Taking Tax Advice From Friends

 

I received a text message one night this past week.

I was researching living trusts on the internet. It sounds like it might work for my situation.

I had two immediate reactions:

First, excellent. I am a fan of doing your own research and understanding what an expert is recommending.

Second - and maybe more important – use the expert.

The problem with DIY tax research is that you may not know what you do not know. Granted, in many cases it might not matter as much (hey, can I deduct the mileage for my gig income?), but in other cases it might matter a lot.

Let’s talk about the Horowitz case from 2019.

Peter Horowitz was an anesthesiologist. Susan Horowitz was a PhD working as a public health analyst for the U.S. Department of Health of Human Services.

In 1984 they moved to Saudi Arabia. They lived mostly on Susan’s income while banking most of Peter’s salary.

They used U.S.-based accountants, so they knew to (and filed) federal taxes on their Saudi earnings.

One thing about a bank account in Saudi Arabia: it does not pay interest. After a couple of years, the Horowitzes got tired of that and opened a Swiss bank account. They were also concerned about untangling the Saudi account when the Saudi gig played out.

Makes sense.

The Horowitzes did not tell the U.S accountants about the Swiss account. This meant that they did not report the interest income nor did they report the existence of the foreign account to the Treasury or IRS.

Why?

Their friends in Saudi Arabia told them that they did not have to pay U.S. tax on interest earned on the Swiss account.

In 2001 they moved back to the U.S. That Swiss account had grown to $1.6 million. Peter called the bank every year or two to keep an eye on the account.

COMMENT:  I would too.

Fast forward to 2008, the year that UBS got in trouble with the (non)reporting on Swiss bank accounts. UBS notified the Horowitzes that they would be closing the account. Peter traveled to Switzerland and moved the funds to another bank. Susan travelled the next year to add her name to that account.

Peter opened a “numbered” account, which meant that a number rather than a name identified the account. He also requested the new bank to not send correspondence (termed “hold mail” - something the IRS did not like).

Why?

The bank explained:

… these services allowed U.S. citizens to eliminate the paper trail associated with undeclared assets and income they held … in Switzerland.”

This is going downhill.

In 2009 Peter started reading about IRS enforcement on foreign bank accounts. He and Susan decided to consult a tax attorney.

The Swiss account was now worth nearly $2 million.

They learned that they were supposed to – all along – have been reporting that account.

 In 2010 they closed the Swiss account, repatriated the funds and applied for a voluntary Treasury disclosure program.

Good idea.

They filed amended returns for the interest income, as well as filing FBARs disclosing the existence of the foreign account.

The interest income was not inconsequential: they sent the IRS more than $100 grand in back taxes.

Got it. It was going to hurt, so they might as well rip the band-aid.

In 2012 they opted out of the voluntary disclosure program (OVDP).

COMMENT:  The default ODVP penalty was 27.5%. I suspect - but do not know for certain - that they were hoping for a better penalty result during the audit process. Considering the Swiss account had neared $2 million, the penalty alone would have been around a half-million dollars.

In 2014 the IRS sent notices. The Horowitzes, their accountants and the IRS conferred but failed to reach an agreement.

The penalties now became an issue. The base FBAR penalty is $10 grand per instance. The IRS however saw the Horowitzes behavior as willful, meaning they wanted enhanced penalties. To muddy the waters further, the law had changed. What used to be a maximum $100 grand penalty was now the greater of $100 grand or 50% of the account.

COMMENT: You may also know the FBAR by its current name: FinCEN Form 114.

The Horowitzes protested. Their behavior was not willful, and - even if it was - the old penalty (maxed at $100 grand) should apply.

The Court was short on the willfulness issue.

The court acknowledged that the couple ‘insis[ed] that neither of them had actual knowledge on the FBAR requirement.’ But, relying on United States v. Williams …., it reasoned that willfulness in the civil context ‘covered not only knowing violations… but reckless ones as well’.”

In particular, the court pointed to the fact that the tax returns signed by the Horowitzes ‘included a question of whether they had foreign bank accounts, followed by a cross-reference’ to the FBAR filing requirement. It also found significant that, by their own account, the Horowitzes had ‘discussed their tax liabilities for their foreign accounts with their friends’ but failed to ‘have the same conversation with the accountants they entrusted with their taxes for years’.”

The Horowitzes appealed.

They argued that they messed up, but that mistake was not willful. The enhanced penalties should not apply.

The IRS countered: “willfulness” in this context includes recklessness, which standard was met by:    

The Horowitzes never asking their tax preparer whether they had to report the Swiss bank accounts,

The Horowitzes asking their friends about international tax matters demonstrated their awareness of potential issues,

The Horowitzes knew to report their Saudi earnings and U.S.-based interest income from domestic banks, and

The Horowitzes signed their tax returns without reviewing them with any care.

Here is the Court:

… their only explanation for not disclosing foreign interest income related to some unspecified conversations they had with friends in Saudi Arabia in the late 1980s. Yet, if the question of whether they had to pay taxes on foreign interest income was significant enough to discuss with their friends, they were reckless in failing to discuss the same question with their accountant at any point over the next 20 years.”

Taking all of these circumstances together, the record indisputably establishes not only that the Horowitzes ‘clearly ought to have known’ that they were failing to satisfy their obligation to disclose their Swiss accounts, but also that they were in a ‘position to find out for certain very easily’.”

How much are we talking about across the years?

Including interest and penalties, it was close to $1 million.

Our case this time was Horowitz v US, No. 19-1280 (4^th Cir. 2020)

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.