An Ugly Case Over An Ugly Penalty

 

You know that the IRS pays especial attention to foreign transactions of U.S. citizens. We are to report foreign bank accounts, for example, should they exceed a certain balance.

Did you know that you may also have to report gifts made to you by individuals (and entities) overseas and exceeding certain threshold amounts?

That may come as a surprise, as we anticipate gifts to be tax free (and unreported) by the recipient. To the extent we pay attention to this area of tax, it is the donor - not the donee - who reports a gift. It is even possible to have a tax (the gift tax) if one cumulatively gifts “too much” over a lifetime.

Let’s be candid here: this is not a risk you or I have to sweat.

What got me thinking about it is a recent case coming out of California. Ms. Huang litigated over IRS penalties for her failure to timely report gifts from her overseas parents. She used TurboTax to prepare her taxes, and TurboTax advised her incorrectly about the gifts. She believes she has reasonable cause for abatement of those penalties.

I agree with her.

I also think this area of tax law is a mess.

Let’s go over this – briefly.

First, there are two considerations with foreign gifts:

·       Disclosure

·       Taxation

It is unlikely that there will be a tax, but it is likely that you must report the gift. There is even a specialized form for this – Form 3520: 

Trust me, one can have a long career in public accounting and never see this form.

The filing threshold varies depending on the donor:

Gifts From Foreign Individuals

·       The threshold is $100,000. Not surprisingly, multiple gifts from the same person (say mom) must be added together.

o   BTW, if mom gets creative and arranges to transfer more than $100 grand via various family members, there is a related party rule that will combine all those donors into one person – and put you over the $100,000 threshold.

o   Once required to file, each gift of $5 thousand or more is to be separately identified and described.

o   There may be excellent reasons for the multiple gifts. There are numerous countries which impose restrictions on outbound currency transfers. South Korea, for example, places a limit of $50,000 (USD).

Gifts From Foreign Corporations or Partnerships

·       The reporting threshold is greatly reduced if a business entity is involved – to $19,570.

·       In addition to the usual gift information, one is also to provide the name, address, and tax identification number (if such exists) for the entity.

Inheritances

The IRS takes the position that an inheritance is comparable to a gift. If one inherits from a nonresident, the inheritance might be reportable on Form 3520.

EXAMPLE: Carlos is a lawful permanent resident of the U.S. His uncle – a nonresident alien - passes away, leaving Carlos a house in a foreign country. While the residence is outside the U.S., Carlos is a U.S. permanent resident and should file a Form 3520.

Let’s change the example a little bit:

EXAMPLE: Carlos’ uncle was also a lawful permanent resident of the United States, even though he lived for substantial periods outside the U.S. The inheritance now is from one “US person for tax purposes” to another, and there is no need to file Form 3520.

  The penalties for not filing a 3520 can be onerous.

·       5% of the gift amount for each month a failure to file exists. In the spirit of not bayoneting the dead, the IRS will (fortunately) stop counting once you get to 25%.

·       If the IRS contacts you before you contact them, the penalty changes. It then becomes $10,000 for each month you fail to file Form 3520 after request.

·       Penalties will apply even if you filed a 3520, if the IRS believes that the return is incomplete or incorrect.

·       BTW this penalty can chase you unto death – and beyond. There are cases where the IRS has demanded penalties from the estates of deceased individuals.

So, what happened to Ms. Huang?

Her name is Jiaxing Huang, and in 2015 and 2016 her parents gifted substantial sums to help her relocate to the U.S. and purchase a home. Ms. Huang, like millions of others, used TurboTax to prepare her taxes for those years. She asked - and TurboTax informed her - that donors, not donees, are required to report gifts. Based on that feedback, she did not file Form 3520 for those years.

COMMENT: TurboTax was correct, IF one was talking about gifts from a U.S citizen or lawful permanent resident to another. It was not correct in specialized circumstances – such as that of Ms. Huang’s.

A couple of years later she learned of her filing obligations. Trying to play by the rules, she immediately filed Form 3520 for 2015 and 2016. She was late, of course, but she filed before the IRS ever contacted her – or had any reason to suspect that she was even required to file.

The IRS responded – here is a (too) common reason people hate the IRS – with penalties exceeding $91 grand.

COMMENT: The IRS churns these letters automatically. They do not go by human eyes. I propose – as a small improvement – that the someone at the IRS review these letters and related files before sending out such onerous penalties. I understand workforce limitations, but let’s be blunt: HOW MANY NOTICES CAN THERE BE?

