Tax Court in Brief | Fairbank v. Comm’r | Reporting Obligations for Foreign Trust Income and Ownership; Statute of Limitations

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The Tax Court in Brief – February 20th – February 24th, 2023

Freeman Law’s “The Tax Court in Brief” covers every substantive Tax Court opinion, providing a weekly brief of its decisions in clear, concise prose.

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Tax Litigation:  The Week of February 20th, 2022, through February 24th, 2023

Fairbank v. Comm’r, T.C. Memo. 2023-19| February 23, 2023 |Weiler, J. | Dkt. No. 13400-18

Summary:  At its core, this 31-page opinion regards married U.S. citizen taxpayers, Leigh Fairbank (Leigh) and Barbara Fairbank (Barbara), challenge to deficiency notices issued for the tax years in issue (2003 through 2009 and 2011) on statute of limitations grounds. The substantive tax issues concern deficiencies for failing to report income Barbara enjoyed or controlled via foreign banking institutions during the tax years. The backstory is long, but in TCIB fashion, a truncated version is below.

In about 1985, Barbara’s former husband (H1) was “jeopardy assessed” some $15 million in taxes, additions to tax, and interest arising from sham transactions and transfers among foreign banks. In 1990, Barbara received innocent spouse relief from her joint and several liability for H1’s tax liability. In Barbara’s divorce from H1—which proceeded from 1983 through about 2001—H1 and Barbara entered into oral agreements, and as part of those, H1—through Barbara’s attorney in Switzerland—paid about $600,000 to a “Swiss establishment, Xavana Establishment,” a foundation formed by Barbara’s Swiss attorney in 1983 for Barbara’s benefit. Xavana had one asset: a UBS bank account, which had a sole beneficiary, Barbara. All correspondence from UBS was sent to Barbara’s Swiss attorney. In 2004, UBS was informed that Barbara remarried to Leigh Fairbank and resided in Florida. Elsewhere, in the British Virgin Islands, Xong Services, Inc. was incorporated in 2009 by Barbara’s Swiss attorney. Barbara was the sole shareholder. The attorney opened a Swiss account for Xong at another Swiss bank, and Barbara was the beneficial owner of that account. The attorney instructed UBS to transfer $500,000 to another account in Dubai and the remaining balance to the new Swiss bank account, which, as of May 2009, had a balance of about $1 million. The banks were instructed to not send correspondence to Barbara in the U.S. From 2007 through 2009, numerous transfers, debits, travel cash cards, checks, and other transactions were made among the foreign accounts and ultimately for Barbara’s benefit or receipt.

For their tax returns filed for years in issue (2003-2009, 2011), the Fairbanks checked “No” to the question about foreign bank accounts. And, the Fairbanks did not make an election under either section 1295 or 1296, file Form 3520, Annual Return To Report Transactions with Foreign Trusts and Receipt of Certain Foreign Gifts, or file Form 3520–A, Annual Information Return of Foreign Trust With a U.S. Owner, with respect to Xavana Establishment. And, the Fairbanks answered “No” to the questions of whether they had an interest in a financial account in a foreign country.

In 2008, the IRS discovered Barbara’s UBS account. In 2010, the Fairbanks’ returns in issue were examined, and the IRS used information received in the investigation from 2010 through 2014 to make proposed adjustments. The Fairbanks filed Forms 5471, Information Return of U.S. Persons With Respect to Certain Foreign Corporations, reporting Xong Services for tax year 2009 through 2010. And, the Fairbanks filed FBARs for one foreign account for tax years 2009 through 2011.

In a notice of deficiency dated April 12, 2018. The IRS determined income tax deficiencies for taxable years 2003, 2004, 2005, 2006, 2007, 2008, 2009, and 2011 (years at issue), totaling about $200,000 and accuracy-related penalties under section 66621 of about $43,000, in the aggregate.

The Fairbanks challenged that deficiency notice as untimely.

Key Issues for TCIB:

(1) Whether the IRS’s notice of deficiency was issued timely under section 6501?

(2) Whether the Fairbanks are liable for accuracy-related penalties under section 6662(a) and (b)(1) for the tax years at issue?

