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If you are the owner or beneficiary of a foreign trust, you must disclose that asset, and any distributions you receive from it to the government every year. Failure to comply with the IRS reporting requirements can add up to steep penalties, and even negate any benefit you received from the trust. But how do those penalties work when the trust owner is also the sole beneficiary? A recent New York federal district court decision settled that score, and the taxpayer won.
In 2003, Joseph Wilson thought his wife was preparing to file for divorce. Not wanting her to receive half of his assets, he opened a foreign trust, funding it with $9 million USD. Wison named himself, grantor, sole owner, and beneficiary of the trust. By 2007, Wilson’s fears had proven true, and his marriage was over. When the divorce proceedings were finished, Wilson terminated the trust, and brought $9,203,381 in foreign trust assets back to his U.S. bank accounts.
From 2003 through 2007, Wilson filed income tax and information returns with the IRS, reporting the foreign trust’s assets, and the interest he earned on those assets. But then, in tax 2007, after the account had been closed, he was late filing Form 3520, “Annual Return to Report Transactions with Foreign Trusts and Receipt of Certain Foreign Gifts.” Because he was late in filing this form, the IRS assessed a late penalty of $3,221,183, which equaled 35% of the distributions closing the trusts.
Wilson objected. As the foreign trust owner, he and his tax attorneys said he should only be fined 5%, not 35%. After filing his objection with the IRS and being ignored, he paid the assessment and then filed a lawsuit to be refunded the overpayment. Wilson died while that lawsuit was pending, first in the United States Court of Federal Claims, and then in the United States District Court for the Eastern District of New York. However, his family carried on with the lawsuit, hoping to recover the $3.2 million foreign trust reporting penalty. Their argument raised two questions:
The U.S. Tax Code lays out the reporting requirements for a U.S. taxpayer with interest in a foreign trust account in 26 U.S.C. 6048. Section (b) applies to owners and requires them to “submit such information as the Secretary may prescribe” each year. Section (c) applies to beneficiaries, requiring them to file tax returns including “any distribution from a foreign trust” each year.
The law also clearly describes the penalty for failing to disclose foreign trust distributions on the required tax return as “35 percent of the gross reportable amount” along with any additional penalties. However this amount can never exceed the gross reportable amount of the trust at the time the IRS determines there has been a failure to report. Any overpayment must be returned to the taxpayer.
However, the very next section of the Tax Code says that for returns filed by the owner of a foreign trust account the penalty should “be applied by substituting ‘5 percent’ for ‘35 percent.’” This was the section the U.S. District Court judge relied on in his opinion. He emphasized that Wilson was both the sole grantor/owner and sole beneficiary of the foreign trust.
“So the question then becomes whether 26 U.S.C. 6677 permits a single person untimely filing a single IRS form to be penalized as two different people -- as an owner and as a beneficiary.”
The judge answered that question “no.” Because the statute used the word “substitute”, the 5% owners’ penalty replaces the 35% beneficiaries’ penalty. The IRS is not permitted to choose between the two as it sees fit.
But the judge was not done. The outcome got even sweeter for Wilson’s estate, when the judge said that the “gross reportable amount” was the limit of all penalties imposed by the IRS for failing to file returns disclosing the foreign trust account. The Tax Code defines the term “gross reportable amount” as “the gross value of the portion of the trust’s assets at the close of the year,” for which the penalty was assessed. Here, Wilson closed the account in 2007 and then was late filing his Form 3520. By the end of 2007, the trust’s assets were $0. The court said, “The Government seeks $3,221,183 above $0, which violates the statute.”
The sections of the Tax Code relating to foreign trust asset reporting don’t come up in tax law very often. Many IRS field agents won’t be familiar with the forms or the penalties for failing to file them on time. The Wilson case gives taxpayers a strong tool to fight back against excessive penalties issued against foreign trust account owners and beneficiaries who receive distributions that shrink or close the accounts. When those assets are disbursed, it could even cancel the penalty altogether.
Attorney Joseph R. Viola is a tax attorney in Philadelphia, Pennsylvania with over 30 years experience. If you have questions regarding foreign trust asset reporting penalties, contact Joe Viola to schedule a free consultation.