Ms. Huang submitted an abatement request based on reasonable cause.

The IRS denied the request. They then withheld her 2019 ($280) and 2022 ($7,859) tax refunds.

Of course.

She appealed the denial of abatement within the IRS itself.

COMMENT: She was trying.

She instead learned that her penalty had jumped to over $153 grand. With interest she was topping $190 grand.

This was so egregious that even the IRS backed down. Appeals reduced the penalty to slightly over $36 grand.

Ms. Huang paid it.

COMMENT: No!!!!!

Two weeks later she filed a Claim for Refund.

COMMENT: Yes!!!!!

Her grounds? Abatement of the penalties – as well as the 2019 and 2022 tax refunds the IRS intercepted.

Let’s take a moment to explain why Ms. Huang paid the penalty.

In many if not most areas of tax law, one can bring suit without paying the tax (or penalty or whatever). That is one of the attractions of the Tax Court: you can get a hearing before sending the IRS a nickel. Not all areas of tax law are like this, however. An area that is not? You guessed it: Form 3520 penalties.

COMMENT: If you think about it, this is one way to keep people from bringing suit. How many can afford to pay the tax (or penalty or whatever) AND pay a tax attorney to litigate? It’s a nice scam you have there, Agent Smith.

The government did its usual: an immediate motion to dismiss the complaint. They even offered four reasons why the Court should dismiss.

The Court agreed with the government on three of the reasons.

It did not agree with the fourth: whether Ms. Huang’s reliance on tax software such as TurboTax under these circumstances could constitute reasonable cause.

Ms. Huang will have her day in Court.

But at what cost to her.

And why – when the IRS is hemorrhaging employees and losing budget allocations it likely should not have received in the first place – are they wasting their time here? The facts are unattractive. Ms. Huang is not a protestor or scofflaw. She tried. She got it wrong, but she tried. There is no win condition here for the government.

Our case this time was Jiaxing Huang v United States, Case No 24-cv-06298-RS, No District California.

A Too Rare Taxpayer Win Over Foreign Reporting

I have become cynical about IRS penalties.

Like many accountants, I initially learned that penalties were in the system as a deterrent. If one complies with reporting responsibilities, penalties should not enter the picture. If they do, they surely would be for ministerial causes (think late payment of an estimated tax) and minor, and – if somehow major – waivable upon showing reasonable cause for the mistake.  

Poppycock.

Congress has been raising and creating penalties for decades to “pay for” their tax bills. I would also argue that the IRS has used penalties as a backstop to its funding, especially during Republican budget stringency after the Lois Lerner fiasco.  

The IRS often assesses penalties automatically, without anyone even glancing at your return. This transfers tax administration from the IRS to you – and then by extension – to me. Say that you have a reportable interest in a foreign corporation. The IRS says you must file a certain information report. I get it: the IRS wants to know what is going on. You file the report, but you file it late. Why late? Who knows. Your accountant was on health leave. You were misadvised. You were never advised because you did not recognize it as a tax-sensitive issue. You will – soon enough – get an automatic IRS notice for a $10,000 penalty – or more. You complied, but not fast enough.

Reasonable cause?

Depends on who defines reasonable. As a practicing tax CPA for decades, I am much more open to reasonable cause. Why? I am closer to the day-to-day, so I do not have the anesthesia of distance and disinterest. Things ... just … happen. No one likes paying, but let’s not use that same brush to accuse one of gaming the system.

Let’s take a look at Wrzesinski.

We will call him “W” to keep our sanity.

W was born in Poland. He moved to the United States when he was 19 years old.

A few years later his mom, who still lived in Poland, won the Polish lottery.

Sweet.

Mom gifted him $830,000 over a couple of years.

W knew about U.S. tax. He contacted his tax advisor to ask what the consequences would be. His advisor (G) correctly told him that the gift would not be taxable, but incorrectly told him that no further reporting was required.

I know that G was wrong, but how could the IRS expect W to know that?

Fast forward a few years and W wanted to make a gift to his godson in Poland. He did an internet search, at which time he realized that – while not taxable – reporting was still required. He realized this situation as his own years before, and he contacted an attorney with expertise in foreign tax matters.

W got into an IRS program for late filing of certain foreign-related returns. The IRS would tread lightly if one had reasonable cause, and both W and his attorney thought he had reasonable cause to spare.

I agree.

