Megan Brackney

Neo-TikTok-Tology

April 13, 2023 by Guest Blogger 3 Comments

We welcome back guest blogger Megan L. Brackney who is a partner in the New York City Office of Kostelanetz. We also welcome as her co-author first time guest blogger Melina Watson who is an intern at Kostelanetz and a student at Spelman College. After graduation in May, Melina will return to Kostelanetz as a paralegal and will be attending Columbia Law School in 2025. Megan would like to thank Prof. Tom Weninger, Jessica L. Jeane, Travis W. Thompson, Jonathan T. Amitrano, and the other members of the Individual and Family Income Tax Committee of the American Bar Association Tax Section who gave her the idea for this post during their excellent presentation, “Combatting Misinformation on Social Media” at the ABA Tax Section meeting in San Diego on February 10, 2023. Les

Given the popularity of TikTok, it is not surprising that there are numerous TikTok videos relating to tax. Some of these videos contain useful and accurate information for people seeking tax advice, some are obviously not trustworthy, and others fall in between and may seem dependable to a layperson, but not actually provide accurate advice.

At right, Taxes with AJ @vidaincometax accurately warns against shady tax preparers

A woman in a polka dot blouse and long straight hair looks straight at the viewer and speaks into the camera. She is sitting on a leather office chair.

As people rely more on social media sources, such as TikTok, for news and information, and the number of qualified, affordable, and available tax professionals continues to decrease, have we reached a point where reliance on tax advice from TikTok could be reasonable cause? When I have asked this question, the reaction of my fellow tax practitioners has been, “no way!” Instead, they say, taxpayers should obtain advice from tax professionals. This is great advice, in theory, but it is becoming more difficult for taxpayers of limited financial means to find affordable and qualified tax professionals who will provide any better advice than what they can get for free on TikTok.

TikTok is one of the many social media platforms that have attracted people seeking free financial advice. This tax season, the hashtag “#taxes” has received increased engagement on TikTok, and according to the platform’s analytics has over 500 million views and 44,000 posts. Posters on TikTok range from CPAs and other tax practitioners to scammers, and while there is quality advice available on TikTok, scams, hacks, and “secret techniques” are being posted, promising higher returns or fewer taxes owed, which may appeal to lower income taxpayers and those who cannot consult a credentialed paid tax preparer or expert. The IRS has even included social media tax advice on its “Dirty Dozen” list for 2023, as this Tax Notes (paywall) article from a few weeks ago discusses.

We can see from statistics from the National Taxpayer Advocate that obtaining quality tax return preparation services and advice is a huge problem for lower income taxpayers. Looking at the statistics related to taxpayers who claim the Earned Income Tax Credit (“EITC”) in 2021, paid return preparers prepared just 53% of those returns, but of those returns, non-credentialed return preparers prepared approximately 58%. see e.g., the NTA 2022 annual report to Congress, at pg. 129. And, in case you wonder whether it matters if a tax return preparer has credentials, i.e., whether a tax authority requires them to have some training and competence, we see that with respect to EITC’s, about 92% of the total amount of dollars in audit adjustments made on 2020 returns occurred on returns prepared by non-credentialed return preparers. see e.g. , the NTA 2022 annual report to Congress, at pg. 128.

And even if you can afford to pay a credential preparer, good luck finding one. There is a shortage of tax return preparers creating difficulties for people of all income levels from getting assistance. Between 2020 and 2022, the Wall Street Journal reports (paywall) that more than 300,000 U.S. accountants and auditors have left their jobs, amounting to a 17% decline. This “exodus” of qualified tax professionals is part of an ongoing and larger economic trend, coupled with fewer people pursuing degrees in accounting.

The Volunteer Income Tax Assistance (VITA) grant program, a service provided by the IRS, is experiencing shortages in volunteers, especially in rural and low-income communities in which those taxpayers have the greatest need. The number of tax filing assistance programs dropped considerably during the pandemic, and the rate of growth has slowed in recent years. The livelihood of low-income tax return preparation services like VITA is mainly dependent on the number of qualified volunteers to assist with these returns. As NewAmerica discusses, a lack of professionals and volunteers means that taxpayers of all incomes, especially low-income taxpayers, will have limited resources.

