Many taxpayers and tax professionals mistakenly believe that Collection Due Process (“CDP”) rights do not attach to international information return penalties.
Many taxpayers and tax professionals believe that Collection Due Process ("CDP") rights do not attach to international information return penalties. This confusion likely stems from the (well known) fact that the usual CDP rights do not attach to penalties for failure to file a timely, complete and accurate Financial Crimes Enforcement Network ("FinCen") Form 114, Report of Foreign Bank and Financial Accounts ("FBAR"). To this end, the Tax Court has specifically held that it "has no jurisdiction to review the [IRS's] determination as to [taxpayers'] liability for FBAR penalties." However, one must distinguish between FBAR penalties, a product of the Bank Secrecy Act of 1970 ("BSA"), which cannot be challenged via CDP procedures, and assessable international penalties for untimely, incomplete or inaccurate Forms 926, 3520, 3520A, 5471, 5472, 8865, or 8938 which are products of the Code and subject to de novo CDP and Tax Court review. The Internal Revenue Manual ("IRM") provides that "[i]nternational information return penalties are civil penalties assessed on a U.S. person for failure to timely file complete and accurate international information returns required by specific [Code] sections." Because the IRM specifically excludes these international penalties from the ordinary deficiency procedures, it is critically important that taxpayers not proactively challenge these international penalties by requesting an abatement prior to the Final Notice that gives rise to CDP rights including Tax Court Review. Moreover, with the exception of failure to file penalties , the IRM requires, as a matter of policy, that the IRS comply with the supervisory approval requirement in I.R.C. ? 6751(b)(1). That Section provides, in pertinent part, that "no penalty under the IRC 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." Therefore, in addition to the reasonable cause defense, and the other penalty defenses discussed below, a taxpayer may argue that IRS non-compliance with the supervisory approval requirement in I.R.C. ? 6751(b)(1) invalidates an international penalty otherwise assessable under the Code.
I. Types of International Informational Returns Subject to Penalties
(A) Form 926; (B) Form 3520 and Form 3520-A; (C) Form 5471; (D) Form 5472; (E) Form 8865; (F) Form 8938
A. Form 926, Return by a U.S. Transferor of Property to a Foreign Corporation
Form 926, Return by a U.S. Transferor of Property to a Foreign Corporation must be filed by U.S. persons, domestic corporations or domestic estates or trusts to report any exchanges or transfers of property described in section 6038B(a)(1)(A). The Form 926 must be complete, accurate, and filed with the taxpayer's income tax return by the due date of the return (including extensions) at the service center where the taxpayer is required to file in order to meet the requirements outlined in Treas. Reg. 1.6038B-1(b)(2)(i). There is an exception that does not require the filing of a Form 926 unless the United States person holds (immediately after the transfer), directly or indirectly, at least a 10-percent interest (as defined in section 6046A (d)) in the partnership, or the value of the property transferred (when added to the value of the property transferred by such person or any related person to such partnership or a related partnership during the 12-month period ending on the date of the transfer) exceeds $100,000.
B. Form 3520, Annual Return To Report Transactions With Foreign Trusts and Receipt of Certain Foreign Gifts
IRM 22.214.171.124.1 explains that a Form 3520, Annual Return to Report Transactions With Foreign Trusts and Receipt of Certain Foreign Gifts, must be filed by a U.S. person to: (1) report the creation of a foreign trust by a U.S. person during the tax year; (2) report certain transfers of money or other property to a foreign trust by a U.S. person; (3) identify U.S. persons who are treated as owners of a foreign trust during all or part of the tax years; (4) provide information about distributions received by a U.S. person from a foreign trust; (5) report the receipt of a loan from a foreign trust during the tax year; (6) report the receipt of uncompensated use of trust property from a foreign trust (applicable only after March 18, 2010), or; (7) provide information about certain gifts or bequests received from foreign persons (penalties related to the failure to report the receipt of such gifts or bequests from foreign persons are imposed under I.R.C. ? 6039F). Form 3520 must be filed separately from the U.S. person's income tax return; must not be attached to the related income tax return; and must be filed by the due date of the income tax return of a U.S. person, including extensions. Form 3520-A is due by the 15th day of the third month after the end of the trust's tax year. Each U.S. person treated as an owner of a foreign trust under I.R.C. ?? 671-679 is responsible for ensuring that the foreign trust files an annual return setting forth a full and complete accounting of all trust activities, trust operations, and other relevant information as the Secretary prescribes. In addition, the U.S. owner is responsible for ensuring that the trust annually furnishes such information as the Secretary prescribes to U.S. owners and U.S. beneficiaries of the trust. A U.S. Owner can file an extension of time to file Form 3520-A with Form 7004.