The IRS came back with its automatic penalties: they wanted $87,500 for one year and $120,000 for the second.

Their reason?

The Notices stated that …

… ignorance of the tax laws was not a basis for penalty abatement under the “reasonable cause” standard and that ordinary business care and prudence require that the taxpayers be aware of their obligations and file or deposit accordingly.”

I would argue the opposite: good faith “ignorance” of tax laws is exactly the basis for the reasonable cause standard. We have more than once huddled here at Galactic Command analyzing tax consequences, especially if planning a transaction. We sometimes disagree. We have run into gaps in tax law, as Congress is churning out this stuff faster than the IRS and the profession can interpret. We have run into contradictions in tax law, especially when the aforesaid gaps are working their way through the courts system. Did I mention that we are all CPAs with varying tax backgrounds? I am, for example, a tax specialist. It is all I do and have done for years.

Consider that there was no tax shelter here, no attempt to avoid reporting income or of claiming bogus deductions. There was a gift from a mother to a son. A gift unfortunately involving some of the most arcane reporting rules embedded in the tax Code. There was no need for the IRS to flog the guy.

W and his attorney protested the penalties.

The IRS lost W’s protest.

Yes, they “lost” his protest.

It took the Taxpayer Advocate to find it.

The IRS abated all but $40 thousand or so of penalties.

W paid it.

And he immediately filed claims for refund.

I like this guy.

The IRS bounced the first claim, saying he did not establish reasonable cause.

You may be figuring out the IRS schtick when in this situation. It is a one-play gamebook: nothing is reasonable. Boyle. Go away.

The IRS bounced the second claim, saying that it was “frivolous.”

Folks, never ever tell a tax practitioner that his/her position is “frivolous.” That is a loaded word in tax practice.

This thing … NO SURPRISE … went to Court.

Let’s fast forward.

In a too-rare taxpayer win, the DOJ conceded the case on February 7, 2023, and requested six to eight weeks to refund W his remaining penalties.

But look at the effort it took.

Our case this time was Krzysztof Wrzesinski v The United States, U.S. District Court, Eastern District of Pennsylvania.

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.

The Mexican Fideicomiso and Foreign Trusts

This topic originated with Karl, who owns a condo in Puerto Vallarta, Mexico.

Karl was incredulous when I had him file a foreign trust tax return for his Mexican condo a couple of years ago. Why? Because the IRS was increasing their attention to foreign matters (think FBAR and FATCA, for example), and the penalties for failure to file had marched full-throated into extortion territory – at least for my clients, as I do not represent P&G, Toyota or their executives.

Under the Mexican constitution, noncitizens cannot directly own real estate within 50 kilometers of the coastline. This means that a U.S. citizen (Karl for example) has to use an agent to purchase the real estate. This agency is called a fideicomiso. Mind you the fideicomiso does nothing other than hold title – there is no bank account to pay taxes or insurance or repairs or anything.

The tax issue with the fideicomiso is whether or not the IRS would consider it to be a foreign trust. For many years practitioners (including me) considered it the equivalent of an Illinois land trust. The IRS treats the Illinois land trust as though it doesn’t exist; a technical way to say it is that the owner has a direct interest in the real estate and reports accordingly.

When the IRS tightened up its foreign reporting, it became unclear how they would treat fideicomisos. I called the National Office, for example, but received no clear-cut answer or leaning. This put me in a difficult spot, as the penalties for failure to file a return when assets are transferred to a foreign trust are the greater of $10,000 or 35% of the assets transferred. There is also an annual filing requirement (it is assumed that the trust is not funded annually), and those penalties are the greater of $10,000 or 5% of the value of the trust assets.

You can see how this gets very expensive.

So I had Karl file a tax return to report the funding (Form 3520) as well as an annual tax return (Form 3520-A). I am uncertain what the IRS got out of this, but Karl racked up additional tax compliance fees.

The IRS has recently published a Private Letter Ruling (PLR 201245003) stating that a fideicomiso is not a trust as that term is intended in IRS Reg. 301.7701-4(a), and that the beneficiary of the trust is to be treated as the direct owner. In other words, the fideicomiso is “invisible” to the IRS.

There are issues with PLRs, primarily that the IRS does not consider them as precedent to anyone other than the person to whom the PLR was issued. That means that – while tax advisors can look to them for markers as to IRS positions – they are not a failsafe if the IRS goes against you.  Karl is not completely protected unless he obtains his own PLR. Those cost money, of course. The filing fee alone can be several thousand dollars. Then you have my fee.