Where does this leave someone without the resources or ability to find and hire a credentialed and competent return preparer? It leads them to do their own research. IRS.gov is full of great resources and information, but it can be difficult to find the answer you are looking for, and, if you have limited time, education, or English language skills, it can be even more challenging. Many taxpayers will look for answers to question on the internet, and this may take them to TikTok.

And what do we find when we go there?

First, we actually see legitimate advice. This poster also provides basic, but also accurate and useful, information about standard deductions, tax brackets, and home mortgage deductions, and some slightly more sophisticated advice on topics like “tax loss harvesting,” i.e., selling some stocks at a loss to offset your gains before ethe end of the tax year. And, the same poster, Eric Powell, also posted a video countering the bad advice (see below) that you can hire your children from birth to get a tax write-off.

In How to pay less in taxes, understand how the tax code works and work… this poster talks about IRC § 1031 exchanges as if they are a secret, illicit strategy, but the advice is accurate This post contains a skit about paying a family member for providing childcare to get the credit for child and dependent care. In the skit, the grandmother is actually providing child care, and the son is actually paying her. The idea is to get a tax benefit and keep the money in their family, which is not a bad idea so long as they comply with the rules. See IRC § 21; and a summary here in IRS pub 503 on the topic.

But, we also see really bad advice. This clip was featured during the ABA Tax Section program, “Combatting Misinformation on Social Media.” In Clothing is not tax-deductible, but UNIFORMS are 🤓 #Taxtiptuesday the poster correctly states that clothing is usually not deductible, but then goes on to say that if you print your name on your clothing, it becomes a uniform, and it is then a valid deduction.

The responses to the tax posts could be an article in themselves, but my favorite response here is: “welcome to your audit.” In any event, what this poster neglects to mention is that uniform expenses are deductible under IRC § 162(a) if the uniforms are “(1) of a type specifically required as a condition of employment, (2) not adaptable to general use as ordinary clothing, and (3) not so worn.” Patitz v. Comm’r, T.C. Memo. 2022-99, at *8 (citing Yeomans v. Comm’r, 30 T.C. 757, 767 (1958)).

In This is how you can legally write-off your travel #taxwriteoff this TikTocker crosses the line on business travel. He explains that business travel expenses are deductible, which may be true depending on the circumstances, but then goes on to claim that as long as you do some work on vacation, you can deduct the cost of basically any travel. The video begins by stating: “You can take your kids to Disneyland and write that trip off if you do work while you’re at Disneyland!” The video does not mention, however, that this trip to Disneyland itself must be “reasonable and necessary in the conduct of the taxpayer’s business and directly attributable to it.” Treas. Reg. § 162-2(a). And moreover, if a taxpayer is engaging in both business and personal activities when they travel, for the travel costs to be deductible, the regulations provide that “traveling expenses to and from such destination are deductible only if the trip is related primarily to the taxpayer’s trade or business.” If the trip is “primarily personal in nature, the traveling expenses to and from the destination are not deductible even though the taxpayer engages in business activities while at such destination.”

Another TikTocker advises viewers to pay their children “from birth” up to $12,000 per year and deduct it as a business expenses. Obviously, if the children are not providing services to the business, they cannot be treated as employees.

There are also a lot of videos about the IRC § 179 bonus depreciation for vehicles that way over 6,000 pounds. This post is typical. In this video, the poster actually does mention that the deduction has to be proportional to the business use of the vehicle, although that is a quick note at the end.

Now that you have a sense of what is out there, we return the question – If a taxpayer relies on advice from TikTok that turns out not to be correct, and ends up with an adjustment of their tax liability, can the taxpayers rely on that advice as a reasonable cause defense to accuracy penalties?

