Penalized as Both Owner/Beneficiary of Foreign Trust Under 3520

Multiple 3520 Penalties for Trust Owner & Beneficiary

Penalized as Both Owner/Beneficiary of Foreign Trust 

When a US Person is the owner or beneficiary of a foreign trust, they have a filing requirement for reporting the foreign trust to the Internal Revenue Service. The two main code sections for foreign trusts is Internal Revenue Code Sections 6048 and 6677. In order to comply with these two code sections, Taxpayers are required to file either Form 3520 filing requirement — along with possibly a Form 3520-A filing requirement as well. The case of Wilson is a bit of a peculiar tax case, because Mr. Wilson was responsible as both the owner of the Trust and Beneficiary Trust — each with different and sometimes overlapping reporting requirements. Recently, the Appellate court in the second circuit  remanded the District Court case limiting the  — and Form 3520 penalties at the forefront of IRS enforcement — let’s dive into the basics of the case:

Form 3520 Beneficiary vs Owner Penalties

By way of background, Beneficiaries of a Foreign Trust can be subject to a 35% penalties, whereas the Owners of Foreign Trusts are usually subject to a 5% penalty.

Court Holding

• • • • Joseph Wilson was the sole owner and beneficiary of a foreign trust.  Under the  Internal  Revenue  Code  (“IRC”),  26  U.S.C.  §  6048(b),  (c),  U.S.  owners  and  beneficiaries of foreign trusts are required to file annual returns.  Because Wilson filed  his  returns  for tax  year  2007  late,  the  Internal  Revenue  Service  (“IRS”)  assessed a 35% penalty  that  applies to beneficiaries of foreign trusts; Wilson paid the  penalty.    Following  Wilson’s  death,  Plaintiffs-Appellees  sued  on  behalf  ofWilson’s  estate  for  a  refund,  arguing  the  IRS  should  have  imposed  only a    5% penalty that applies to owners of foreign trusts.  

Penalty on Wilson

• • • • We disagree and hold that the 35% penalty applies including when  the  beneficiary  is  the  owner  of  the  trust.    Accordingly,  we  VACATE  the judgment  of  the  district  court  and  REMAND  for  further  proceedings  consistent  with this opinion. 

Case Background

• • • • “Wilson established a foreign trust in 2003 with a value of approximately $9 million.1    In  2007, Wilson  liquidated  the  trust  and  distributed  all  its assets, approximately $9.2 million,2 to himself.”

Reporting Requirement

• • • • “Section 6048 of the IRC imposes disclosure requirements related to foreign trusts.  

6048(c) Beneficiaries

• • • • Subsection (c) instructs “any United States person [who] receives . . . during any taxable year . . . any distribution from a foreign trust” to “make a return with respect to such trust for such year” that includes, inter alia, “the aggregate amount of  the  distributions  so  received  from  such  trust.”    26  U.S.C.  §  6048(c).    In  other  words,  § 6048(c) requires beneficiariesof  a  foreign  trust––such  as  Wilson––to disclose distributions they received from the trust in an annual filing. 

6048(b) Owners

• • • • (b) orders U.S. owners“of any portion of a foreign trust” to “ensure that . . . such trust makes a return for such [taxable] year which sets forth a full and complete accounting   of   all   trust   activities   and   operations   for   the   year” and   “other   information as the Secretary [of the Treasury] may prescribe.”  Id. § 6048(b).”

Filing Requirements

• • • • To satisfy these two separate reporting requirements, Wilson and the trust needed  to  file  Forms  3520-A  and  3520.    Form  3520-A, the  “Annual  Information  Return of Foreign Trust With a U.S. Owner,” provides that “[a] foreign trust with a U.S. owner must file Form 3520-A in order for the U.S. owner to satisfy its annual information  reporting  requirements  under  [§] 6048(b).”    J.A.  128.   

      • It  contains  a  section to report distributions from the trust.  Form 3520, the “Annual Return To Report  Transactions  With  Foreign  Trusts  and  Receipt  of  Certain  Foreign  Gifts,”  directs  owners  of  “any  part  of  the  assets  of  a  foreign  trust”  to provide  the information in Part II and beneficiaries of a foreign trust to disclose distributions they  received  in  Part  III.    Id.at  109.  

      • If  the  owner  of  a  foreign  trust  received  a  distribution and completes Part II of Form 3520, and the trust has filed Form 3520-A, the  instructions  for  Form  3520  state  “do  not  separately  disclose  distributions again in Part III.”  Id. at 114.

Missed Filing Requirement

• • • • Wilson failed to file Form 3520 and failed to ensure that his trust file Form 3520-A by  their  respective  deadlines  for tax year  2007.3    As  a  result,  he  did  not timely disclose   the   $9.2   million   distribution   he   received   or   report   other   information about his trust. 

      • The IRS assessed a late penalty of $3,221,183, 35% of the $9.2 million distribution.  This penalty derives from § 6677(a) of the IRC, which provides “if any notice or return required to be filed by [§] 6048” is not filed on time or is incomplete, “the person required to file such notice or return shall pay a penalty equal to . . . 35 percent of the gross reportable amount.”  26 U.S.C. § 6677(a).

Plaintiffs Argument

• • • • Wilson initially paid the penalty, but less than two months later submitted a claim to the IRS seeking a full refund.  He argued that because he was both thesole beneficiary and the sole owner of the trust, only a 5% penalty applies for his failure  to  timely  report  the  distribution  to  himself.   