Primary Holdings:

(1)  Yes. Section 6501(a) provides that any tax imposed under the Code shall be assessed within three years after the return was filed. However, subsection (c) provides exceptions, including subsection (c)(8), entitled “Failure to notify Secretary of certain foreign transfers.” Xavana Establishment was a foreign trust. Contrary to I.R.C. § 6048, Barbara, as the deemed U.S. owner of Xavana, failed to provide any written return setting forth a full and complete accounting of Xavana’s activities for the years at issue. And, Barbara, as Xavana’s U.S. beneficiary, failed to make any return that includes the name Xavana and which outlines the aggregate amount of distributions she received during each of the tax years at issue from Xavana. The Fairbanks neither filed IRS Form 3520–A or Form 3520 nor satisfied their reporting obligations under section 6048. Finding that the Fairbanks did not comply with section 6048(b) and (c), the period of limitations had not expired under section 6501(c)(8) when the NODs were issued.

(2) Yes. The Fairbanks failed to properly report Mrs. Fairbank’s beneficial ownership in her foreign UBS account; accordingly, the period of limitations remained open at the time the IRS’s NOD was issued. Therefore, the determination of tax deficiencies and penalties were sustained. The IRS satisfied its burden of production for the imposition of the accuracy-related penalties under section 6662(a) and (b)(1). And, the Fairbanks failed to show entitlement to a reasonable cause defense.

Key Points of Law:

Entity Classification. The Code prescribes the classification of various organizations for federal tax purposes. Treas. Reg. § 301.7701-1(a)(1). “Whether an organization is an entity separate from its owners for federal tax purposes is a matter of federal tax law and does not depend on whether the organization is recognized as an entity under local law.” Id. In general, an arrangement will be treated as a trust if it can be shown that the purpose of the arrangement is to vest in trustees responsibility for the protection and conservation of property for beneficiaries who cannot share in the discharge of this responsibility and, therefore, are not associates in a joint enterprise for the conduct of business for profit. See Elm St. Realty Tr. v. Commissioner, 76 T.C. 803, 814–15 (1981); Treas. Reg. § 301.7701-4(a).

Elements of a Trust for Tax Purposes. The four elements of a trust for federal tax purposes are (1) a grantor, (2) a trustee that takes title to property for the purpose of protecting or conserving it, (3) property, and (4) designated beneficiaries. See Treas. Reg. § 301.7701-4(a). A facts-and-circumstances analysis is applied when determining whether an arrangement should be treated as a trust or a business entity by determining whether the arrangement includes (1) associates and (2) an objective to carry on a business and divide the gains therefrom. The absence of either of these essential characteristics will cause an entity to be classified as a trust. See Estate of Bedell v. Commissioner, 86 T.C. 1207, 1218 (1986). When distinguishing between an association and a trust for tax classification, relevant features of the arrangement are its “nature,” “purpose,” and “operations,” with weight given to organizing documents. See Swanson v. Commissioner, 296 U.S. 362, 365 (1935); Morrissey v. Commissioner, 296 U.S. 344, 357 (1935). The “parties are not at liberty to say that their purpose was other or narrower than that which they formally set forth in the instrument under which their activities were conducted.” Helvering v. Coleman-Gilbert Assocs., 296 U.S. 369, 374 (1935).

Foreign Trust or Domestic Trust. A foreign trust is “any trust other than a trust” that is a “United States person” (i.e., a domestic trust). I.R.C. § 7701(a)(30)(E), (31)(B); Treas. Reg. § 301.7701-7(a)(2). Treasury Regulation § 301.7701-7(a) provides a two-factor test to determine whether a trust is domestic. A trust is domestic if (1) “[a] court within the United States is able exercise primary supervision over the administration of the trust” (court test) and (2) “[o]ne or more United States persons have the authority to control all substantial decisions of the trust” (control test). Id.subpara. (1). Failure to satisfy either the court test or the control test will result in the trust’s being deemed a foreign trust for federal tax purposes. Id. subpara. (2).