The baseline for reasonable cause as a defense to accuracy penalties in IRC § 6662 (and fraud penalties in IRC § 6663) is in Treasury Regulation 1.6664-4(b)(1), which states that this facts and circumstances determination “made on a case-by-case basis.” [Note that there is a different articulation of reasonable cause for failure to file and failure to pay penalties. Also, fraud penalties raise other issues that are outside of the scope of this post]. The key factor is “is the extent of the taxpayer’s effort to assess the taxpayer’s proper tax liability.” The Regulation goes on to say that circumstances that indicate a good faith effort to assess the proper liability include: “the experience, knowledge, and education of the taxpayer.” Id.

One of the most effective reasonable cause defenses to accuracy penalties is reliance on a tax professional. The regulations state that the minimum requirements for this defense are that the taxpayer provided all of the pertinent facts to the advisor, the advice is not based on unreasonable factual or legal assumption, and the taxpayer relies in good faith on the advice. Treas. Reg. § 1.6664-4(c)(1). The advice does not have to be in any particular form and can be “any communication. . . provided to (or for the benefit of) the taxpayer and on which the taxpayer relies, directly or indirectly.” Treas. Reg. § 1.6664-4(c)(2).

Courts have articulated similar tests for reasonable cause, most notably in Neonatology Assocs., P.A. v. Comm’r, 115 T.C. 43, 98-99 (2000), aff’d, 299 F.3d 221 (3d Cir. 2002), in which the Tax Court and Court of Appeals explained that good faith reliance on an independent, competent professional as to the tax treatment of an item may constitute reasonable cause. Reasonable cause and good faith are present where: (1) the taxpayer reasonably believes that the professional upon whom the reliance is placed is a competent tax adviser who has sufficient expertise to justify reliance; (2) the taxpayer provides necessary and accurate information to the adviser; and (3) the taxpayer actually relies in good faith on the adviser’s judgment. See Internal Revenue Manual 20.1.1.3.3.4.3. Neonatology, 115 T.C. at 99. Similarly, in United States v. Boyle, 469 U.S. 241 (1985), a case that concerned reliance on a tax advisor to meet a filing deadline, the Supreme Court explained that reliance on a tax advisor establishes reasonable cause where the issue was substantive, and the taxpayer provided all of the information to a competent tax advisor. As stated in Boyle:

When an accountant or attorney advises a taxpayer on a matter of tax law, such as whether a liability exists, it is reasonable for the taxpayer to rely on that advice. Most taxpayers are not competent to discern error in the substantive advice of an accountant or attorney. To require the taxpayer to challenge the attorney, to seek a “second opinion,” or to try to monitor counsel on the provisions of the Code himself would nullify the very purpose of seeking the advice of a presumed expert in the first place.
Id. at 251.

The obvious problem with trying to fit the TikTok advice into reasonable cause based on reliance on professionals is that the communication is one-directional – the taxpayer receives general advice but has not provided the factual information about their situation to the tax advisor.

Given the lack of access to tax professionals and the complexity of some Code provisions that impact low income taxpayers, the Neonatology/Boyle iterations of reasonable cause are insufficient for current times. Instead, the IRS should adopt a more expansive view of reasonable cause that includes information from advisors on social media, along with taxpayer’s own study of the issue. What the IRS and courts should not do is determine that a taxpayer does not have reasonable cause merely because they did not consult a tax professional. In that regard, the case of Reiff v. Comm’r, T.C. Summ.Op. 2013-40, at *6, is troubling. There, the Tax Court sustained accuracy penalties, noting that although the taxpayer conducted online research regarding deductions on his self-prepared return, he “did not consult or otherwise seek the advice of a tax professional in preparing their return.” There is simply no requirement in the Treasury Regulations that a taxpayer consult a tax professional. Of course, in some circumstances, it might be appropriate in the reasonable cause analysis to require a high net worth taxpayer who can afford competent tax advisors to seek professional tax advice, but this requirement should not be imposed without analysis of the taxpayer’s ability to hire a tax professional.

