In recent years, it appears that the Internal Revenue Service (IRS) has devoted more attention to the imposition and collection of penalties for late filing of various tax or information returns and less attention to auditing returns to uncover understatements of tax.
require far less time and effort by the IRS because they are usually
simple fact situations. Was the taxpayer required by the Internal
or IRS regulations to file an income tax or information return? If so,
return filed on time? Was any tax due with the filing of the return? If
the full amount paid and was it paid in the time prescribed?
A $95,000 Penalty Assessment for Filing Six
2005, I filed a
timely return (Form 3520-A) for a foreign trust by March 15th. It later turned out that the IRS did not get
the form until March 21st. An
agent imposed a penalty of 5% of the assets in the trust, amounting to
for a late filing of the return. As it turned out, I had mailed this
the client because he was out of the country and I had mailed it via
Many Penalties Are for Non Filing or Late Filing
As a general rule, the individual income tax return (Form 1040) does not have to be filed if no tax is due based on the amount of income and statutory deductions or exemptions. (Itemized deductions can’t be taken into account for this purpose.) Otherwise, there is a penalty of 5% of the tax due (up to a maximum of 25%) for each month the return is filed late. The corporate income tax return is required to be filed regardless of whether a tax is due, but the penalty for a late filing of the return is also 5% of the tax due, up to 25%.
virtually all other tax
information returns, there is a specific penalty for a failure to file
or for late filing of the form – regardless of whether any
due because of the information that should be reported on the
assortment of other penalties apply for a failure to report income paid
others, to withhold and pay any taxes from other persons (such as
for a substantial understatement of the tax that is due, for civil
for criminal fraud.
past five years, most of the tax returns I have prepared have
been international information returns for prior tax years. In
nearly every case, I've been able to offer some justification on behalf
of the taxpayer for the delinquent returns and have prepared
requests on their behalf to request a waiver of penalties for a failure
to file the returns on a timely basis. Thus far, none of my
clients have been assesed penalties but there is no assurance that
penalties can be avoided. And, recent developments in the
IRS indicate that they are going to become far less agreeable to
waive these penalties.
The Law of Unintended Consequences
not most) laws have an impact that is exactly the opposite of what is
intended. The U.S. government wants U.S. taxpayers to file various tax
and information returns - even if they are filed late. However,
Between a Rock and a Hard Place
Filing late can result in punitive financial penalties but will rarely result in criminal charges. Not filing and getting caught can result in criminal prosecution. And tax professionals can't advise you not to file. It would be a crime for an accountant or an attorney to advise a taxpayer not to file delinquent returns. However, consultation with an accountant is not protected as a privileged communication to the same extent as a consultation with an attorney. Although an attorney can not advise a client that it would be best not to file, the attorney can not be compelled to testify as to the nature of the consultation. An accountant or other tax preparer can be compelled to testify. So if a taxpayer discusses the matter with an accountant and then decides not file, the accountant could be compelled to disclose the details of the discussion.
How would the IRS find out? There are many ways the IRS could discover that a taxpayer had consulted with a tax preparer other than an attorney, but the most likely is that the IRS might uncover information from other sources regarding the existance of unreported foreign bank or other financial accounts, foreign credit cards, foreign trusts or foreign corporations. That is likely to lead to an audit. The audit could easily result in producing information that the taxpayer had discussed the matter with an accountant. The IRS would then ask for the name of the accountant and would secure a court order to compel the accountant to divulge the nature of the discussion.
Congress and the IRS
have become particularly frustrated by the failure of many
Annual Information Return of Foreign Trust
The U.S. owner (grantor) of any trust assets is subject to a penalty of 5% of the gross value of the portion of the trust assets that are treated as owned by the U.S. grantor if the foreign trust fails to file a timely Form 3520-A or does not provide the information required. A waiver of penalties can be made by the IRS upon a showing of a reasonable cause for a failure to file this form, but, according to the IRS, "The fact that a foreign country would impose penalties for disclosing the required information is not reasonable cause." The form is required to be filed three and ½ months after the end of the tax year of the trust. For a trust using a calendar year, it must be filed by March 15th or the penalty will be imposed. However, an extension of time to file can be requested with Form 2758.