C. Form 5471, Information Return of U.S. Persons With Respect to Certain Foreign Corporations
Form 5471 is used by certain U.S. citizens and residents who are officers, directors, or shareholders in certain foreign corporations, or invested in certain foreign partnerships. The form and schedules are used to satisfy the reporting requirements of I.R.C. ?? 6038 and 6046, and the related regulations. A taxpayer meets the requirement by providing the required information on a timely filed Form 5471. Form 5471 is filed with the U.S. person's income tax return on or before the date required by law for the filing of that person's income tax return, including extensions.
D. Form 5472, Information Return of a 25% Foreign-Owned U.S. Corporation
Form 5472 is filed as an attachment to the U.S. income tax return by the due date of that return, including extensions. Even if the reporting corporation's income tax return is not timely filed, Form 5472 must still be timely filed at the service center where the return is due. And when the income tax return is ultimately filed, a copy of Form 5472 must be attached. Additionally, a separate Form 5472 must be filed with regard to each related party that has reportable transactions with the reporting corporation.
E. Form 8865, Return of U.S. Persons With Respect to Certain Foreign Partnerships
Form 8865 is used to report the information required under I.R.C. ? 6038 (reporting with respect to controlled foreign partnerships), ? 6038B (reporting of transfers to foreign partnerships), or I.R.C. ? 6046A (reporting of acquisitions, dispositions, and changes in foreign partnership interests). Form 8865 must be filed with the U.S. person's income tax return on or before the date required by law for the filing of that person's income tax return, including extensions. Similar to Form 926 penalties, IRM 126.96.36.199.3 provides that a penalty for failure to file a Form 8865 is asserted on Form 8278 when an examiner establishes that the taxpayer: (1) is a U.S. person and has made a transfer to a foreign corporation or a foreign partnership; (2) has failed to timely file Form 8865 as specified in I.R.C. ? 6038B, and; (3) has not shown that such failure to comply was due to reasonable cause.
F. Form 8938, Statement of Specified Foreign Financial Assets
Beginning with the 2011 tax year, Form 8938 must be filed annually to report each of a taxpayer's specified foreign financial assets, if the aggregate value of those specified foreign assets exceeds $50,000 on the last day of the taxable year or $75,000 at any time during the taxable year. A specified foreign asset is defined as: (1) any financial account maintained by a foreign financial institution; (2) foreign financial assets held for investment that are not in an account maintained by a US or foreign financial institution (including stock or securities not issued by a U.S. person, any interest in a foreign entity, and any financial instrument or contract that has a non-U.S. person as the issuer or counterparty). The information that is required to be reported for each specified foreign financial asset includes: (1) for all accounts and assets, the maximum value of each account and asset during the year; (2) in the case of any account, the name and address of the financial institution in which such account is maintained and the number of such account; (3) in the case of any stock or security, the name and address of the issuer and such information as necessary to identify the class or issue of which such stock or security is a part, and; (4) in the case of any other instrument, contract or interest, such information as is necessary to identify such instrument, contract, or interest, and the names and addresses of all issuers and counter-parties with respect to such instrument, contract, or interest. There is an exemption that does not require a taxpayer to file Form 8938 for financial accounts maintained by: (1) a U.S. payer (e.g., a U.S. domestic financial institution); (2) the foreign branch of a U.S. financial institution, or; (3) the U.S. branch of a foreign financial institution. Another exception applies to specified foreign financial assets that have already been reported by a taxpayer on a timely filed: Form 3520 (Annual Return to Report Transactions with Foreign Trusts and Receipt of Certain Foreign Gifts); Form 5471 (Information Return of U.S. Persons with Respect to Certain Foreign Corporations), or; Form 8865 (Return of U.S. Persons with Respect to Certain Foreign Partnerships). Therefore, any specified foreign financial assets that are timely reported on a Form 3520, 5471, or 8865 need not be reported a second time on Form 8938. However, a taxpayer is still required to file Form 8938 and identify in Part IV which of the other international information forms were used to report the specified foreign financial assets at issue.
