U.S. taxpayers are subject to substantial penalties assessed by the for failure to file international information returns. The author outlines procedure and defenses that have proved successful in avoiding such penalties.
In the 1990s lawyers and others traversed the United States promoting “asset protection” schemes to doctors. The schemes involved transfer of the doctors’ financial assets to purported trusts in foreign countries. The schemes capitalized on doctors’ fears of financial consequences of malpractice liability.
In the pre-internet days, Dr. Able heard one such promoter, Barker, speak on a cassette-tape newsletter. Barker’s scheme resonated with Dr. Able. Dr. Able called Barker, and soon Barker was on retainer with Dr. Able.
Dr. Able’s concern about malpractice liability was unfounded. He has never incurred a malpractice claim, and he has always had malpractice insurance coverage.
Barker transferred Dr. Able’s financial assets to a custodian in a Caribbean country. Barker then disappeared, without advising Dr. Able on reporting required by the U.S. government of America concerning his foreign financial assets.
Americans are subject to U.S. income tax on their worldwide income. Some Americans have used foreign accounts, trusts, and companies to evade U.S. income tax. For this reason, U.S. law requires rigorous reporting of Americans’ interests in such devices, and imposes heavy penalties for failure to perform the required reporting.
The Caribbean custodian invested Dr. Able’s financial assets in foreign mutual funds, and gouged the funds periodically for heavy fees. The foreign mutual funds performed poorly.
The scheme made no sense. Dr. Able’s financial assets were far less secure in the hands of strangers in Caribbean than they would have been under the protection of our laws in the United States. Dr. Able’s financial assets in the Caribbean surely would have been reachable by his judgment creditors, if any he had.
Fortunately, Dr. Able timely reported the gross income from his Caribbean financial assets on his Forms 1040, U.S. Individual Income Tax Return. Tax evasion was not part of his plan.
Dr. Able is not the only physician I have represented who was taken by such an “asset protection” scheme.
Eventually Dr. Able began to doubt the efficacy of his Caribbean investments. Through an attorney in the United States, Dr. Able requested return of his financial assets. The Caribbean custodian, through its attorney in the U.S., requested that a Form 3520-A, Annual Information Return of Foreign Trust with a U.S. Owner, be prepared and filed with the Internal Revenue Service reporting Dr. Able’s Caribbean financial assets. A foreign trust with a U.S. owner must annually file Form 3520-A reporting the trust. If the trust fails to file the Form 3520-A, then the U.S. owner is required to file it. In the latter case, the Form 3520-A must be labeled a “substitute” Form 3520-A.
The custodian requested a Form 3520-A concerning Dr. Able’s Caribbean financial assets on the theory that the custodian was a trustee with respect to the assets. The custodian styled itself a “trust company.” But the custodian really was not a trustee with respect to Dr. Able’s Caribbean financial assets. Dr. Able never signed a trust indenture concerning the Caribbean financial assets. At all times Dr. Able retained dominion and control of the assets. Dr. Able and his U.S.-based financial advisor managed investment of the Caribbean financial assets. Whenever Dr. Able requested a distribution from the assets, the Caribbean custodian complied. The Caribbean assets were ultimately repatriated to Dr. Able at his discretion. The arrangement was not a trust but a brokerage account controlled and beneficially owned by Dr. Able.
Dr. Able was referred to a large law firm to secure repatriation of his Caribbean financial assets. The law firm did not demand that the custodian return Dr. Able’s Caribbean financial assets to him. The law firm did, however, direct Dr. Able’s accounting firm to prepare Forms 3520-A as well as Forms 3520, Annual Return To Report Transactions With Foreign Trusts and Receipt of Certain Foreign Gifts, reporting the Caribbean financial assets. The accounting prepared Forms 3520 and 3520-A reporting Dr. Able’s Caribbean financial assets not for one year but for the preceding five years. Remember that the Caribbean custodian had requested only that a Form 3520-A be filed with respect to Dr. Able’s Caribbean financial assets, and for only one year. Generally, when a Form 3520-A is filed with respect to a U.S. person’s foreign financial assets, the IRS will look for a Form 3520 also to be filed with respect to those assets.
Apparently, it did not occur to the law firm or the accounting firm retained by Dr. Able that the arrangement for Dr. Able’s Caribbean financial assets was a brokerage account not a trust.
Dr. Able faced much higher penalties with the arrangement for his Caribbean financial assets characterized as a trust rather than a brokerage account. The penalty for failure to timely file a Form 3520 is the greater of $10,000 or the following:
The penalty for failure to timely file Form 3520-A is the greater of $10,000 or 5 percent of the gross value of the foreign trust’s assets treated as owned by the U.S. person under the grantor trust rules as of the close of the tax year.