Form 3520: Annual Return to Report Transactions with Foreign Trusts and Foreign Gifts
penalties for a failure
to file this form include (1) 35% of the gross value of the
received from a foreign trust or
transferred to a foreign trust, and
(2) 5% per
month for the amount of certain foreign gifts -- to a maximum of 25%.
may be waived by the IRS on a showing of reasonable cause for a failure
Form 5471 is due with the income tax return of the affected shareholder. For most domestic corporation shareholders, that would March 15th or the extended due date. For most individual shareholders, that would be April 15th or the extended due date. The penalties for failing to file this form are severe, even though no tax may be due. There is a penalty of $10,000 for each year for failing to file the form on a timely basis. The penalties may be waived by the IRS on a showing of reasonable cause for failing to file the form. If the taxpayer is notified by the IRS of a duty to file, the penalty is $10,000 per month up to a maximum of $50,000. For a late filing of the form, “any person who fails to file or report all of the information required within the time prescribed will be subject to a reduction of 10% of the foreign tax credit available for credit.” There are additional penalties that are described in the instructions to the form. An abbreviated method of reporting is provided for a dormant controlled foreign corporation, but it is not clear if an unfunded foreign corporation is considered to be dormant. An argument could be made by the IRS that the filing fees paid to form the corporation represent an intangible asset of the corporation and it is therefore funded to the extent of those filing fees and other expenses of keeping the entity in existence.
Return by a
Generally, the form is required for transfers of property in exchange for stock in the foreign corporation, but there is an assortment of tax code sections that may require the filing of this form. The penalty for a failure to file the form is 10% of the fair market value of the property at the time of the transfer.
Return by a
It is not
mandatory to file
this form unless there is a distribution of income from a passive
investment company (PFICs) in which a
The form is required to be filed with the income tax return of each partner, including any extensions of time to file. In most respects it is a combination of the U.S. Form 1065 partnership return and the Form 5471 return for controlled foreign corporations. The penalties for failing to file the form or for failing to file it on a timely basis are the same as for foreign corporations. The penalty is $10,000 per year for a failure to file and the loss of 10% of available foreign tax credits for filing late.
Form 8832: Election to be Taxed as a Disregarded Entity
A foreign corporation or foreign limited liability company will be treated as a foreign corporation for U.S. tax purposes unless the owners make an election to be treated as a partnership (where there are multiple owners) or as a disregarded entity (for one owner). Making the election by filing this form is optional, but if the form is not filed with 75 days after the end of the first taxable year of the foreign entity, the default treatment will to treat it as a foreign corporation. A later conversion from a foreign corporation will require a dissolution of the corporation (with possible taxes on unrealized gains).
Information Return of
form was introduced for the 2004 tax year so that the IRS could have
Form TD F 90-22.1: Report of Foreign Bank and Financial Accounts
Civil and criminal penalties, including in certain circumstances a fine of not more than $500,000 and imprisonment of not more than five years, are provided for failure to file a report, supply information, and for filing a false or fraudulent report.
because the penalties were imposed for a willful failure to file and
willfulness is difficult to prove and because the penalties were so
they were never imposed. The Congress
then introduced a smaller penalty of “up to $10,000” for a non-willful
to file the form, effective for filing dates after
Waiver of Penalties for “Reasonable Cause”
These varied penalties can sometimes be waived or reduced at the discretion of the IRS if the taxpayer can show a “reasonable cause” for a failure to file or for a failure to file by the due date of the form or return.
According to an article at BankRate.com
Built into its agent handbook are guidelines for determining reasonable cause that might warrant abating a penalty. They include such things as:
These are reasonable cause areas as defined by the IRS, not automatic loopholes out of a tax penalty. If your reason falls into one of these categories, you may be able to convince the IRS to let you off; if it doesn't, you are out of luck.
Note that the mention of “ignorance of the law” in the article from BankRate.com is a potential defense with respect to potential criminal penalties, but is not necessarily a defense with respect to civil penalties.
For more information about avoiding penalties see “Reasonable Cause Can Waive Penalties” a PDF report by Nancy Faucett, CPA
And “Avoiding IRS Penalties” by Gail Perry
And “Reducing IRS Penalties” by Robert McKenzie, Esq.
In the case of a failure to file various returns for foreign trusts, corporations, partnerships, etc., reasonable cause may be justified where the taxpayer can show that an effort was made to determine the tax filing obligations for such entities and where persons who reasonably appeared to be knowledgeable about such matters had informed the taxpayer that no U.S. taxes were due unless or until income was repatriated back to the U.S.
However, reliance on the advice of others is not an assurance that penalties can be avoided if that advice is wrong. Under new regulations by the IRS and new tax code sections introduced in the American Jobs Creation Act of 2004, taxpayers may not be able to avoid the imposition of various penalties unless they receive a “covered opinion” from a qualified tax professional. A covered opinion is essentially a written opinion that includes a comprehensive analysis of all the potentially pertinent tax issues and arrives at a conclusion that the opinion expressed is more likely than not to prevail in the event of a dispute with the IRS. However, this is a very simplistic description of that subject and a much more detailed discussion is available at http://www.offshorepress.com/vkjcpa/disclosurerules.htm
The information and opinions in this article are those of the author and are intended as educational material and commentary for public discussion. This article is not intended to represent tax advice for any reader of this information and may not be cited as authority for any tax position.
Copyright, 2005, All rights reserved.