Taxpayers with limited resources should not be shut out of penalty relief because they were not able to hire a tax professional and instead looked to advice that seemed reasonable to them, recalling the Supreme Court’s statement in Boyle that most taxpayers are not competent to discern errors in tax advice. As one of the facts and circumstances, the IRS should consider the taxpayer’s access to a tax professional, and, whether the taxpayer was not able to hire a tax professional, either because of lack of resources or lack of availability.

There is a basis for this approach already recognized by the IRS and the courts. In Internal Revenue Manual (“IRM”) 20.1.1.3.2.2.6, the IRS states that reasonable cause can include ignorance of the law, and looks to the taxpayer’s education, whether the taxpayer has previously been subject to the tax, if the taxpayer has been penalized before, if there were recent changes in the tax forms or law that a taxpayer could not reasonably be expected to know, and the level of complexity of the issue.

In Pemberton v. Comm’r, T.C. Summ. Op. 2017-91, at *7–8, where the taxpayer deducted undergraduate education expenses. This was incorrect, but the Court found that the taxpayer had consulted an IRS publication and believed that his education expenses were deductible under its guidance. The Tax Court noted that “[a]lthough petitioner had some undergraduate education at the time he prepared his . .. Form 1040, he is not a tax professional. The determination of whether education expenses are deductible as ordinary and necessary business expenses under section 162 is a fact-intensive analysis and requires a reference to and analysis of caselaw as more fully discussed in this opinion.”

In contrast, in Remy v. Comm’r, T.C. Memo. 1997-72, at *8, the Tax Court found that “it is evident that he attempted to research the tax law to find authority for his position,” but because there was such a weight of authority against the position (that he could reduce his taxable income by deducted the value of uncompensated services to clients), the Tax Court found that that there was no reasonable case. The lesson from this case is that the taxpayer should double-check the advice on TikTok to confirm it has not been previously rejected by the IRS or the courts.

A taxpayer who is relying on TikTok or other social media, or internet searches for tax information should maintain these sources. In Woodard v. Comm’r, T.C. Summ.Op. 2009-150, at *3-4, the Tax Court seems open to the idea that internet research could provide reasonable cause, but the taxpayer was not able to provide any information about the sources he relied on. “From the record, it is not clear that he questioned the provenance or accuracy of the information he found through the Google search engine.Without knowing the sources of the information, it is impossible for the Court to determine that those sources were competent to provide tax advice. Accordingly, we cannot conclude that [the taxpayer] exercised ordinary business care and prudence in selecting and relying upon the information he found on line.”

TikTok videos remain online indefinitely (unless the poster or the site removes them), but there is no guarantee that a particular video will be there in two or three years when the return is being audited. This is true for other internet sources as well. In order to successfully raise a “TikTok Defense,” the taxpayer will need to preserve the video along with other tax records.

Applying these standards to our examples here, a taxpayer who attempts to deduct a personal vacation is unlikely to avoid penalties by relying on the TikTok post above. The poster is not a CPA or other tax professional, and the comments from other users should raise skepticism. Also, this is not a new, obscure, or complex question, and other basic internet research, including IRS.gov., provides accurate information in a user-friendly format. See e.g., IRS discussions here and here.

In contrast, the TikToks on the IRC § 179 deduction may provide a reasonable cause defense. There are hundreds if not thousands of people claiming to use it or endorse it, many of whom appear to be tax professionals. If taxpayers try to do their own internet research, the IRS’s guidance does not even appear on the first page of an internet search for “Section 179 heavy vehicle deduction.” When you find it, the IRS guidance contains terms like “depreciation,” and “MACR’s” that may not be familiar to the average taxpayer, see e.g., IRS Pub 946 and instructions for Form 4562. It is not surprising that instead of trying to find information about IRC § 179 from the IRS, that a taxpayer would return to quick and easy explanations on TikTok.

Before closing out this post, I’d like to recognize a couple of TikTockers trying to bring some order to the chaos. Nick Krop, “Nick the CPA,” very quickly knocks down the five worst tax ideas on TikTok including the purported IRC § 179 deduction for heavy vehicles. He has many other videos cutting through the nonsense of other posters that are worth checking out.

