Reliance on accountant may avoid penalty for failure to file foreign trust form

There are a great deal of complicated rules, related to reporting any foreign income.  These provisions put the burden of reporting on the taxpayer and “encourage” compliance by imposing significant penalties of taxpayer who fail to comply.  Since, most accountants do not deal with these foreign tax provisions on a regular basis is not uncommon for us to get new clients who have no knowledge of these complicated laws.

The good news: A district court has denied IRS’s motion for summary judgment in a case dealing with the Code Sec. 6677 penalty for failure to file Form 3520, Annual Return To Report Transactions With Foreign Trusts and Receipt of Certain Foreign Gifts.

The court concluded that there was a genuine issue of material fact about whether the taxpayer’s accountant provided him with advice on which he reasonably relied in not filing the form.

An owner of a foreign trust must file Form 3520, due at the same time as his federal income tax return for that year.

A trust owner who fails to timely file Form 3520, or who submits an incomplete or incorrect form, is subject to a penalty of $10,000 or 35% of the gross reportable amount, whichever is greater.

If any failure to file continues for more than 90 days after the day on which IRS mails notice of a failure to file to the person responsible for the penalty, that person must pay an additional penalty of $10,000 for each 30-day period (or fraction thereof) during which the failure continues after the expiration of the 90-day period, up to a maximum of the gross reportable amount.

However, no penalty is imposed if the failure to file was “due to reasonable cause and not due to willful neglect.”

To date, IRS hasn’t issued regs explaining the meaning of “reasonable cause” for failure to file Form 3520. According to IRS’s Internal Revenue Manual (IRM), reasonable cause generally exists when a taxpayer exercises ordinary care and prudence in determining his tax obligations despite his failure to comply. Whether reasonable cause exists depends on all of the facts and circumstances, including the taxpayer’s reason for failing to properly file, and the extent of his efforts to comply. The IRM provides that ignorance of the law may provide reasonable cause if: (a) a reasonable and good faith effort was made to comply with the law; or (b) the taxpayer was unaware of a requirement and could not reasonably be expected to know of the requirement.

Facts. In an effort to protect his assets from potential malpractice claims, Dr. Brian Chivas James created an irrevocable foreign trust in Nevis, West Indies. From 2001 through 2003, his contributions to the trust totalled $1,604,146. For all relevant years, the trust timely filed Form 3520-A, Annual Information Return of Foreign Trust with a U.S. Owner, as it was required to under Code Sec. 6048.

However, Dr. James failed to file the required Form 3520 for 2001 through 2003. He argued that his failure to do so was the fault of his former accountant, George Famiglio, who had prepared Dr. James’s personal and business taxes for a number of years. Dr. James relied on Famiglio to properly oversee and advise him about the tax requirements of the foreign trust. According to Dr. James, he timely provided Famiglio with all appropriate trust documents and information for each year in question, yet Famiglio failed to timely file Form 3520, and/or advise Dr. James that it should be filed.

Dr. James further contended that he was personally unaware of the requirement to file Form 3520. He argued that he acted prudently and with sound business judgment in engaging Famiglio to handle all issues related to the foreign trust, and that his accountant simply dropped the ball. In short, Dr. James argued that he had “reasonable cause” in failing to file Form 3520 by reasonably relying on Famiglio.

In 2006, IRS assessed Dr. James with $578,950 in penalties for failure to file Form 3520 for tax years 2001 through 2003. Dr. James paid the penalties and sued for a refund, arguing that his failure to file Form 3520 was due to reasonable cause and not willful neglect.

IRS asked for summary judgment.

Summary judgment denied. The district court said it was clear that a taxpayer may reasonably rely on an expert’s advice that no return is required; thus, if an expert erroneously advises him that no return is required, or erroneously advises him that it can be filed beyond the due date, reasonable cause may be found. The court pointed to these factors in deciding that there was a genuine issue of material fact about whether Famiglio provided Dr. James with advice upon which the latter reasonably relied:

  • Dr. James timely provided all required trust forms to Famiglio and relied on Famiglio to advise him on all matters related to the trust;
  • Famiglio advised him on at least some trust matters (for example, he advised on how to report loans from the trust for tax purposes and that the trust loans did not result in taxable income);
  • Dr. James relied on Famiglio to advise him about making the appropriate filings for the trust, but Famiglio failed to so advise him; and
  • Dr. James, based on his conversations with Famiglio, believed that he had filed all required forms.

In addition, the court pointed out that Famiglio prepared James’s personal tax returns. On Schedule B of his Form 1040 tax returns, Famiglio answered “no” to the question asking whether the taxpayer received a distribution from, or was the grantor of or transferor to, a foreign trust. The court said that answering “no” to this question could be construed as Famiglio providing advice that Dr. James need not file Form 3520, advice upon which James could have potentially reasonably relied.

As a result, the court denied IRS’s motion for summary judgment.

If you have any question regarding your foreign assets and their reporting or the impact on your individual situation, please do not hesitate to contact us.

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