In contrast, the penalty for failure to file a Form 8938, Statement of Specified Foreign Financial Assets, reporting foreign financial accounts is a discrete $10,000.
A practitioner is required to inform a client of penalty consequences reasonably likely to ensue from the practitioner’s tax advice. IRS Circular 230, Regulations Governing Practice Before the Internal Revenue Service, Section 10(c) provides in part:
(c) Advising clients on potential penalties —
(1) A practitioner must inform a client of any penalties that are reasonably likely to apply to the client with respect to —
(i) A position taken on a tax return if —
(A) The practitioner advised the client with respect to the position; or
(B) The practitioner prepared or signed the tax return; and
(ii) Any document, affidavit or other paper submitted to the Internal Revenue Service.
(2) The practitioner also must inform the client of any opportunity to avoid any such penalties by disclosure, if relevant, and of the requirements for adequate disclosure.
The Forms 3520-A were prepared in Dr. Able’s name. The Forms 3520-A should have been prepared in the foreign custodian’s name; this likely would have satisfied the foreign custodian. The IRS cannot assess a penalty against a non-U.S. person.
The Forms 3520-A were not labeled “substitute” Forms 3520-A. The law firm and the accounting firm that worked on the Forms 3520 and Forms 3520-A and the reasonable cause statement and filed them truly did not know what they were doing.
The Forms 3520 were signed by Dr. Able as the taxpayer and the law firm as preparer. The Forms 3520-A were signed for the Caribbean custodian as trustee.
At the direction of the law firm retained by Dr. Able, Dr. Able’s accounting firm prepared a reasonable cause statement to file with the Forms 3520-A and 3520. To avoid penalties Dr. Able needed the reasonable cause statement to clearly make the case that Dr. Able is an Ophthalmologist; that his tax returns are complicated; that he relied, reasonably, upon his accounting firm for tax compliance; and that the accounting firm failed him. But the accounting firm could not get past its conflict of interest. It vaguely, falsely attributed Dr. Able’s noncompliance to unnamed “prior advisors.” The reasonable cause statement was weak and ineffectual. It should have been prepared by a law firm independent of the accounting firm responsible for Dr. Alward’s noncompliance.
The reasonable cause statement was signed by Dr. Able and no one else. The reasonable cause statement should have been signed under oath by the preparer as having prepared it, and by Dr. Able as having read it. Again, it was a completely incompetent effort.
The law firm and the accounting firm were both involved in preparation of the Forms 3520 and 3520-A and the reasonable cause statement. It is unclear which of them filed the documents with the IRS.
Soon after the Forms 3520 and 3520-A and the reasonable cause statement were filed, the IRS assessed penalties in substantial amounts against Dr. Able for late filing of the Forms 3520-A and 3520. Later the IRS Appeals Office acknowledged that written, supervisory approval of the penalties for failure to timely file Forms 3520 required under Section 6751(b)(1) had not been obtained, and it abated the Form 3520 penalties. But the penalties for failure to timely file Forms 3520-A remained.
Neither the law firm nor the accounting firm ever suggested to Dr. Able that they had erred in filing the Forms 3520 or 3520-A. But they were delighted to contest the penalties. After five years of contesting the penalties, the law firm finally advised Dr. Able to “just pay” the remaining balances of penalties. At that point, the penalties with accrued interest totaled over $1.5 million. That is when the case came to me.
I immediately called the IRS Appeals Officer on the case. She was about to sustain the penalties. I asked her to please allow me an opportunity to make a supplemental submission concerning the penalties. She acceded to my request.
When the IRS asserts international information return penalties, it is important for the taxpayer to raise available defenses, including the following:
The taxpayer should make a Freedom of Information Act request for a copy of the IRS administrative file concerning the penalties. The taxpayer should specifically request of IRS Disclosure proof, if any, of written, supervisory approval of the penalties required by Section 6751(b)(1). The taxpayer should review IRS Disclosure’s response to confirm the absence of required, written approval.
My supplemental submission made four arguments against the penalties. The first concerned reasonable cause. Section 6677, which prescribes penalties for failure to timely file Forms 3520-A or 3520, provides an exception for “any failure which is shown to be due to reasonable cause and not due to willful neglect.” Regulation Section 301.6651-1(c)(1) provides in part:
A failure to pay will be considered to be due to reasonable cause to the extent that the taxpayer has made a satisfactory showing that he exercised ordinary business care and prudence in providing for payment of his tax liability and was nevertheless either unable to pay the tax or would suffer an undue hardship (as described § 1.6161-1(b) of this chapter) if he paid on the due date.
Dr. Able presented quintessential reasonable cause. He is an eye surgeon, immersed in his profession. He has no training in taxes. He relied, completely, reasonably, upon his CPA and his tax attorney for tax compliance. Both failed Dr. Able, resulting in the penalty assessments in controversy.