A trust satisfies the court test if the governing document does not direct that the trust be administered outside of the United States, the trust, in fact, is administered exclusively in the United States, and the trust is not subject to an automatic migration provision that would move it outside the United States if a U.S. court were to attempt to assert jurisdiction. Treas. Reg. § 301.7701-7(c)(1), (4)(ii).

With respect to the control test, control means having the power, by vote or otherwise, to make all of the substantial decisions of the trust, with no other person having the power to veto any of the substantial decisions. Id. para. (d)(1)(iii). Substantial decisions are those decisions that are “authorized or required” under the trust instrument and applicable law, which include, but are not limited to, decisions concerning whether and when to distribute income or corpus, the amount of any distribution, whether to terminate the trust, etc. Id. subdiv. (ii).

Reporting Obligations. Pursuant to section 6048(b) of the Code, each United States person who is treated as the owner of any portion of a foreign trust, under the grantor trust rules of sections 671 through 679, is responsible for ensuring that the trust annually “makes a return . . . which sets forth a full and complete accounting of all trust activities and operations for the year, the name of the United States agent for such trust, and such other information as the Secretary may prescribe.” I.R.C. § 6048(b)(1)(A). This prescribed information is provided by filing Form 3520–A. See Rost v. United States, 44 F.4th 294, 298 (5th Cir. 2022); Wilson v. United States, 6 F.4th 432, 434 (2d Cir. 2021). Moreover, any United States person who is a beneficiary of a foreign trust and receives any distribution from that foreign trust must file an information return that includes the name of the trust, the aggregate amount of the distribution received from the trust during the taxable year, and such other information as the Secretary may prescribe. I.R.C. § 6048(c)(1). This mandatory reporting requirement is satisfied when the U.S. beneficiary files Form 3520. See I.R.S. Notice 97-34, 1997-1 C.B. 422.

“Look Through” Trust Form to Person in Control. “When a grantor or other person has certain powers in respect of trust property that are tantamount to dominion and control over such property, the Code ‘looks through’ the trust form and deems such grantor or other person to be the owner of the trust property and attributes the trust income to such person.” Estate of O’Connor v. Commissioner, 69 T.C. 165, 174 (1977); see alsoI.R.C. § 671. A person other than the grantor shall be treated as the owner of any portion of a trust with respect to which that person has a power exercisable solely by himself to vest the corpus or the income therefrom in himself. I.R.C. § 678(a)(1).

Statute of Limitations. Section 6501(a) provides that any tax imposed under the Code shall be assessed within three years after the return was filed (whether or not the return was filed on or after the date prescribed) and no proceeding in court without assessment for the collection of the tax shall be begun after the expiration of that period. For a timely filed return, the three-year period begins to run as of the due date of the return. See I.R.C. § 6501(b). Subsection (c) provides for a number of exceptions to the general three-year period of limitations rule found in section 6501(a). One exception is in subsection (c)(8), entitled “Failure to notify Secretary of certain foreign transfers.”. Section 6501(c)(8) provides as follows:

In the case of any information which is required to be reported to the Secretary under section 6038, 6038A, 6038B, 6046, 6046A, or 6048, the time for assessment of any tax imposed by this title with respect to any event or period to which such information relates shall not expire before the date which is 3 years after the date on which the Secretary is furnished the information required to be reported under such section.

Statutory Reporting Obligations of U.S. Owner/Beneficiary of Foreign Trust.

Section 6048(b), entitled “United States Owner of foreign trust,” provides that each United States person treated as the owner of any portion of a foreign trust shall be responsible to ensure that (A) the trust makes a return for the year which sets forth a full and complete accounting of all trust activities and operations for the year, the name of the United States agent for such trust, and such other information as the Secretary may prescribe and (B) the trust furnishes such information as the Secretary may prescribe to each United States person (i) who is treated as the owner of any portion of the trust or (ii) who receives (directly or indirectly) any distribution from the trust. I.R.C. § 6048(b)(1).

Section 6048(c), entitled “Reporting by United States beneficiaries of foreign trusts,” provides that any United States person who receives (directly or indirectly) during any taxable year of the person any distribution from a foreign trust shall make a return with respect to that trust for the year which includes (A) the name of the trust, (B) the aggregate amount of the distributions so received from the trust during the taxable year, and (C) the other information as the Secretary may prescribe. I.R.C. § 6048(c)(1).