II. Challenging Penalties for Failure to File Timely, Complete and Accurate International Information Forms
First, it is important to recognize that a taxpayer's ability to dispute underlying liability for tax or penalties is limited by I.R.C. ? 6330(c)(2)(B) to cases in which the taxpayer did not receive any statutory notice of deficiency or "did not otherwise have an opportunity to dispute such tax." By example, Treas. Reg. ? 301-6330-1(e)(3), Q&A-E2, which interprets I.R.C. ? 6330(2)(2)(B), identifies "a prior opportunity for a conference with Appeals" as the sort of meaningful opportunity to dispute liability that precludes subsequent challenges to that same liability via CDP and judicial review. Further to this point, the government often argues that a taxpayer's failure to protest a pre-assessment 30-day letter - like a taxpayer's failure to file a petition to a 90-day letter or a protest to the I.R.C. ? 6672 based 60-day letter - was a prior, meaningful opportunity for the taxpayer to dispute the penalty and hence, there is no de novo CDP or Tax Court review. In the case of assessable international penalties, IRM 188.8.131.52.1 sets forth the policy that the penalties are assessed without a 30-day letter, and provides that the "penalties listed in this section, unless otherwise noted, are assessable penalties and are not covered by deficiency procedures of I.R.C. ?? 6211-6215 (relating to deficiency procedures for income, estate, gift, and certain excise taxes). For these penalties, there is no 30-day letter, no agreement form, and no notice is required prior to assessment." However, the IRS may send "penalty notice" forms that invite a taxpayer response. In that case, inaction may be the best approach, as the IRS views any administrative protest of the penalty before the issuance of the final notice as an "opportunity to dispute the underlying liability" that precludes the taxpayer from subsequently disputing liability via CDP and appeal to the Tax Court. Therefore, should a taxpayer receive a notice regarding any of the international information forms discussed below, best practices dictate that the taxpayer resist the impulse to protest or otherwise request penalty abatement prior to receipt of the final notice which permits the taxpayer to challenge the international penalties assessed through the standard Appeals procedures with de novo CDP and judicial review.
A. Form 926 Penalties
I.R.C. ? 6038(B) states that "if any United States person fails to furnish the [Form 926] at the time and in the manner required by regulations, such person shall pay a penalty equal to 10 percent of the fair market value of the property at the time of the exchange (and, in the case of a contribution described in subsection (a)(1)(B), such person shall recognize gain as if the contributed property had been sold for such value at the time of such contribution)." However, IRM 184.108.40.206.1 excepts from the penalty certain transfers of stock or securities to a foreign corporation, and the penalty also does not apply to certain transfers of cash described in I.R.C. ? 6038B(a)(1)(A). IRM 220.127.116.11.3 provides that, for failure to file a Form 926, a penalty is asserted on Form 8278 when the examiner establishes that the taxpayer: (1) is a U.S. person and has made a transfer to a foreign corporation or a foreign partnership; (2) has failed to timely file Form 926 and attachments as specified in I.R.C. ? 6038B, and; (3) has not shown that such failure to comply was due to reasonable cause. The reasonable cause exception in Section 6038(B) provides that the penalties "shall not apply to any failure if the United States person shows such failure is due to reasonable cause and not to willful neglect" once the taxpayer is in compliance for all open years (not on extension). Finally, the penalty for failure to file a Form 926 with respect to any exchange shall not exceed $100,000 unless the failure with respect to such exchange was due to intentional disregard.