Also, Alisha Rodriguez, a CPA at AJ’s Tax, provides a spot-on explanation of how to identify unscrupulous return preparers and why you should avoid them and hire credentialed tax professionals. And she even provides a version of this video in Spanish!

These posters show that just because information is on TikTok, rather than published by the IRS or in a more formal, academic or professional journal, does not mean that it is not reliable and cannot form the basis of a reasonable cause defense.

Filed Under: Civil Penalties Tagged With: Megan Brackney, Melina Watson

The IRS’s Aggressive Enforcement of Foreign Information Return Penalties Has Created Ethical Dilemmas For Practitioners (Part 2)

December 8, 2022 by Guest Blogger 6 Comments

In today’s post, Megan L. Brackney.turns to the challenging issues that practitioners must confront when faced with a client or potential client’s failure to file foreign information returns. Les

Ethical Standards Related to a Client’s Non-Compliance With Foreign Information Reporting

In yesterday’s post, I discussed some common penalties for failing to file foreign information returns and the practical and legal challenges associated with establishing that a client is entitled to relief from those penalties. Today we focus on how this penalty regime raises difficult ethical issues for practitioners who want to zealously represent their clients but also want to practice in a way that is consistent with their responsibilities and duties.

Circular 230 governs attorneys, CPA’s, enrolled agents, and others who practice before the IRS. On the subject of a taxpayer’s error or omission, Circular 230, Section 10.21 states as follows:

A practitioner who . . . knows that the client has not complied with the revenue laws of the United States or has made an error in or omission from any return . . . must advise the client promptly of the fact of such noncompliance, error, or omission.”

This section goes on to say that “the practitioner must advise the client of the consequences as provided under the Code and regulations of such noncompliance, error, or omission.” It does not, however, require the practitioner to advise the client to self-correct.

The Statements on Standards for Tax Services (“SSTS”),SSTS No. 6 contains a slightly different iteration of the duties concerning knowledge of a client’s error or omission:

A member should inform the taxpayer promptly upon becoming aware of an error in a previously filed return, an error in a return that is the subject of an administrative proceeding, or a taxpayer’s failure to file a required return. A member also should advise the taxpayer of the potential consequences of the error and recommend the corrective measures to be taken.

In SSTS No. 6(13) (Explanation). the AICPA explains, however, that the SSTS do not require CPAs to advise clients to amend if “an error has no more than an insignificant effect on the taxpayer’s tax liability,” a question which “is left to the professional judgment of the member based on all the facts and circumstances known to the member.”

On the taxpayer’s side, it is generally understood that taxpayers do not have an obligation to file amended returns. As stated in Badaracco v. Comm’r, 464 U.S. 386, 393 (1984), “[t]he Internal Revenue Code does not explicitly provide either for a taxpayer’s filing, or for the Commissioner’s acceptance, of an amended return; instead, an amended return is a creature of administrative origin and grace.”)

It is also generally understood that a tax practitioner cannot advise a client not to file a return that is currently due. There is no guidance on whether the same is true for a delinquent return once the filing deadline has passed. Do tax practitioners have an unending obligation to recommend that their clients file delinquent returns?

The IRS’s policy is to solicit unfiled income tax returns for the prior six years. See IRS Policy Statement 5-133, Delinquent returns—enforcement of filing requirements (IRM 1.2.1.6.18 (08-04-2006) ( “Normally, application of the above criteria will result in enforcement of delinquency procedures for not more than six (6) years. Enforcement beyond such period will not be undertaken without prior managerial approval.”). This indicates that there may be some period of time after which we would not view a practitioner’s advice not to file a tax return as unethical but this is by no means a clear standard (Last season’s Form 1040? Ten years ago?).

Another aspect of the practitioner’s ethical duties is the prohibition on basing advice on the likelihood of audit. For purposes of advising a client on a return position, it is clear that the tax practitioner cannot consider the likelihood of audit but must instead determine whether the position is objectively reasonable.I.R.C. § 6694(a)(2); Circular 230 10.34; SSTS No. 1(4), (5). Circular 230, Section 10.37(a)(2) states that “the Practitioner must not, in evaluating a Federal tax matter, take into account the possibility that a tax return will not be audited or that a matter will not be raised on audit.”See also Regulations Governing Practice Before the Internal Revenue Service, 79 FR 33685-01 (“Treasury and the IRS agree that audit risk should not be considered by practitioners in the course of advising a client on a Federal tax matter, regardless of the form in which the advice is given.” ).

