The 35% penalty under I.R.C. section 6677 for failing to report a distribution from a foreign trust applies against a person who is both the beneficiary and grantor/owner of a foreign trust. At least, that is now the rule for taxpayers in the second circuit. This draconian penalty for failing to properly report a foreign trust is applicable even if the taxpayer and trust paid all required taxes, if any, with respect to the trust.
In the case before the court, the taxpayer (Wilson) was the sole owner and beneficiary of a foreign trust. He received a distribution from the foreign trust. He filed his tax return late. The IRS assessed a penalty equal to 35% of the amount of the distribution for failing to timely disclose the distribution.
The crux of the issue was whether the IRS should have imposed only the 5% penalty that applies to owners of foreign trusts or whether the 35% penalty applied. Unfortunately for the taxpayer, the court of appeals held that the 35% penalty applies even when the beneficiary is the owner of the trust
A Little Background
Wilson was the sole owner and beneficiary of a foreign trust. He established the foreign trust in 2003 by contributing some $9 million. In 2007, he liquidated the trust and distributed its assets to himself.
Wilson reported the distribution, but he filed his tax returns for tax year 2007 late. It appears that all of the income and activities of the trust were otherwise properly reported. Because Wilson failed to timely report under § 6048(c), the IRS assessed—in accordance with § 6677(a) and (c)—a penalty of more than $3 million.
Wilson paid the penalty, then filed a request for a refund. He argued that because he was both the sole beneficiary and the sole owner of the trust, the 35% penalty was not applicable; at most, he argued, the 5% penalty applied with respect to the failure to timely report the distribution to himself. In the alternative, he argued that there was “reasonable cause” that excused the untimely filing.
The Legal Obligation to Report a Foreign Trust
The Internal Revenue Code requires that U.S. owners and beneficiaries of foreign trusts file annual tax returns. The proper filing and reporting obligations are, however, complex—often necessitating that a tax attorney analyze the statutes, regulations, and other administrative authorities governing foreign-trust reporting in order to properly apply the provisions.
The tax code requires that U.S. owners of a foreign trust ensure that the trust files an annual return. Specifically, the I.R.C. requires that U.S. owners “of any portion of a foreign trust” “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 report “other information as the Secretary [of the Treasury] may prescribe.”
The tax code also requires that U.S. beneficiaries of a foreign trust file a return reporting the distributions that they receive. Specifically, the IRC provides that “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.”
Additional reporting obligations apply depending on the circumstances.
Section 6677 imposes two different penalties for failing to file the applicable returns on a timely basis: a 35% penalty for beneficiaries who fail to timely report their distributions; and a 5% penalty for owners who fail to ensure that their trust timely files an annual return.
Forms 3520 and 3520-A.
To satisfy these two separate reporting requirements, taxpayers and foreign trusts are generally required 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).”
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.
Penalties for Failing to Timely Report a Foreign Trust.
I.R.C. Section 6677(a) provides that “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).
I.R.C. Section 6677, however, also provides for a 5% penalty: “In the case of a return required under [§] 6048(b),” the reporting requirement for trust owners, a 5% penalty is substituted for the 35% penalty. Id. § 6677(b)(2).
Taxpayers facing Form 3520 and 3520-A penalties for failing to properly report a foreign trust may be able to take advantage of relief initiatives, such as those covered in our post on Guidance on Foreign Trusts. Taxpayers may also qualify for relief under the IRS’s Streamlined Filing Compliance Procedures or other avenues.
For more on reporting obligations, see our prior posts: (i) Form 3520-A, Information Return of Foreign Trusts with a U.S. Owner; and (ii) Form 3520, Reporting Transactions With Foreign Trusts and Receipt of Certain Foreign Gifts.