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.

The Estate of Marilyn Monroe

There is a saying among tax pros: “do not let the tax tail wag the dog.” The point is to not let taxes so influence the decision that the final decision is not in your best interest. An example is failing to sell a profitable stock position for the sake of not paying taxes. Seems a good idea until the stock market – and your stock – takes a dive.

This past week I was reading about the estate of Marilyn Monroe. Did you know that her estate was the third highest-earning estate in 2011?  Her estate earned $27 million and came in behind the estates of Michael Jackson and Elvis Presley. What is driving this earning power?

What is driving it is “rights of publicity.” For example, the website Squidoo.com reports that Marilyn Monroe posters remain one of the top-sellers for students decorating their dorm rooms. A “right of publicity” exists at the whim of state statute. There is no federal law equivalent. Indiana is considered to have one of the most far-reaching statutes, recognizing rights to publicity for 100 years after death.

Marilyn Monroe divorced Joe DiMaggio in October, 1954. She then left California for New York. In 1956 she married Arthur Miller, and the couple lived In Manhattan’s Sutton Place. Marilyn still considered this her home when she died in Brentwood, California in August, 1962.

The executors of her estate had a tax decision to make: was her estate taxable to California (where she died) or New York (where she maintained the apartment and staff). They decided it would be New York, primarily because California’s estate taxes would have been expensive. By treating her as a New York resident, they were able to limit California to less than $800 in taxes.

Let’s go forward three or four decades, and states like California and Indiana now permit celebrities’ estates to earn large revenues, in large part by liberalizing property interests such as publicity rights. Some states have not been so liberal - states such as New York.

You can see this coming, can’t you?

Let’s continue. In 2001 The New York County Surrogate’s Court permitted the estate to close, transferring the assets to a Delaware corporation known as Marilyn Monroe LLC (MMLLC). The licensing agent for MMLLC is CMG Worldwide, an Indiana company that also manages the estate of James Dean. Is the selection of Indiana coincidental? I doubt it, given what we discussed above.

Marilyn is an iconoclastic image, and her photographs – and the rights to those photographs – are worth a mint. Enter Sam Shaw, who took many photographs of Marilyn, including the famous photo of her standing over a subway grate with her skirt billowing. The Shaw Family Archives (SFA) got into it with MMLLC, with MMLLC arguing that it exclusively owned the Monroe publicity rights.  SFA sued MMLLC in New York, and the court granted SFA summary judgment. The court noted that Marilyn Monroe was not a domiciliary of Indiana at her time of death, so her estate could not transfer assets to Indiana and obtain legal rights that did not exist when she died. She was either a resident of New York or California, and neither state recognized a posthumous right of publicity at her time of death.

MMLLC had no intention of rolling over. It called a few people who knew a few people.

In 2007 Governor Schwarzenegger signed into law a bill creating a posthumous right of publicity, so long as the decedent was a resident of California at the time of death. Even better, the law was made retroactive. The law could reach back to the estate of Marilyn Monroe. Wow! How is that for tax planning!

Now the estate of Marilyn Monroe started singing a different tune: of course Marilyn was a resident of California at her time of death. That entire issue of making her a New York resident was a misunderstanding. She had been living in California. She loved California and had every intention of making it her home, especially now that California retroactively changed its law 45 years after her death.

You know this had to go to court. MMLLC did not help by aggressively suing left and right to protect the publicity rights.

Last week the Ninth Circuit Court of Appeals (that is, California’s circuit) ruled that The Milton Greene Archives can continue selling photographs of Marilyn Monroe without paying MMLLC for publicity rights. The court noted that the estate claimed Monroe was a New York resident to avoid paying California taxes. The estate (through MMLLC) cannot now claim Monroe was a California resident to take advantage of a state law it desires.

NOTE: This is called “judicial estoppel,” and it bars a party from asserting a position different from one asserted in the past.

The appeals judge was not impressed with MMLLC and wrote the following:

"This is a textbook case for applying judicial estoppel. Monroe’s representatives took one position on Monroe’s domicile at death for forty years, and then changed their position when it was to their great financial advantage; an advantage they secured years after Monroe’s death by convincing the California legislature to create rights that did not exist when Monroe died. Marilyn Monroe is often quoted as saying, 'If you’re going to be two-faced, at least make one of them pretty.'”

What becomes now of MMLLC’s rights to publicity? Frankly, I do not know. It is hard to believe they will pick up their tent and leave the campground, however.

I am somewhat sympathetic to the estate and MMLLC’s situation. It was not as though the estate made its decision knowing that property rights were at stake.  At the time there were no property rights. It made what should have been a straightforward tax decision. Who could anticipate how this would turn out?

On a related note, guess whose case will also soon come before the Ninth Circuit on the issue of post-mortem publicity rights?  Here is a clue: he was from Seattle, had a four-year career and died a music legend. Give up?

It’s the estate of Jimi Hendrix.