The IRS Is Looking For Hundreds of Thousands of Canadian Trust Returns

The IRS wants us to believe that there are hundreds of thousands of Americans who have failed to file required U.S. tax returns for their Canadian trusts.

Nonsense.

Let’s go over this, as it reflects a relentless demand by Treasury and the IRS for ever-more information on any financial transaction that may have –even remotely - an American connection. 

If an American funds or receives a distribution from a foreign trust, he or she is supposed to file tax Form 3520 with his/her Form 1040. If an American has a continuing interest in the trust (the likely reason is that he/she is a beneficiary), then he/she also has to file Form 3520-A annually. 

If one is so obstinate as to not file the 3520 or 3520-A, the IRS has a penalty of $10,000 they will gladly drop on you. You can get out of the penalty by showing “reasonable cause” for not filing, but the IRS reserves the right to define reasonable cause. 

  

The issue with reasonable cause is that it presumes both parties are reasonable, a presumption the IRS is near to abrogating. For example, whose brilliant idea was it to impose an automatic $10,000 penalty? The penalty for late filing of your personal tax return is 5% of the tax due per month – not $10,000. Late file a partnership return and the penalty is $195 per K-1 per month – not $10,000.  Why is this penalty different? Does the Treasury suspect that we are all hiding hundreds of thousands if not millions of dollars overseas? If so, where is mine?

Am I being heavy-handed? Let me give you three examples of what the IRS considers to be Canadian trusts:

• registered education savings plans (RESPs)
• tax free savings accounts (TFSAs)
• registered disability savings plans (RDSPs)

A RESP is a Canadian Section 529 plan, but with a twist. Like the American 529 plan, you open the account at a bank, broker or other financial institution. You or other family members can contribute. Unlike a 529, however, Canada will match your contribution, up to a certain percentage. Like a 529, there will be taxes when the child withdraws money to attend college.

There is no U.S. equivalent to a tax-free savings account. There is no deduction for the contribution, but there is no tax on withdrawals either. This aspect resembles an American Roth, but the Canadian TFSA is not limited to retirement savings. There are limits on how much one can contribute, of course, and for low-income taxpayers the government will contribute 500 hundred dollars Canadian.

Once again, there is no U.S. equivalent to a registered disability savings plan. The government will match one’s contribution, and for low-income taxpayers it will contribute up to 2 thousand dollars Canadian. Its purpose is self-descriptive.

The issue with the above three is that most people – even financially astute people – would not consider these vehicles to be trusts. We see savings vehicles, perhaps government-subsidized, but we do not see trusts. The problem however is that the IRS sees them as trusts. The IRS has defined a dog as a four-legged animal, and it now doesn’t know how to undefine any four-legged animal from being a dog. We are sitting ducks for that $10,000 penalty. 

What if you decide not to file prior IRS returns and just begin filing for the current year? One could easily come to this decision if there isn’t much money involved. This technique is known as “quiet disclosure.” Many practitioners, including me, have used it. The IRS does not care for it. The IRS has three reservations about quiet disclosures:

(1) Using quiet disclosures undermines the incentive to use government-approved disclosure programs, such as the most recent OVDP with its 27.5% penalty on the account’s highest balance over the last eight years. That is on top of any other applicable IRS penalties.

(2) Taxpayers using quiet disclosures may pay fewer penalties than those using the government-approved programs.

(3) Quiet disclosure is antithetical to general fairness, meaning that some taxpayers receive more favorable treatment than others do.

OBSERVATION: After the 501(c)(4) scandal, one will forgive my extreme cynicism on argument (3). Perhaps I will relent some when IRS bigwigs go to jail. It's only fair.

Reread (1) and (2) and you can see the real reason the IRS does not like quiet disclosures. It is not sufficient merely to bring someone back into compliance.

How is a reasonable person supposed to comply with the tax law, when the law is capricious? Consider that ignorance of the tax law is not defined as “reasonable cause” and you begin to see the box that the IRS is placing you in. They can pass any ludicrous demand – perhaps they want the napkin from your third lunch in the fifth week of alternating quarters – and then, with a straight face, say that your ignorance of their requirements is not an excuse.

It is also how they can say that hundreds of thousands of American citizens have failed to file for their Canadian trusts.