In brief

On 28 July 2021, the U.S. Court of Appeals for the Second Circuit overturned the district court to hold that the Internal Revenue Service (IRS) could impose the 35% penalty for the taxpayer’s untimely filing of his Form 3520. The court noted that application of a reporting requirement for trust owners to the taxpayer did not eradicate the owner’s concurrent reporting obligation as a beneficiary of such trust. While the decision in the Wilson case addressed the specific issue of whether the government has the authority under the Internal Revenue Code (“Code”) to impose a 35% penalty when the taxpayer is both the sole owner and beneficiary of a foreign trust and fails to report distributions received from the trust, the case arises in a time of heightened difficulties for taxpayers when they are regularizing international information returns


In depth

In 2003, Joseph Wilson established a foreign trust with a value of approximately USD 9 million. Wilson was the sole owner and beneficiary of such foreign trust. Then, in 2007, Wilson liquidated the trust and distributed all of its assets, approximately USD 9.2 million, to himself. Under the relevant statutes, 26 U.S.C. 6048(b),(c), the foreign trust and Wilson needed to file Forms 3520-A and 3520, the “Annual Information Return of Foreign Trust with a U.S. Owner” and the “Annual Return To Report Transactions With Foreign Trusts and Receipt of Certain Foreign Gifts” respectively. 26 U.S.C. 6677(a),(b) imposes penalties for the late filing of these returns: a 35% penalty applies to beneficiaries who fail to timely report their distributions and a 5% penalty applies to owners who fail to ensure that their trust timely files an annual return. Wilson filed both returns for the 2007 tax year late and the IRS assessed a 35% penalty against Wilson for failing to disclose the distribution he received from his foreign trust. Wilson initially paid the 35% penalty and then filed for a refund, arguing he should have solely been charged the 5% penalty applying to trust owners.

Wilson passed away while his claim for a refund was pending. Wilson’s estate sued for a refund arguing that only the 5% penalty should have applied and alleging in the alternative that reasonable cause excused Wilson’s untimely filing. Wilson’s estate moved for partial summary judgment on their 5% penalty argument, which the district court granted. The government appealed and the Second Circuit reviewed de novo.

The Second Circuit determined that the plain language of the relevant disclosure and penalty provisions unambiguously demonstrate that when an owner of a foreign trust fails to timely disclose a distribution received as a beneficiary of that trust, he violates both of the reporting requirements and triggers the 35% penalty provision.  The Second Circuit also found that the statute dealing with the disclosure requirements is concerned with the actual disclosure requirements and not the forms on which such requirements are satisfied.

The Second Circuit found that nothing in the Code: (i) exempts a beneficiary who is also the owner of a foreign trust from timely reporting the distribution received from such trust; (ii) eliminates the applicability of the 35% penalty to Wilson as a beneficiary of the trust; or (iii) indicates that the government may impose only a single penalty even if the taxpayer violates multiple filing requirements.

The Second Circuit focused on whether the actual statutory disclosure requirements were satisfied rather than the form on which such disclosures are made. The Second Circuit noted that whether the taxpayer files Form 3520, Form 3520-A, or both, they must disclose any distributions received from a foreign trust even if they are the sole owner and sole beneficiary. Further, the Second Circuit indicated that even if the forms generate some ambiguity, forms can only be used to clear up ambiguity within a statute not to create it. 

The IRS has been regularly assessing penalties on taxpayers filing late international information returns, particularly the Form 3520, which was at issue in the Wilson case. The result is that taxpayers who owe no taxes and who may be eligible for relief from penalties for late filing of information returns because of reasonable cause are forced into a lengthy appeals process when they realize they missed a filing. For taxpayers who have both unreported foreign-source income and delinquent Forms 3520 both due to non-willful non-compliance, the streamlined filing compliance procedure may provide the best option for coming into compliance.  

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