B. Form 3520 and Form 3520-A Penalties
Individuals who have an I.R.C. ? 6048 filing obligation as a result of engaging in certain transactions with a foreign trust (or are treated as owning a foreign trust), and who fail to file a complete and accurate Form 3520, Annual Return to Report Transactions With Foreign Trusts and Receipt of Certain Foreign Gifts, or Form 3520-A, Annual Return of Foreign Trust With a U.S. Owner, may be assessed penalties for such failures unless it is shown that such failure was due to reasonable cause and not to willful neglect. Regarding the penalty letter, notice letters, and notices for failure to file a Form 3520 or 3520-A, the IRS utilizes: (1) Letter 3804, a five page opening notice letter required to be mailed to a taxpayer under the provisions of I.R.C. ? 6677(a); (2) Letter 394, a closing acceptance letter to be utilized after a taxpayer responds and the examiner determines that no penalties will be asserted; (3) Letter 3944, a closing no response letter to be utilized when a taxpayer either fails to respond to notice letter (Letter 3804) and when a taxpayer does not provide a statement of reasonable cause for failing to file such returns, and; (4) Letter 3946, a closing reasonable cause rejected letter to be utilized after a taxpayer responds and the examiner determines that penalties will be asserted. An initial penalty is asserted by field examiners on Form 8278 when the examiner determines that Form 3520 or 3520-A returns were required to be filed and were not timely filed or were not complete and accurate, and that the failure was not due to reasonable cause. The initial penalty for failure to file a Form 3520 is equal to the greater of $10,000 or the following: (1) 35 percent of the gross reportable amount of any property transferred to a foreign trust for failure by a U.S. transferor to report the creation of, or transfer to, a foreign trust, or; (2) 35 percent of the gross reportable amount of the distributions received from a foreign trust for failure by a U.S. person to report receipt of the distribution, or; (3) 5 percent of the gross reportable amount of the portion of the trust's assets treated as owned by a U.S. person for failure by the U.S. person to report the U.S. owner information (this penalty is imposed under I.R.C. ? 6677(b) and is discussed further in IRM 18.104.22.168). The penalties for failure to file Form 3520-A are similar to the penalties for failure to file Form 3520 except that I.R.C. ? 6677(b) changes the amount of the initial penalty to the greater of $10,000 or 5 percent of the gross reportable amount. If a foreign trust fails to file Form 3520-A, the penalties are imposed on the U.S. person who is treated as the owner of the foreign trust. There is a Continuation Penalty for any failure that continues more than 90 days after the day on which the notice of such failure was mailed to the taxpayer (the "90-day period"), in which case additional penalties apply. The continuation penalty is steep - $10,000 for each 30-day period (or fraction thereof) during which such failure continues after the expiration of the 90-day period. These additional penalties are also asserted on Form 8278. The maximum penalty (both initial penalty and continuation penalty) for failure to file Form 3520 is the gross reportable amount each year, while the maximum penalty for failure to file Form 3520-A is the gross value of the portion of the trust owned by the U.S. person. While there is a reasonable cause defense to penalties for failure to file Forms 3520 and 3520-A, the IRM makes clear that: (1) no reasonable cause should be considered until the taxpayer has filed the complete and accurate information required for all open years" excluding years on extensions; (2) a taxpayer will not have reasonable cause merely because a foreign country would impose a civil or criminal penalty on the taxpayer (or other person) for disclosing the required information ; (3) refusal on the part of a foreign trustee to provide information for any other reason, including difficulty in producing the required information or provisions in the trust instrument that prevent the disclosure of required information, will not be considered reasonable cause, and; (4) the fact that the trustee did not provide the taxpayer with a copy of the owner's statement of Form 3520-A is not reasonable cause because the taxpayer owner is also the person responsible for ensuring that the Form 3520-A is filed and that he or she receives a copy of the owner's statement.
C. Form 5471 Penalties
Pursuant to I.R.C. ? 6038(b)(1), taxpayers are subject to a penalty of $10,000 for each Form 5471 that is filed after the due date of the income tax return (including extensions) or that does not include the information outlined in ? 6038(a). The initial penalty is $10,000 per failure to timely file complete and accurate information on each Form 5471. The penalty is assessed for each form (of each foreign corporation or partnership) for each year that was not timely filed with complete and accurate information. The continuation penalty is $10,000 for each 30-day period (or fraction thereof) during which such failure continues after the expiration of the 90-day period. All penalties are asserted on Form 8278. The maximum total penalty under I.R.C. ? 6038(b) is $60,000 per Form 5471 required to be filed per year (an initial penalty maximum of $10,000 plus the continuation penalty maximum of $50,000 per return). IRM 22.214.171.124.5 sets forth the standard for reasonable cause and provides that to show that reasonable cause exists for the initial penalty, the person required to report such information must be in compliance with all open reporting years that are not on extension and must make an affirmative showing of all facts alleged as reasonable cause for such failure in a written statement. The written statement must contain a declaration that it is made under the penalties of perjury. Moreover, there is no reasonable cause exception for the continuation penalty. Additionally, I.R.C. ? 6038(c) provides for a reduction in foreign tax credit for a failure to furnish information with respect to a controlled foreign corporation (see I.R.C. ? 957) or a controlled foreign partnership that is required to be filed under I.R.C. ? 6038.