Deficiencies. The IRS’s determinations in a notice of deficiency are presumed correct, and the taxpayer bears the burden of proving error. Rule 142(a); Welch v. Helvering, 290 U.S. 111, 115 (1933). Section 61(a) provides that gross income “means all income from whatever source derived,” including gains derived from interest. I.R.C. § 61(a)(4). In cases of unreported income, the IRS’s determinations are presumptively correct if supported by a minimal evidentiary foundation connecting the taxpayer with an income producing activity. See Blohm v. Commissioner, 994 F.2d 1542, 1549 (11th Cir. 1993), aff’g T.C. Memo. 1991-636; United States v. McMullin, 948 F.2d 1188, 1192 (10th Cir. 1991). Once the IRS has established some evidentiary foundation linking the taxpayer with an income-producing activity, the burden shifts to the taxpayer to prove that the determinations are arbitrary or erroneous. See Blohm, 994 F.2d at 1549.

Accuracy-Related Penalties. Section 6662(a) and (b)(1) imposes a penalty equal to 20% of the portion of an underpayment that is attributable to negligence or disregard of rules or regulations. “Negligence” includes any failure to make a reasonable attempt to comply with the provisions of the internal revenue laws or to exercise ordinary and reasonable care in the preparation of a tax return. I.R.C. § 6662(c); Treas. Reg. § 1.6662-3(b)(1). “Disregard” includes any careless, reckless, or intentional disregard of rules or regulations. I.R.C. § 6662(c); Treas. Reg. § 1.6662-3(b)(2). The IRS bears the burden of production with respect to a penalty imposed by section 6662(a) and is required to present sufficient evidence showing that the penalty is appropriate. See I.R.C. § 7491(c); Higbee, 116 T.C. at 446–47. This includes showing compliance with the procedural requirements of section 6751(b)(1). See I.R.C. § 7491(c). Once the IRS meets this burden of production, the taxpayer bears the burden of proving that the IRS’s determination is incorrect. Higbee, 116 T.C. at 447.

Avoiding Penalties by Reasonable Cause. A taxpayer may avoid a section 6662(a) penalty by showing that there was reasonable cause for any portion of the underpayment and that the taxpayer acted in good faith. I.R.C. § 6664(c)(1). Reasonable cause requires that the taxpayer have exercised ordinary business care and prudence as to the disputed item. See United States v. Boyle, 469 U.S. 241, 246 (1985). Whether a taxpayer acted with reasonable cause and in good faith within the meaning of section 6664(c)(1) is determined on a case-by-case basis, taking into account all relevant facts and circumstances. Treas. Reg. § 1.6664-4(b)(1). The most important factor is the extent of the taxpayer’s effort to assess his proper tax liability for the year. Id. Circumstances that may indicate reasonable cause and good faith include an honest misunderstanding of fact or law that is reasonable under all of the circumstances, including the taxpayer’s education, experience, and knowledge. Id.

Reliance on Professional. Where a taxpayer claims reliance on professional advice, section 6664(c) will apply if the taxpayer meets the following three-prong test: (1) the adviser was a competent professional who had sufficient expertise to justify reliance, (2) the taxpayer provided necessary and accurate information to the adviser, and (3) the taxpayer actually relied in good faith on the adviser’s judgment.

Insights: A U.S. taxpayer with an interest in or control over a foreign trust is wise to evaluate and execute federal income tax reporting obligations. Each United States person who is treated as the owner of any portion of a foreign trust is responsible for ensuring that the trust annually makes a return which sets forth, among other things, a full and complete accounting of all trust activities and operations for the year. And, any United States person who is a beneficiary of a foreign trust and receives any distribution from that foreign trust must file an information return that includes, among other things, the name of the trust, the aggregate amount of the distribution received from the trust during the taxable year, and such other information as the IRS may prescribe. Failing to comply with these reporting requirements could lead to tax liabilities assessed many years ahead due to the tolling of the standard three-year statute of limitations.