matter, to make an assessment of additional income tax within three years of when the tax return is filed.[i] Barring some exceptions, the IRS may not make an assessment of tax outside this three-year window. With respect to the collection phase, Congress permits the IRS, again as a very general matter, to take collection actions within ten years after an assessment has been made.[ii]
But every general rule has its exceptions, and the assessment phase is no different. Under the governing provisions of section 6501 of the Code, for example, the IRS may make an assessment of additional tax at any time if the taxpayer files a fraudulent tax return.[iii] Similarly, section 6501 provides that the general three-year period to make an assessment does not run at all if the taxpayer has failed to file an income tax return.
Buried within the litany of exceptions in section 6501 is also a rule associated with the non-filing of certain foreign information returns (e.g., Form 3520, Form 3520-A, Form 5471, Form 8865, and Form 8621). Under the rules of section 6501(c)(8), if a taxpayer fails to file one of these information returns, the IRS may make an assessment of additional tax within three years after the foreign information return is filed. If the taxpayer has reasonable cause for the non-filing, the IRS is limited to making assessments related solely to the information that should have been reported on the foreign information return. However, if the taxpayer lacks reasonable cause for the non-filing, the IRS may make any proposed assessments with respect to any item on the tax return, regardless of whether there was a connection with the non-filing.
Taxpayers often forget about this nasty exception to the three-year assessment rule. As the recent case in Fairbank[iv] shows, taxpayers should bear this rule in mind, particularly if they are subject to foreign information return reporting obligations.
Facts in Fairbank
The Tax Court issued its memorandum opinion in Fairbank on February 23, 2023. In that case, the IRS sought to propose additional assessments and penalties against the taxpayers for tax years 2003 through 2009 and 2011 (“Years at Issue”). Notably, the Years at Issue were well after the general three-year statute of limitations for the IRS to make an assessment because the taxpayers had timely filed all of those returns.
In the proceedings, the taxpayers contended that the IRS was time-barred from making the additional assessments. The IRS disagreed, contending instead that because Mrs. Fairbank had reportable interests in a foreign trust and did not file appropriate information returns (Forms 3520 and 3520-A) that the general three-year statute of limitations period did not apply—i.e., section 6501(c)(8) applied.
Form 3520 / 3520-A Reporting in General
As a reminder to the readers, section 6048 of the Code requires taxpayers to file certain foreign information returns with the IRS if they engage in certain transactions with a foreign trust or if they have certain interests in the foreign trust. To the extent these reporting rules apply, the taxpayer must file both IRS Form 3520, Annual Return to Report Transactions with Foreign Trusts and Receipt of Foreign Gifts, and IRS Form 3520-A, Annual Information Return of Foreign Trust with a U.S. Owner. Taxpayers who fail to timely and properly file these forms may be assessed significant civil penalties. In addition, and as mentioned supra, the failure to file these returns may result in an extension of the general three-year statute of limitations period for the IRS to make an assessment. In Fairbank, the IRS contended that Mrs. Fairbank had both Form 3520 and 3520-A reporting obligations. The IRS further contended that because Mrs. Fairbank failed to timely file these information returns, section 6501(c)(8) applied in permitting the IRS more time to make the assessments.
The Tax Court concluded that Mrs. Fairbank had a reportable interest in a foreign trust. For those who are interested in knowing how the federal courts determine whether a trust is a foreign trust, the memorandum opinion in Fairbank is worth a read. Also, see one of our blog posts here on foreign trusts and section 3520 penalties. Because the Tax Court concluded that Mrs. Fairbank had Form 3520 and Form 3520-A reporting obligations for the Years at Issue, the Tax Court continued to analyze whether the three-year statute of limitations to make an assessment had been extended under section 6501(c)(8).
In Fairbank, the taxpayers made a clever argument that section 6501(c)(8) did not apply. Specifically, under the statutory language of section 6501(c)(8), it provides that the statute of limitations is tolled until “the date on which the [IRS] is furnished the information required to be reported under” the governing provision in play (here, section 6048, which requires Forms 3520 and 3520-A). Based on the bolded statutory language, the taxpayer contended that they provided the IRS with the “information required to be furnished” during the examination in 2014. According to the taxpayers, section 6501(c)(8) did not require them to submit a specific form—rather, all that the statute required was that they provide information related to the foreign trust to the IRS. The IRS disagreed with the taxpayers’ contentions, arguing instead that section 6501(c)(8) is not satisfied “unless and until a taxpayer has filed the required information returns [Forms 3520-A and 3520].”
The Tax Court held in favor of the IRS. Based on prior federal court decisions and the statutory language of section 6048, the Tax Court concluded that the actual filing of a Form 3520 and Form 3520-A, and not merely providing information outside the scope of the return filing, was the relevant qualifier to start the three-year period under section 6501(c)(8). Because the taxpayers had not filed Forms 3520 and 3520-A with the IRS, the notice of deficiency issued by the IRS in 2018 was timely under section 6501(c)(8).
In most instances, the IRS has three years to examine a tax return and make proposed adjustments to the return via the assessment procedures. However, there are numerous exceptions under section 6501 of the Code that extend this general three-year timeline. Taxpayers with foreign information return filing obligations should bear in mind that the failure to file a timely and complete foreign information return with the IRS increases the risk that the IRS may examine many more years than what would otherwise be permitted. Accordingly, taxpayers should carefully discuss these foreign information return requirements with their tax professional.
[i] I.R.C. § 6501(a).
[ii] I.R.C. § 6502.
[iii] I.R.C. § 6501(c)(1).
[iv] Fairbank, T.C. Memo. 2023-19.
Have a question? Contact Matthew Roberts, Freeman Law, Texas.
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