My second argument was that the IRS had failed to obtain prior, written supervisory approval of the penalties required by Section 6751(b). Section 6751(b) provides:
(b) Approval of assessment.
(1) In general.
No penalty under this title shall be assessed unless the initial determination of such assessment is personally approved (in writing) by the immediate supervisor of the individual making such determination or such higher level official as the Secretary may designate.
(2) Exceptions.
Paragraph (1) shall not apply to-
(A) any addition to tax under section 6651, 6654, 6655, or 6662 (but only with respect to an addition to tax by reason of paragraph (9) or (10) of subsection (b) thereof); or
(B) any other penalty automatically calculated through electronic means.
Where the IRS has failed to obtain the required written, supervisory approval, the penalty must be abated.
Cases have applied Section 6751(b)(1)’s written, supervisory approval requirement to Section 6662 accuracy-related penalties, to Section 6662 substantial understatement penalties, and to Section 6663(a) civil fraud penalties. Such penalties involve a judgment, Section 6662 accuracy-related penalties about whether the taxpayer was negligent, and Section 6663 penalties about whether the taxpayer was fraudulent. A reasonable cause argument, under Section 6664, also is available against all Section 6662 penalties as well as against Section 6663 penalties.
Section 6751(b)(2) excepts from Section 6751(b)(1) penalties which, on their face, appear not to involve a judgment. For example, excepted are Section 6651 penalties, for failure to timely report or pay tax, or failure to timely file a tax return. International information return penalties, too, penalize the failure to file an international information return. But each of these penalties has a reasonable cause exception: the penalty is not to be exacted for noncompliance due to reasonable cause and not willful neglect. Section 7491(c) allocates to the taxpayer the burden to raise reasonable cause. But once the taxpayer raises reasonable cause against an asserted penalty, it is up to the IRS to decide whether there is reasonable cause for abatement of the penalty. And the decision of whether the taxpayer’s noncompliance is due to reasonable cause surely does involve a judgment.
When a taxpayer submits a response, written or otherwise, challenging a penalty or the tax liability to which the penalty relates, Section 6751(b)(1) written, supervisory approval of the penalty is required before the IRS sends the taxpayer a written communication asking the taxpayer to sign consenting to assessment of the penalty. This is true of all penalties, even those listed in Section 6751(b)(2)(A). Internal Revenue Manual 20.1.5.2.3, Supervisory Approval of Penalties – IRC 6751 Procedural Requirements, provides in part:
(6) Any penalties automatically calculated through electronic means are excluded from IRC 6751(b)(1) requirement.
a. AUR (Automated Underreporter) and CEAS (Correspondence Examination Automation Support) cases in which the Substantial Understatement Penalty is systemically asserted, will fall within the exception for penalties automatically calculated through electronic means if the taxpayer does not submit any response to the 30-day letter that proposes the penalty.
b. However, if a taxpayer submits a response, written or otherwise,that challenges the penalty or the liability to which the penalty relates, written supervisory approval under IRC 6751(b)(l) is required before any written communication of penalties that offers the taxpayer an opportunity to sign an agreement, or consent to assessment or proposal of the penalty. See IRM 20.1.1.2.3.1, Timing of Supervisory Approval. The exception for penalties automatically calculated through electronic means no longer applies once a Service employee makes an independent determination to pursue a penalty or to pursue adjustments to tax for which a penalty is attributable.
Similarly, Proposed Regulation § 301.6751(b)-1(a)(3)(iv) provides:
(vi) Automatically calculated through electronic means. A penalty, as defined in paragraph (a)(3)(i) of this section, is automatically calculated through electronic means if an IRS computer program automatically generates a notice to the taxpayer that proposes the penalty. If a taxpayer responds in writing or otherwise to the automatically-generated notice and challenges the proposed penalty, or the amount of tax to which the proposed penalty is attributable, and an IRS employee considers the response prior to assessment (or the issuance of a notice of deficiency that includes the penalty), then the penalty is no longer considered “automatically calculated through electronic means.”
Thus, once a taxpayer challenges a penalty, the Section 6751(b)(1) written, supervisory approval requirement applies to the penalty. This underscores how important it is for a taxpayer to challenge penalties.
I made a Freedom of Information Act request to the IRS for its administrative file concerning the penalties assessed against Dr. Able. The IRS’ response included no evidence whatsoever of written, supervisory approval of the penalties.
I repeatedly asked the Appeals Officers assigned to the case for proof of the required, written supervisory approval of the penalties. Not surprisingly, the Appeals Officers produced no proof of written, supervisory approval.
Sometimes, in a letter in response to a FOIA request, IRS Disclosure will admit the absence of written, supervisory approval of penalties.
