Tax laws are created by Congress, with the Internal Revenue Service (“IRS”) often required to add details by issuing regulations, Revenue Procedures, Notices, and the like. Sometimes though, input from those two sources is not enough; courts must intervene to address voids in or disagreements about the rules. Unfortunately, courts cannot render decisions on important issues if the government is unwilling to subject its behavior to judicial scrutiny. In other words, taxpayers cannot obtain critical answers when the government forces issues to litigation and then surrenders prematurely. That is exactly what has occurred recently with conflicts over foreign gifts and trusts. These issues, which might have been obscure decades ago, are becoming increasingly common and worth a closer look.
Duties Triggered by Foreign Gifts and Trusts
Foreign gifts prompt certain obligations for the recipients. Section 6039F of the Internal Revenue Code generally states that if a U.S. individual receives a gift totaling more than $100,000 during a year, then he or she must notify the IRS by filing a Form 3520 (Annual Return to Report Transactions with Foreign Trusts and Receipt of Certain Foreign Gifts). The penalty for an unfiled Form 3520 is five percent of the gift for each month it is late, reaching a cap of 25 percent.
U.S. taxpayers with connections to foreign trusts have other compliance burdens, which depend on their specific relationship with the trusts. For instance, a “responsible party” (such as a grantor, executor of an estate, or transferor of property) normally must file a Form 3520 within 90 days of certain events. If a U.S. person is the “owner” of any part of a foreign trust under the grantor trust rules, then he or she must file a Form 3520 personally, as well as ensure that the trust itself files a Form 3520-A (Annual Information Return of Foreign Trust with a U.S. Owner). Finally, a beneficiary who receives any distribution from a foreign trust must submit Form 3520. Failure by a responsible party or beneficiary to file Form 3520 sparks a sanction equal to 35 percent of the relevant event. Owners failing to file Forms 3520-A face a fine of five percent.
Notable Recent Events
A lot has been happening in the world of Form 3520 and Form 3520-A in recent years, some positive and some negative from the perspective of taxpayers. For starters, the IRS launched a Compliance Campaign in 2018, which has led to many penalty battles. Shortly after, the IRS issued Revenue Procedure 2020-17 whose primary purpose was to create an exemption from filing Forms 3520 and Forms 3520-A with respect to certain “foreign retirement trusts” and “foreign non-retirement trusts.” Taxpayers initially cheered this relief, but soon came to realize its limitations. Among other things, the eligibility criteria can be difficult to meet, it does not affect tax liabilities associated with foreign trusts, and taxpayers must continue to file information returns where the trusts are classified as foreign accounts or foreign financial assets. About two years later, the IRS informed its Appeals Officers that they have the authority to waive certain international penalties using the first-time-abate policy. The IRS, unfortunately, excluded penalties related to foreign gifts and trusts from such preferential treatment. Most recently, the IRS asked for public comments regarding Forms 3520 and Forms 3520-A, and it got them. Several tax and accounting organizations provided input suggesting many improvements to the IRS, such as carefully analyzing “reasonable cause” statements before assessing penalties, ensuring that IRS personnel handling complex international issues are duly trained, requiring penalty approval by high-level supervisors, applying the first-time-abate policy to foreign gifts and trusts, and publishing comprehensive guidance to clarify when foreign pensions and other retirement plans constitute foreign trusts. The IRS has yet to take action in response to these and other public recommendations.
First Recent Government Concession
The issue of missing Forms 3520 and corresponding penalties recently arose in a novel case, Wrzesinski v. United States.
The taxpayer in that case was born and raised in Poland, immigrated to the United States when he was a teenager, and later served his community as a police officer. In 2010, his mother, who was still a citizen and resident of Poland, won the Polish lottery and decided to gift her son $830,000 over a two-year period. The taxpayer called his tax advisor from Poland to inquire about any U.S. duties triggered by the receipt of the gift. The advisor inaccurately told him that the gift did not cause any U.S. duties.
Nothing happened for many years, until 2018. At that time, the taxpayer wanted to send a portion of the earlier gift to his godson, who was still back in Poland. Concerned about maintaining tax compliance, the taxpayer did some Internet searches for potential duties related to making, not receiving, foreign gifts. Only then did he discover that he should have filed Forms 3520 for 2010 and 2011 to report his mother’s generosity to the IRS.
Upset with what he had found, the taxpayer contacted an attorney with international tax experience. The attorney confirmed that he had inadvertently violated the law and potentially faced large penalties for the missing Forms 3520. The attorney also offered some good news, namely that the taxpayer might be able to rectify the matters penalty-free by approaching the IRS through a voluntary disclosure program called the Delinquent International Information Return Submission Procedure (“DIIRSP”). The taxpayer did so, filing his late Forms 3520 pursuant to the DIIRSP, along with a detailed statement of “reasonable cause” explaining why he should not be punished. Approximately one year later, the IRS sent the taxpayer two notices, indicating that he owed the highest possible penalties for the gifts received in 2010 and 2011. They totaled $207,500.
