In recent years, it appears that the Internal Revenue Service (IRS) has devoted more attention to the imposition and collection of penalties for late filing of various tax or information returns and less attention to auditing returns to uncover understatements of tax.

In many cases, penalties require far less time and effort by the IRS because they are usually based on simple fact situations. Was the taxpayer required by the Internal Revenue Code or IRS regulations to file an income tax or information return? If so, was the return filed on time? Was any tax due with the filing of the return? If so was the full amount paid and was it paid in the time prescribed?

A $95,000 Penalty Assessment for Filing Six Days Late

In 2005, I filed a timely return (Form 3520-A) for a foreign trust by March 15^th.  It later turned out that the IRS did not get the form until March 21^st.  An agent imposed a penalty of 5% of the assets in the trust, amounting to $95,000 for a late filing of the return. As it turned out, I had mailed this return for the client because he was out of the country and I had mailed it via the U.S. postal service with a certified mail receipt that I had carefully identified as being for that client and that particular form. The IRS is supposed to retain a copy of the mailing envelope with the mailing date, but in this case, they either did not keep it, had lost it or were simply trying to see if they could trick the client into giving up $95,000.  After multiple letters back and forth, they rescinded the penalty.

Many Penalties  Are for Non Filing or Late Filing

As a general rule, the individual income tax return (Form 1040) does not have to be filed if no tax is due based on the amount of income and statutory deductions or exemptions. (Itemized deductions can’t be taken into account for this purpose.) Otherwise, there is a penalty of 5% of the tax due (up to a maximum of 25%) for each month the return is filed late. The corporate income tax return is required to be filed regardless of whether a tax is due, but the penalty for a late filing of the return is also 5% of the tax due, up to 25%.

For virtually all other tax information returns, there is a specific penalty for a failure to file the form or for late filing of the form – regardless of whether any additional tax is due because of the information that should be reported on the return. An assortment of other penalties apply for a failure to report income paid to others, to withhold and pay any taxes from other persons (such as employees), for a substantial understatement of the tax that is due, for civil fraud and for criminal fraud.

For the past five years, most of the tax  returns I have prepared have been international information returns for prior tax years.  In nearly every case, I've been able to offer some justification on behalf of the taxpayer for the delinquent returns and have  prepared requests on their behalf to request a waiver of penalties for a failure to file the returns on a timely basis.  Thus far, none of my clients have been assesed penalties  but there is no assurance that penalties can be avoided.  And, recent developments in the IRS indicate that they are going to  become far less agreeable to waive these penalties.

The Law of Unintended Consequences

Many (if not most) laws have an impact that is exactly the opposite of what is intended. The U.S. government wants U.S. taxpayers to file various tax and information returns - even if they are filed late. However,
the potential penalties may represent a very large percentage of the assets in an offshore trust or a foreign corporation.  After finding out how severe the penalties could be, some taxpayers may prefer to take their chances by not filing the delinquent returns.  However, if the IRS should discover that the returns have not been filed and if they should somewho discover that the taxpayer consulted with a tax preparer other than an attorney, they could then argue that the failure to file was intentional and was therefor a felony, subject to criminal prosecution and sanctions.

Between a Rock and a Hard Place

Filing late can result in punitive financial penalties but will rarely result in  criminal charges. Not filing and getting caught can result in criminal prosecution.  And tax professionals can't advise you not to file. It would be a crime for an accountant or an attorney to advise a taxpayer not to file delinquent returns. However, consultation with an accountant is not protected as a privileged communication to the same extent as a consultation with an attorney. Although an attorney can not advise a client that it would be best not to file, the attorney can not be compelled to testify as to the nature of the consultation. An accountant or other tax preparer can be compelled to testify.  So if a taxpayer discusses the matter with an accountant and then decides not file, the accountant could be compelled to disclose the details of the discussion.

How would the IRS find out? There are many ways the IRS could discover that a taxpayer had consulted with a tax preparer other than an attorney, but the most likely is that the IRS might uncover information from other sources regarding the existance of unreported foreign bank or other financial accounts, foreign credit cards, foreign trusts or foreign corporations. That is likely to lead to an audit. The audit could easily result in producing information that the taxpayer had discussed the matter with an accountant. The IRS would then ask for the name of the accountant and would secure a court order to compel the accountant to divulge the nature of the discussion.

