A recent Second Circuit holding in Wilson v. U.S.,¹ highlights yet again how the Internal Revenue Service (IRS) is continuing to aggressively pursue taxpayers with non-compliant foreign assets – and how taxpayers are increasingly finding little relief in courts. In this case, where the foreign trust’s sole beneficiary and owner, Mr. Wilson, failed to comply with filing requirements, the court’s decision allowed the IRS to inflict a 35% penalty on Mr. Wilson as the foreign trust’s beneficiary and rejected the notion that the applicable penalty was limited to 5% for his failure to report ownership of the trust.
We encourage our readers to consider the case below and heed two practical takeaways, in particular: (1) timely and proper U.S. tax compliance is crucial to avoid significant and possibly duplicative, penalties, and (2) if you believe you might have a problem, consult with an experienced tax professional for assistance with coming into compliance ASAP!
Mr. Wilson was the sole owner and beneficiary of an overseas trust that he established in 2003, valued then at $9 million. In 2007, Mr. Wilson liquidated the trust and distributed its $9.2 million in assets to himself. Subsequently, Mr. Wilson failed to timely file Form 3520, Annual Return To Report Transactions With Foreign Trusts and Receipt of Certain Foreign Gifts. He also neglected to ensure the timely filing of Form 3520-A, Annual Information Return of Foreign Trust With a U.S. Owner. In other words, Mr. Wilson failed to timely disclose the $9.2 million foreign trust distribution and other information about his trust. For such failures, the IRS ultimately assessed a significant penalty in the amount of $3,221,183—calculated as 35% of the $9.2 million distribution.
Mr. Wilson paid the 35% penalty but submitted a claim for a refund shortly thereafter maintaining that “because he was both the sole beneficiary and the sole owner of the trust, only a 5% penalty applies for his failure to timely report the distribution to himself.”² Mr. Wilson passed away while the claim for refund was pending. However, the executrix of the estate brought suit in the United States District Court for the Eastern District of New York, alleging that only the 5% penalty applied, or in the alternative that Mr. Wilson had “reasonable cause” for untimely filing. The District Court determined that Mr. Wilson was indeed only subject to the 5% penalty as the foreign trust owner. The IRS appealed.
Under Internal Revenue Code (IRC) §6048, as applicable for the 2007 tax year at issue in Wilson, owners, and beneficiaries of foreign trusts must satisfy two reporting requirements relevant in this case. First, a taxpayer who owns any portion of a foreign trust during a tax year has an “annual reporting requirement” and must report the ownership of the trust, the trust activities, and the trust beneficiaries.³ Second, a taxpayer who is a beneficiary of a foreign trust must report the name of the trust and aggregate distributions received from the trust (“distribution disclosure requirement”).⁴ Thus, timely and accurate filing of Forms 3520-A and 3520 satisfies the owner’s annual reporting requirement and the beneficiary’s distribution disclosure requirement, respectively.
As with most reporting requirements, failure to file timely carries penalties. As an owner, failure to ensure the timely filing of the Form 3520-A in satisfaction of the annual reporting requirement implicates the IRC §6677(b) penalty, which is equal to 5% of the gross value of the trust assets which the owner was treated as owning at the end of the tax year. Furthermore, a beneficiary who fails to timely file Form 3520 to report distributions triggers the IRC §6677(a) penalty, which is equal to 35% of the amount of the distribution.⁵
In its de novo review, the Second Circuit first considered the relevant statutory language of IRC §§6048 and 6677 and emphasized that the plain language:
unambiguously demonstrates that when an owner of a foreign trust fails to timely disclose a distribution she received as a beneficiary of that trust, she violates § 6048(c) and thereby triggers the 35% penalty under § 6677(a).⁶
The court was careful to point out that the express language of IRC §6048 “makes no exception for a beneficiary who is also the owner of a foreign trust.” Thus, according to the court, Mr. Wilson was clearly required to timely report the distribution. Having failed to satisfy his distribution disclosure requirement, the court determined that the IRS correctly assessed the 35% penalty. As the court stated:
[b]ecause 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.
Ultimately, the Second Circuit vacated and remanded the District Court’s decision to conduct further proceedings aligned with the Second Circuit’s ruling. Until then, as it stands now in the Second Circuit, the 35% penalty for failing to report a distribution from a foreign trust is applicable against a person who is both the beneficiary and owner of a foreign trust.
Since the 2007 year at issue in Wilson, the IRS’s enforcement authority in the context of foreign trust ownership has only increased. Amendments in 2010 imposed additional reporting requirements under IRC §6048(b) and added a minimum $10,000 penalty under §6677 for foreign trust reporting failures. And even greater IRS scrutiny is a very real possibility in the near future considering the Biden administration’s proposal to provide significant funding dedicated to an enhanced tax enforcement program. Remember, timely and proper tax compliance remains key; otherwise, you risk significant, possibly duplicative, penalties.