The taxpayer challenged the penalties, filing a Protest Letter with the IRS. He strengthened his position by attaching a letter from his tax advisor, who admitted that he had given the taxpayer incorrect advice about his Form 3520 duties years ago. The Appeals Officer assigned to the case eventually agreed to reduce the penalties to five percent of the amount of the gifts, or $41,500. The taxpayer disagreed with this partial vindication, but paid the lower amount anyway and then filed a Suit for Refund in federal court.
The attorneys for the Department of Justice (“DOJ”) handling the case surely saw troubles ahead and likely wanted to avoid a loss of this nature on their records. Whatever the reason, they agreed to fully concede the case in favor of the taxpayer before they submitted any pleadings with the court, engaged in any discovery actions, filed any legal briefs, or otherwise attempted to defend the IRS’s earlier position that the taxpayer should be stuck with penalties.
Second Recent Government Concession
Taxpayers and practitioners were excited in 2023 when a new case involving foreign trusts and Form 3520-A penalties materialized, Ueland v. United States.
According to the Amended Complaint filed with the court, the taxpayer was a U.S. citizen who had been living in Australia for many years. He was fully compliant with his tax duties in Australia. He also filed an annual U.S. tax return with the IRS, enclosed several international information returns, and paid all amounts due. Because he was an Australian resident and business owner, he was obligated to participate in a common retirement instrument there called an Australian Superannuation Fund (“ASF”). The taxpayer treated the ASF as a foreign trust for U.S. purposes, meaning he filed an annual Form 3520 and Form 3520-A.
The taxpayer went unbothered by the IRS for years, but problems eventually surfaced. The taxpayer, who adhered to a calendar year, filed a timely U.S. tax return and Form 3520 for 2017. All was copacetic with the IRS in this regard. Things were different with the ASF, though. That retirement instrument used a fiscal year ending June 30, 2018, as opposed to a calendar year ending December 31, 2017. This mismatch, so to speak, triggered the dispute. The taxpayer submitted an extension request for the Form 3520-A, which postponed the deadline until March 15, 2019.
The IRS, without giving the taxpayer any prior notice, assessed a penalty of $96,000. It then used its power of “administrative offset” to seize a tax refund from 2019 to cover the penalty from 2017. Importantly to the case, the subsequent IRS letter informing the taxpayer of the seizure did not identify the tax provision under which the penalty was assessed, the reason for the penalty, or how it was calculated. This left the taxpayer with many valid questions. Did the sanction apply to Form 3520 or Form 3520-A? Was the relevant return missing, late, incomplete, or inaccurate? What was the event or balance on which the penalty was determined?
Seeking answers and the return of his money, the taxpayer filed a Claim for Refund. The IRS did not issue a Notice of Disallowance, but rather sent a form letter ambiguously stating that the Claim for Refund “did not establish reasonable cause or show due diligence.” The taxpayer then elevated the matter, asking the IRS Appeals Office for reconsideration. It took no action, later claiming that it had “no record” of ever receiving the taxpayer’s request.
The taxpayer, therefore, filed a Suit for Refund in federal court. He suggested to the court that the IRS must return his money because it ignored several procedural requirements. Specifically, he explained that the IRS failed to make a prior demand for payment, failed to obtain necessary approvals from a supervisor, and failed to include in its notice the name of the penalty, the tax provision from which it derives, and how it was calculated. The taxpayer also raised a much simpler justification for the refund: He filed his Form 3520-A on time, and the IRS simply ignored that the ASF operated on a fiscal year and that he obtained a filing extension.
Taxpayers were eager for the court to issue an Opinion analyzing substantive and procedural issues applicable to virtually all foreign trusts, but this never happened. Similar to what happened in the foreign gift case explored above, the case ended, swiftly, before trial. The DOJ attorneys fully conceded the issues and directed a full refund to the taxpayer, thereby preventing the court from rendering important judicial guidance about foreign trusts.
Concluding Thoughts – Open Issues
Complete victories for the taxpayers in Wrzesinski v. United States and Ueland v. United States are a great result, at least for the two individuals involved. However, the unwillingness of the government to go the distance, to litigate tough cases to a court decision, leaves everyone else with unresolved issues about foreign gifts and foreign trusts. Taxpayers and their advisors will remain on the lookout, hoping for clarity from the courts, as the IRS continues its aggressive enforcement in the international realm.