The Congress and the IRS have become particularly frustrated by the failure of many U.S. taxpayers to file the information returns required for foreign trusts, foreign corporations, foreign partnerships, foreign disregarded entities, foreign mutual funds and other foreign financial accounts. The rest of this article is a very brief summary of the penalties that may be imposed for the failure to file these information returns or to merely fail to file them on time.

Form 3520-A:  Annual Information Return of Foreign Trust with a U.S. Owner (Grantor)

The U.S. owner (grantor) of any trust assets is subject to a penalty of 5% of the gross value of the portion of the trust assets that are treated as owned by the U.S. grantor if the foreign trust fails to file a timely Form 3520-A or does not provide the information required. A waiver of penalties can be made by the IRS upon a showing of a reasonable cause for a failure to file this form, but, according to the IRS, "The fact that a foreign country would impose penalties for disclosing the required information is not reasonable cause."  The form is required to be filed three and ½ months after the end of the tax year of the trust. For a trust using a calendar year, it must be filed by March 15^th or the penalty will be imposed.  However, an extension of time to file can be requested with Form 2758.

Form 3520:  Annual Return to Report Transactions with Foreign Trusts and Foreign Gifts

The penalties for a failure to file this form include (1) 35% of the gross value of the distributions received from a foreign trust or transferred to a foreign trust, and (2) 5% per month for the amount of certain foreign gifts -- to a maximum of 25%. Penalties may be waived by the IRS on a showing of reasonable cause for a failure to file.  The U.S. does not consider that a reasonable cause includes the fact that the disclosure of this information might be a crime in another country. This form is due with the income tax return of the U.S. grantor of the foreign trust, including any extensions of time to file.

Form 5471:  Information Return of U.S. Persons with Respect to Certain Foreign Corporations

Form 5471 is due with the income tax return of the affected shareholder. For most domestic corporation shareholders, that would March 15th or the extended due date. For most individual shareholders, that would be April 15th or the extended due date.  The penalties for failing to file this form are severe, even though no tax may be due. There is a penalty of $10,000 for each year for failing to file the form on a timely basis. The penalties may be waived by the IRS on a showing of reasonable cause for failing to file the form. If the taxpayer is notified by the IRS of a duty to file, the penalty is $10,000 per month up to a maximum of $50,000.  For a late filing of the form, “any person who fails to file or report all of the information required within the time prescribed will be subject to a reduction of 10% of the foreign tax credit available for credit.”  There are additional penalties that are described in the instructions to the form.  An abbreviated method of reporting is provided for a dormant controlled foreign corporation, but it is not clear if an unfunded foreign corporation is considered to be dormant. An argument could be made by the IRS that the filing fees paid to form the corporation represent an intangible asset of the corporation and it is therefore funded to the extent of those filing fees and other expenses of keeping the entity in existence.

Form 926:  Return by a U.S. Transferor of Property to a Foreign Corporation

Generally, the form is required for transfers of property in exchange for stock in the foreign corporation, but there is an assortment of tax code sections that may require the filing of this form.  The penalty for a failure to file the form is 10% of the fair market value of the property at the time of the transfer.

Form 8621:  Return by a U.S. shareholder of a Passive Foreign Investment Company

It is not mandatory to file this form unless there is a distribution of income from a passive foreign investment company (PFICs) in which a U.S. person is a shareholder or a disposition of the shares of a PFIC by gift, death and most types of otherwise tax free exchanges or redemptions. However, taxpayers or preparers will not find a statement to this effect anywhere in the instructions to the form or in the applicable IRS regulations.  U.S. shareholders of a PFIC may choose to file this form on an annual basis to report income from the fund as a “Qualified Electing Fund” or using the “mark-to-market” method of accounting. If the income of the fund is not reported on an annual basis, there is a very punitive method of taxation of distributions of fund income or dispositions of fund shares.

Form 8865:  Return of U.S. Persons with Respect to Certain Foreign Partnerships

The form is required to be filed with the income tax return of each partner, including any extensions of time to file.  In most respects it is a combination of the U.S. Form 1065 partnership return and the Form 5471 return for controlled foreign corporations. The penalties for failing to file the form or for failing to file it on a timely basis are the same as for foreign corporations. The penalty is $10,000 per year for a failure to file and the loss of 10% of available foreign tax credits for filing late.