Does this rule apply when advising on whether to correct a past failure to file?

What Advice Can We Give?

fter considering the above ethical standards, if we return to the example of the college student, we know it is highly likely that if she files the Form 3520, the IRS will impose the maximum penalty. If she does not self-correct, given the low audit rates and the fact that her non-compliance was several years ago, there is a very strong chance that the IRS will never audit this tax year. Are we doing this client a disservice by not providing her with this information when as she decides whether or not to file the Form 3520 now? Do the ethical standards for tax practitioners actually require me to lead my client into financial ruin in order to correct a five-year old mistake that caused no actual harm?

It is not clear how the ethical rules apply in this context. Is a taxpayer who previously filed an income return but failed to file a foreign information return more like a taxpayer filing an amended return or filing a delinquent return? Certain foreign information returns, like Forms 5471 and 8938, are attached to the income tax return. And, the IRS has instructed that when taxpayers file these returns late, they be accompanied with a Form 1040X, even if there are no changes to the income tax return.

One could argue that a practitioner does not have an ethical duty to advise clients to file delinquent Forms 5471 and 8938 and other foreign information returns filed with the income tax returns because that would be the equivalent of filing an amended return.

But what about Form 3520? As the instructions provide, Form 3520 is not filed with the income tax return, but separately filed with the IRS Service Center in Ogden, Utah. Is filing a Form 3520 more like filing a delinquent income tax return?

I have difficult time believing that there should be different ethical rules for forms attached to the income tax return, such as Form 8938, and a free-standing form like the Form 3520. That is slicing it a bit too thin. And many practitioners would say that for a delinquent return, after the filing deadline has passed, the situation is similar to that of an amended return, and they are not obligated to recommend that the client self-correct. I think that this is a reasonable interpretation of the ethical rules, and that the Circular 230 practitioner is not required to recommend self-correction but should fully advise the client on the potential penalties, and the CPA should recommend self-correction if the failure to file a particular foreign information return is material.

What about the likelihood that a taxpayer will be audited in the future, after the non-compliance has already occurred? Is it unethical for a practitioner to advise the client in our example ho failed to file the Form 3520 five years ago that there is almost no chance that the IRS will audit this issue? The statute of limitations for assessment does not close until the taxpayer files all required foreign information returns. I.R.C. § 6501(c)(8). The same is true for income tax returns, for which the statute of limitations does not begin to run until the return is filed, but nonetheless the standard advice for long-term non-filers is to just file returns for the preceding six years.

As to discussing the likelihood of audits, this information is publicly available,and we should be able to discuss it if a client asks. However, I would still not base my advice on the likelihood of audit, as even with the currently low rates, I cannot accurately predict whether a particular client will be audited. However, we can advise our clients on the potential outcomes if they are audited so that they can weight the cost of voluntarily compliance versus waiting to be contacted by the IRS.

I believe practitioners should be able to use their professional judgment to advise clients while still upholding their ethical obligations to the IRS and the tax system. On the other side, the IRS should re-think its enforcement of these penalties in order to encourage, rather than punish, voluntary compliance, and, as the IRM provides, live up to its own obligations to ensure that penalties “encourage noncompliant taxpayers to comply,” and are “objectively proportioned to the offense.” I genuinely want to encourage tax compliance, but it is challenging when it is so harshly penalized. The IRS could help tax practitioners, as well as taxpayers, by providing some reasonable options for correcting past failures to file foreign information returns.