D. Form 5472 Penalties
When an examiner determines that a U.S. corporation that is 25 percent foreign-owned during a taxable year has had transaction(s) with a related party and: (1) has failed to timely file Form 5472; (2) has filed a Form 5472 which is inaccurate or incomplete, or; (3) has failed to maintain records of transactions with related parties, an initial penalty may be asserted on Form 8278. The initial penalty is $10,000 for each failure during a taxable year of a reporting corporation to: (1) timely file a separate Form 5472 with respect to each related party with which it had a reportable transaction during such taxable year, or; (2) maintain the required records relating to a reportable transaction, or in the case of records maintained outside the U.S., meet the non-U.S. record maintenance requirements. If the failure continues more than 90 days after the day on which the notice of such failure was mailed to the taxpayer (90-day period), the continuation penalty is $10,000 for each 30-day period (or fraction thereof) during which such failure continues after the expiration of the 90-day period. All penalties are asserted on Form 8278 and, under certain circumstances, an additional penalty for a taxable year may be imposed if, at a time subsequent to the time of imposition of the initial penalty, a second failure is determined and the second failure continues after notification. To advance a reasonable cause defense, the taxpayer must: (1) establish that reasonable cause exists; (2) establish that the reporting corporation must have filed for all open years that are not on extension, and; (3) make an affirmative showing of all the facts alleged as reasonable cause for the failure in a written statement containing a declaration that it was made under the penalties of perjury. In addition, Treas. Reg. 1.6038A-4(b) provides a separate reasonable cause exception for small corporations (gross receipts for a taxable year are $20,000,000 or less) when the small corporation had no knowledge of the I.R.C. ? 6038A requirements, has limited presence in (and contact with) the U.S., promptly and fully complies with all requests to file Form 5472, and promptly and fully complies with all requests to furnish books and records relevant to the reportable transaction.
E. Form 8865 Penalties
Form 8865, like Form 5471, carries an initial penalty of $10,000 for failure to timely file complete and accurate information. The penalty is assessed for each form (of each foreign corporation or partnership) for each year that was not timely filed with complete and accurate information. If any failure continues more than 90 days after the day on which the notice of such failure was mailed to the taxpayer (90-day period), there is a continuation penalty of $10,000 for each 30-day period (or fraction thereof) during which such failure continues after the expiration of the 90-day period. All penalties are asserted on Form 8278. Regarding the reasonable cause defense for failure to file Form 8865, IRM 126.96.36.199.5 provides that in order to show that reasonable cause exists, the person required to report such information must be in compliance with all open reporting years (not on extension) and must make an affirmative showing of all facts alleged as reasonable cause for such failure in a written statement. As with Form 5471, there is no reasonable cause exception for to the continuation penalty.
F. Form 8938 Penalties
The initial penalty for failure to file a timely, complete and accurate Form 8938 is $10,000 for each taxable year with respect to which such failure occurs. There is also an additional continuation penalty for any failure that continues more than 90 days after the notice of such failure was mailed to the taxpayer. This continuation penalty is $10,000 for each 30-day period (or fraction thereof) during which the failure continues after the 90-day period. Pursuant to IRM 188.8.131.52.2, Letter 4618 is the notice letter that is required to be mailed to the taxpayer under the provisions of IRC 6038D(d). The initial penalty is asserted on Form 8278 when an examiner determines that a taxpayer failed to disclose information on Form 8938 with respect to specified foreign financial assets. Continuation penalties are also asserted on Form 8278. The maximum continuation penalty is limited to $50,000 per failure. IRC 6038D(g) provides that no penalty shall apply if the individual shows that the failure is due to reasonable cause and not to willful neglect. However, IRM 184.108.40.206.5 clarifies that no reasonable cause should be considered until the taxpayer has filed all open years (not on extension).
Taxpayers and tax professionals must be mindful of the distinction between FBAR penalties pursuant to the Bank Secrecy Act, to which CDP rights do not attach, and assessable international penalties under the Code. Moreover, taxpayers are reminded that "patience is a virtue" when it comes to assessable international penalties and are advised to wait until the final notice of the international penalty to argue reasonable cause or another exception to the assessment. By waiting until the final notice, the taxpayer may challenge the international penalty via the standard Appeals procedures, including de novo CDP and judicial review. However, if the taxpayer mistakenly, or unknowingly, requests penalty abatement or enters a protest in response to a notice of penalty charge or letter that is not the Final Notice giving rise to CDP rights, the IRS will take the position that the taxpayer previously enjoyed a meaningful opportunity to challenge the underlying liability in another forum, and therefore waived the right to de novo review of the liability issue via CDP and Tax Court review.
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