Form 8832:  Election to be Taxed as a Disregarded Entity

A foreign corporation or foreign limited liability company will be treated as a foreign corporation for U.S. tax purposes unless the owners make an election to be treated as a partnership (where there are multiple owners) or as a disregarded entity (for one owner). Making the election by filing this form is optional, but if the form is not filed with 75 days after the end of the first taxable year of the foreign entity, the default treatment will to treat it as a foreign corporation.  A later conversion from a foreign corporation will require a dissolution of the corporation (with possible taxes on unrealized gains). 

Form 8858:  Information Return of U.S. Persons with Respect to Foreign Disregarded Entities

This form was introduced for the 2004 tax year so that the IRS could have assurance that U.S. persons with foreign disregarded entities were reporting the income from those entities. It is to be filed with the income tax return of the U.S. person (or corporation) that is a shareholder or partner of a foreign entity that is treated as a disregarded entity. A $10,000 penalty is imposed for each year of each controlled foreign corporation or controlled foreign partnership for a failure to file this form within the time prescribed.

Form TD F 90-22.1:  Report of Foreign Bank and Financial Accounts

U.S. persons who have direct or indirect authority over, or a financial interest in, a foreign financial account may be required to report certain information about each account on or before June 30^th of the year following the preceding calendar year. The report is not required if the aggregate value of all foreign financial accounts is less than $10,000 at all times during the preceding calendar year. A willful failure to file the form is subject to severe civil and criminal penalties. According to the instructions to the form,

Civil and criminal penalties, including in certain circumstances a fine of not more than $500,000 and imprisonment of not more than five years, are provided for failure to file a report, supply information, and for filing a false or fraudulent report.

However, because the penalties were imposed for a willful failure to file and because willfulness is difficult to prove and because the penalties were so extreme, they were never imposed.  The Congress then introduced a smaller penalty of “up to $10,000” for a non-willful failure to file the form, effective for filing dates after October 22, 2004.  There is no specific penalty for a failure to file the form on a timely basis and it is not clear if the non-willful penalty will be imposed for a late filing of the form for years after 2003.

Waiver of Penalties for “Reasonable Cause”

These varied penalties can sometimes be waived or reduced at the discretion of the IRS if the taxpayer can show a “reasonable cause” for a failure to file or for a failure to file by the due date of the form or return.

According to an article at BankRate.com

Built into its agent handbook are guidelines for determining reasonable cause that might warrant abating a penalty. They include such things as:

•           A mistake made despite ordinary business care and prudence
•          Forgetfulness
•          Ignorance of the law
•          Death, serious illness or unavoidable absence
•          Inability to obtain records
•          Inability to obtain tax forms
•          Return was filed at the wrong IRS office
•          Followed advice from a tax adviser
•          Followed oral advice from the IRS
•          IRS error

These are reasonable cause areas as defined by the IRS, not automatic loopholes out of a tax penalty. If your reason falls into one of these categories, you may be able to convince the IRS to let you off; if it doesn't, you are out of luck.

Note that the mention of “ignorance of the law” in the article from BankRate.com is a potential defense with respect to potential criminal penalties, but is not necessarily a defense with respect to civil penalties.

For more information about avoiding penalties see “Reasonable Cause Can Waive Penalties” a PDF report by Nancy Faucett, CPA

And “Avoiding IRS Penalties” by Gail Perry 

And “Reducing IRS Penalties” by Robert McKenzie, Esq.

In the case of a failure to file various returns for foreign trusts, corporations, partnerships, etc., reasonable cause may be justified where the taxpayer can show that an effort was made to determine the tax filing obligations for such entities and where persons who reasonably appeared to be knowledgeable about such matters had informed the taxpayer that no U.S. taxes were due unless or until income was repatriated back to the U.S.  

However, reliance on the advice of others is not an assurance that penalties can be avoided if that advice is wrong. Under new regulations by the IRS and new tax code sections introduced in the American Jobs Creation Act of 2004, taxpayers may not be able to avoid the imposition of various penalties unless they receive a “covered opinion” from a qualified tax professional. A covered opinion is essentially a written opinion that includes a comprehensive analysis of all the potentially pertinent tax issues and arrives at a conclusion that the opinion expressed is more likely than not to prevail in the event of a dispute with the IRS. However, this is a very simplistic description of that subject and a much more detailed discussion is available at http://www.offshorepress.com/vkjcpa/disclosurerules.htm

The information and opinions in this article are those of the author and are intended as educational material and commentary for public discussion. This article is not intended to represent tax advice for any reader of this information and may not be cited as authority for any tax position.

Vernon K. Jacobs

Http://www.offshorepress.com/vkjcpa/

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