Filed Under: Circular 230, Civil Penalties Tagged With: Megan Brackney

The IRS’s Aggressive Enforcement Of Foreign Information Return Penalties Has Created Ethical Dilemmas For Practitioners (Part 1)

December 7, 2022 by Guest Blogger 2 Comments

Today’s guest post is the first of a two-part series by Megan L. Brackney. These posts raise important questions about practitioners’ ethical responsibilities when confronting clients’ potential exposure to penalties for failing to file foreign information returns. Megan previously wrote a terrific series of posts considering problems with the IRS’s administration of these penalties, and in today and tomorrow’s posts Megan situates how these problems raise challenges for practitioners wanting to effectively and ethically represent their clients.

Megan is a partner at Kostelanetz LLP in New York who focuses her practice in civil and criminal tax controversies. She would like to thank Grace Hall for her assistance in researching this series. Grace was a paralegal in the D.C. office of the firm and is now attending the University of Virginia Law School. Les

The IRS’s practice of assessing penalties against taxpayers who voluntarily attempt to get into compliance with their filing of foreign information returns puts tax practitioners in a difficult position. Most practitioners understand that they have an obligation to the tax system and genuinely strive to comply with that obligation to assist their clients with compliance. And, indeed, most taxpayers believe in tax compliance. See Comprehensive Taxpayer Attitude Survey, 2017 Executive Report, Practitioners also have duties to their clients to ensure that they are not recommending actions that will cause them to unnecessarily incur penalties. In the past several years, as the IRS continues to impose the maximum level of penalties against taxpayers who file untimely or incomplete foreign information returns, it is getting harder for practitioners to recommend that clients should self-correct, as the outcome is the same if they do not self-correct and are later audited.

Most of us would agree, for instance, that a young person who received a reportable (but nontaxable) gift from a foreign relative for the first time and who prepared her own return and did not know about the Form 3520 requirement at the time of filing, but then filed it 6 months after learning about the filing requirement should not have to pay a penalty of 25% of the foreign gift to the IRS. The IRS, however, would assess this penalty without a second thought – and indeed does so with regularity.

Considering the example above, assume that your client has come to you for advice before she files the late Form 3520. The client she tells you that she received the gift 5 years ago but has heard that the IRS could still assess penalties, and that she has limited financial resources such that a large penalty would be financially devastating to her. If she asks whether you recommend filing the Form 3520 reporting the foreign gift now, knowing that this will immediately result in a penalty of 25% of the amount of the gift, and that if the client likely would not be able to satisfy the IRS’s interpretation of the standard for reasonable cause and thus would likely be unsuccessful in challenging a penalty, what is your advice? Do you have an ethical duty to advise the client to file the delinquent Form 3520 despite knowing what the outcome will be? How do you balance your duty to tax system and ethical obligations under Circular 230 with your duty to obtain the best possible outcome for your client And can you consider the likelihood that the client will be audited in giving advice as to whether she should file the late Form 3520?

Before discussing the practitioner’s ethical duties, we will briefly review the common foreign information return filing requirements and penalties to provide context for this discussion.

Basic Background on Foreign Information Return Penalties – Types and Amounts of Penalties

Foreign information return penalties include penalties for failure to file a host of forms that report U.S. taxpayer’s foreign assets and transactions. The forms for which we most commonly see the assessment of penalties are Form 5471 (Information Return of U.S. Persons with Respect to Certain Foreign Corporations), Form 5472 (Information Return of a 25% Foreign-Owned U.S. Corporation or a Foreign Corporation Engaged in a U.S. Trade or Business), Form 3520 (Annual Return to Report Transactions with Foreign Trusts and Receipt of Certain Foreign Gifts), and Form 3520-A (Annual Information Return of Foreign Trust with U.S. Owner), and other forms. Forms 3520 and 3520-A were the subject of an IRS Large Business and International “Campaign,” which the IRS discontinued on February 28, 2022. (We note that there are several other foreign information returns, but this article focuses on the forms for which we see the most IRS penalty action.