Don’t get me wrong: I have used PLRs in IRS representation before, and I have gotten greater or lesser traction depending on the examiner, manager or appeals officer and the magnitude of the specific issue to the exam. I suspect that, in the case of fideicomisos, the IRS is waving the flag and giving advisors a clue on their position and enforcement intentions. But one cannot be sure, and there’s the rub.

So how would you have me advise Karl? Would you advise him/her to get his/her own PLR (for thousands of dollars), would you rely on the issued PLR or would you have Karl continue filing Forms 3520/3520-A?

And remember: all we are talking about is a condo. A nice one, granted, but this "trust" has never even been near Switzerland.

Be Careful With Foreign Tax Information Returns

Today we filed an extension for a client company with a foreign subsidiary. I was recently reading a Chief Counsel’s Advice concerning the same type of tax return that our client will be filing in a few months.

There is an additional form to file when one owns a foreign corporation. That is Form 5471 “Information Return of U.S Persons with Respect to Certain Foreign Corporations.” The common ownership threshold for filing is 10 percent. There is a twist in which an officer or director has a responsibility to file, even if the officer or director owns no shares directly, as long as a US citizen owns at least 10 percent.

Frankly, this is a confusing return. There are four types of “filers,” and each has to fill-out – or not fill-out- certain sections of the return. One may have to provide an income statement for the foreign company, for example, or track its earnings and profits.

The 2010 HIRE Act amended the tax Code (Section 6501(c )(8)) so that the statute of limitations for an income tax return to which an international “information return“ relates does not start until the information return is filed.

What does this mean? Well, Form 5471 is considered an “information return.” This means that it has numbers on it, but there is no line that says “tax due.” There is a similar form (Form 8865) for foreign partnerships and another (Form 3520) for foreign trusts.

So you own (enough of) a foreign corporation to file Form 5471. The accountant doesn’t think about it and files the corporate return without it.  The IRS in CCA 201104041 clarified that the statute of limitations on the corporate return does not begin to run until the Form 5471 is filed.

The client referred to above is new to the firm. One of the reasons that they switched firms? Their former CPA had not been filing Forms 5471.

If you remember, there are also penalties for not filing foreign information returns, including Form 5471. That however is for another blog post.

Do You Have To Report Foreign Gifts?

My brother-in-law is married to an English citizen. My other brother-in-law lives near Saffron Walden, north of London. Perhaps it is because of my wife’s family, but I have paid attention to the tax issues of expatriates for a long time.

Let’s reverse the direction, however, for today’s discussion. Let’s say that you are a U.S. citizen or green card holder. You live in the United States. It is the family that lives abroad. You receive a gift or bequest from the family. To simplify the discussion, let’s stipulate that the family has no ties to the U.S., other than having you in the family. Maybe you are the in-law.

What does your tax radar tell you?

Generally there is no U.S. gift tax on a gift from overseas – with some exceptions. There are always exceptions. The gift could be subject to U.S. gift tax if it is “U.S. situs” property. In general, tangible property located in the U.S. is “U.S. situs” property. Examples would include:

·         Residence

·         Vacation property

·         Boat

·         Cash

Did I say cash? Yep. The IRS considers cash to be tangible property. The IRS could, for example, consider a check given to you in the U.S. to be a gift of personal property subject to the gift tax. I personally would visit the family overseas, receive the check and sidestep this issue altogether. I have never understood why cash is singled out. I like to remember tax law by understanding what the law is attempting to reach, but this rule has never made sense to me.

Generally intangible property is not considered “U.S. situs” property. Intangibles would include stocks and bonds, for example. There is a different rule with respect to U.S. stocks and bonds and the estate tax, but we are discussing only gift tax today.

Short of transferring a house to you, it is unlikely that your in-laws will have a U.S. gift tax return. You however may have to file Form 3520, “Annual Return to Report Transaction With Foreign Trusts and Receipt of Certain Foreign Gifts,” depending on the amount of the gift. The good news is that there is no tax with Form 3520. It is a reporting form. You are required to file Form 3520 only if gifts from individuals exceed $100,000 for the year. There is a lower threshold for gifts from a foreign corporation or partnership - $14,375. I have never seen a gift from a foreign corporation or partnership, however.

But remember to file the 3520, because if you don’t file the penalties will be 5% of the gift amount for each month you don’t file.

I suspect you figured out where the IRS gets its money on foreign gifts.