      • The  5%  penalty  stems  from§ 6677(b)  of  the  IRC,  which  states  “[i]n  the  case  of  a  return  required  under  [§] 6048(b),”  the reporting  requirement  for  trust  owners,  a  5%  penalty  will  substitute the 35% penalty.  Id. § 6677(b)(2).

      • While Wilson’s claim for a refund was pending, he passed away.  Plaintiffs brought  this  action  against  the  government  to  recover  the  money  for  Wilson’s  estate, pursuing Wilson’s 5% penalty argument and alleging in the alternative that there  was  “reasonable  cause”  that  excused  Wilson’s  untimely  filing.4   

      • The government moved to dismiss only the 5% penalty claim, arguing that Plaintiffs did not exhaust their refund claim in the administrative process, which the district court denied.5  Plaintiffs moved for partial summary judgment on their 5% penalty argument,  which  the  district  court  granted,  concluding  that  “[t]he  IRS  can  . . . assess only the 5% penalty under . . . § 6677 –   not bothor either the 5% and/or 35% penalty  –   for  Wilson’s  untimely  filing  of  his  2007  Form  3520.”Wilson  v.  United  States,  No.  19-CV-5037  (BMC),  2019  WL  6118013,  at  *8  (E.D.N.Y.  Nov.  18,  2019). 

      • The government appeals, arguing that the district court erred in its construction of the IRC. DISCUSSION“We review a grant of summary judgment de novo; specifically, where the disposition  presents  only  a  legal  issue  of  statutory  interpretation,  as  here,  we  review de novowhether the district court correctly interpreted the statute.”  Power Auth. v. M/V Ellen S. Bouchard, 968 F.3d 165, 170 (2d Cir. 2020) (internal quotation 4 Section 6677 contains a “reasonable cause” exception, providing that “[n]o penalty shall be imposed . . . on any failure which is shown to be due to reasonable cause and not due to willful neglect.”  26 U.S.C. § 6677(d).  5 “The [g]overnment does not appeal the [d]istrict [c]ourt’s denial of [its] partial motion to dismiss.”  Appellant’s Br. at 15 n.8. 

Court’s Reasoning

• • • The applicability of the 35% penalty to Wilson as a beneficiary of the trust. 

District Court

• • • However, the district court relied on § 6677(b) to conclude that the 35% penalty cannot apply.  See Wilson, 2019 WL 6118013, at *6.  Section 6677(b) “substitut[es] ‘5 percent’ for ‘35  percent’  [of  the  gross  reportable  amount]” as  the  applicable  penalty  for  the  failure to timely file “a return required under [§] 6048(b),” which is the reporting requirement for owners of foreign trusts. 

    • According to the court,  because  Wilson  violated  § 6048(b)  by  failing  to  timely  file  as  an  owner,  § 6677(b)’s  “mandate[]  that  the  5%  replace  the  35%”  applies.  Wilson,  2019  WL  6118013, at *6 (emphasis omitted).   The  problem  with  the  district  court’s  analysis  is  that  §  6677(b)  leaves  untouched the 35% penalty that applies to all otherreporting requirements under §   6048,  including  to a   return  disclosing distributions required by  § 6048(c). 

    • The district  court  and Plaintiffs  do  not  identify any  text  in  the  statute  that  elides  therequirement  to  disclose  distributions  received  as  a  beneficiary  under  §  6048(c)  when the beneficiary is also the owner of a   foreign trust.  Nor is there any textual support for the court and Plaintiffs’ view that when the owner and beneficiary are one, a   failure to timely report the distribution received violates only § 6048(b) andnot § 6048(c). 

    • Even if the information the owner must report under § 6048(b) coversthe trust’s distributions, nothing in the statute indicates that as a result, § 6048(b) displaces or merges with the separate requirement  to  report  distributions  under § 6048(c).  See id.at *6–7.  Because Wilson’s failure to timely report the distribution he received violates § 6048(c) even if that same failure also violates his reporting requirements as an owner under § 6048(b), the 5% penalty under § 6677(b) does not supplant the 35% penalty.

    • The district court and Plaintiffs’ remaining textual arguments fail to defeatthis conclusion.  The district court criticized the government’s justification of the 35%  penalty  as  presenting  “an  irreconcilable  textual  conflict,” asserting  that  because §   6677(a)  instructs  the  penalty  should  not  “exceed  the  gross  reportable  amount,” “a taxpayer should not be liable for any two penalties if their combined assessment would add up to more than the gross reportable amount for any one violation.”  Id.at *7 (quoting 26 U.S.C. § 6677(a)).  “Because the gross reportable amount for an owner’s untimely filing . . .  is ‘the gross value of the portion of the trust’s assets at the close of the year,’ Wilson’s $0 in trust assets at the end of 2007 yields  a  $0  gross  reportable  amount”––the  government’s  pursuit  of  “$3,221,183  above $0 [therefore] violates the statute.”  Id.The  court’s  reasoning misses the  fact  that  “gross  reportable  amount”  has  more  than  one  meaning  under  §  6677(c).7    The  definition  of  “gross  reportable  amount” varies depending on the subsection of § 6048 an individual violated.

Holding Summarized by Court

• • • The  plain  language  of  §§  6048  and  6677 requires  that  when  an  individualfails to timely report the distributions she received from a foreign trust, the 35% penalty applies; her concurrent status as owner of the trust does not alter this rule.Because  the  statute’s  meaning is  clear  based  from  its  text,  we  need  not  consider  any extrinsic sources.  See New York v. Nat’l Highway Traffic Safety Admin., 974 F.3d 87, 95 (2d Cir. 2020).

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