My third argument was that Dr. Able’s Caribbean financial assets were not held in a trust, and, therefore, that Forms 3520-A were not required to be filed for the assets. The elements of a private express trust at common law are: (1) the settlor’s capacity to create a trust; (2) his intention to create a trust; (3) a declaration of trust or a present disposition of the res; (4) an identifiable trust res; (5) a trustee; and (6) identifiable beneficiaries.
The language or conduct creating the trust must be clear and unambiguous. A statement will be sufficient evidence of a trust if the beneficiary, the trust property, and the purpose of the trust all are identified therein.
Dr. Able never signed a written agreement or declaration of trust. Generally, to establish a trust by acts alone in the absence of an express trust agreement there must be shown unequivocally an intent on the part of the maker to divest himself of control and dominion of the res. The maker might retain certain benefits of the res, but there must be more than creation of an agency relationship; the trustee must have control or dominion of the property, in addition to bare legal title.
A private express trust likely could not be created, under the laws of the United States or of the United Kingdom, where, as here, there was no written agreement or declaration of trust. Indeed, without a written agreement or declaration of trust, the terms of a trust cannot be “expressed.”
There is nothing to indicate that Dr. Able intended to create a trust, or that he even understood what a trust is. To the contrary, Dr. Able at all times exercised complete dominion and control over his Caribbean assets. Through his investment advisor in the U.S. Dr. Able directed investment of the Caribbean assets. The Caribbean custodian of the assets reported on the performance of investments to Dr. Able and to no one else. Whenever Dr. Able requested a distribution from the Caribbean assets, the custodian complied. Dr. Able reported the income of his Caribbean assets on his U.S. income tax return, as noted above. The Caribbean assets were ultimately repatriated to Dr. Able at his direction.
In Sullivan’s Petition, the Orphans’ Court of Pennsylvania, Berks County, said:
“If the donor has full control and dominion over the trust property, so that according to the terms of the trust he can use it as and when he pleases, the trustee becomes his mere agent to hold title to the property, invest, sell, and collect income for him and pay as he directs. The donor has parted with no dominion over his property nor any part thereof by the terms of the trust, and such an agreement is no valid trust agreement”: Warsco, Admr., v. Oshkosh Savings & Trust Co. et al., 183 Wis. 156, 160, 161, 196 N. W. 829.
In Coosa River Water, Sewer and Protection Authority v. Southwest Trust of Alabama, the Supreme Court of Alabama quoted American Jurisprudence 2d, Trusts § 29 (1992):
[A] revocable living trust is valid even though the settlor reserves an extensive power of control over administration of the corpus. However, where the powers retained by the settlor amount, in cumulative effect, to ownership of the trust estate, with such control over the administrative functions of the trustee as to make of him simply the settlor’s representative, no valid trust is established. Similarly, while a trust instrument may purport to name a beneficiary, if the settlor reserves a substantial interest or unbridled control over management of the operations that is not for the benefit of the purported beneficiary, the trust may be found to be illusory. In such circumstances, it has been stated that the settlor remains the owner of the property and there is no beneficiary.
United Kingdom authorities are in accord that where, as here, the settlor retains dominion and control for his benefit of property purportedly held in trust, the trust is illusory, there is no valid trust, and the settlor is deemed the owner of the property.
My fourth argument was that the penalties were assessed against Dr. Able, and the assessment immediately began accruing interest (as of the third quarter, 2024, at the rate of 8 percent per annum, compounded daily), and the unpaid assessment immediately operated as a federal tax lien against all of Dr. Able’s property, and the IRS maintained the right to levy Dr. Able’s property to satisfy the lien, without any due process whatsoever afforded to Dr. Able. The assessments thus violated Dr. Able’s right to due process of law guaranteed by the Fifth Amendment to the U.S. Constitution.
Several months after I made my supplemental submission asserting the above defenses, the IRS Appeals Office abated the penalty assessments against Dr. Able, without any communication to us. But there was one problem. Prior counsel had neglected to make a Section 6330 collection due process appeal for one year’s penalty, and, as a result, that year’s penalty was not before the Appeals Office, and hence was not abated. We filed a Form 843, Claim for Refund and Request for Abatement, requesting abatement of that year’s penalty, on the same grounds the other years’ penalties were abated. If our request is denied we will request IRS Appeals Office review of the denial.
When the IRS asserts international information return penalties, the taxpayer must raise available defenses, including the following:
The taxpayer should make a Freedom of Information Act request for a copy of the IRS administrative file on the penalties, specifically requesting proof of written, supervisory approval of the penalties required by Section 6751(b)(1). The taxpayer should review IRS Disclosure’s response to confirm absence of required, written, supervisory approval.