This post focuses only on the Title 26 foreign information return penalties and does not address the IRS’s enforcement of penalties for failure to file FinCen Form 114 (the “FBAR”), as those are not assessed under Title 26 (the Internal Revenue Code), but Title 31 (the Bank Secrecy Act). The rules for assessment and collection of FBAR penalties are contained in 31 U.S.C. § 5321..Failure to file Form 8938 (Statement of Specified Foreign Financial Assets) is also subject to penalties, but we have not seen the same level of enforcement of penalties as with the forms listed above. This may change in the future, however, as the Treasury Inspector General for Tax Administration has criticized the IRS for its lack of enforcement in this area. Additional Actions Are Needed to Address Non-Filing and Non-Reporting Compliance Under the Foreign Account Tax Compliance Act

The penalties for not filing Forms 5471 and 8938 are $10,000 for the initial failure to file the form, and an additional $10,000 for every 30-day period, or part thereof, after the IRS has notified the taxpayer of the failure to file, up to a maximum of $50,000, meaning that the IRS can assess penalties of up to $60,000 for each form. Beginning with the 2018 tax years, the penalty for failure to file Forms 5472 increased to $25,000 per failure, an additional $25,000 with every 30-day period, or part thereof, after the IRS has mailed a notice of failure, with no outer limits. See I.R.C. §§ 6038, 6038A, 6038B, 6038C, 6039F, 6677

The penalty for not reporting a transaction with a foreign trust on Form 3520 is 35% of the “gross reportable amount,” increasing by $10,000 for every thirty days for which the failure to report continues up to the “gross reportable amount.” As per Section 6677(c), the “gross reportable amount” is the transfer of any money or property (directly or indirectly) to a foreign trust by a U.S. person, or the aggregate amount of the distributions so received from such trust during such taxable year.

The penalty for failure to file Form 3520-A, results in penalties of 5% of the “gross reportable amount.” The gross reportable amount for this penalty is “the gross value of the portion of the trust’s assets at the close of the year treated as owned by the United States person.” If the IRS notifies a taxpayer of a failure to file the Form 3520-A, and the taxpayer does not file the form within the next 90 days, there is an additional penalty of $10,000 for each 30-day period (or fraction thereof) during which the failure to file continues, up to the gross reportable amount. I.R.C. §§ 6048(b); 6667(b), (c).

These penalties are related to the failure to file, or the incomplete filing, of these foreign information returns, and are not related to any tax deficiency. Accordingly, the IRS can – and frequently does – assess these penalties even where there is no tax due as a result of the failure to file or the incomplete form. Despite the policy statement in the Internal Revenue Manual that penalties should “be objectively proportioned to the offense,”( see IRM 20.1.1.2.1 (11-25-2011)) the IRS routinely assesses the maximum amount of foreign information return penalties even for short delays and where there is no tax due as a result of the late filing.

For all of the foreign information return penalties, reasonable cause is a defense.. The IRS applies the same standards for reasonable cause for failure to file income tax returns under I.R.C. § 6651 to failure to file foreign information returns, i.e., the exercise of ordinary business care and prudence. See e.g., Chief Counsel Advisory200748006. Many clients simply cannot meet this standard (at least as the IRS interprets it). These are taxpayers who were not willful and who did not intend to evade tax (and in many cases, there is no tax liability related to the late filing of the foreign information returns), but who may have been negligent or could have made a better effort at understanding their filing obligations.

In Notice 2022-36, the IRS recently provided some limited relief to taxpayers who had not filed, or had already been assessed penalties for late filing of, several different forms, including Forms 3520, 3520-A, and some Forms 5471. This relief is limited to the 2019 and 2020 tax years, and penalties “assessed by the campus assessment program” with respect to Forms 3520 and 3520-A (Annual Information Return of Foreign Trust with U.S. Owner). The IRS also limited relief to taxpayers who were able to file their delinquent returns within the 37-day period between August 24, 2022, the date that IRS announced Notice 2022-36, and the September 30, 2022, deadline. In addition, Notice 2002-36 stated that the IRS will cancel penalty charges for those forms and years, and issue refunds, as appropriate.

Notice 2002-36 provided cold comfort as it did not provide relief for earlier years and applied to a limited category of forms, and did not guarantee that the IRS would not assess penalties, only that they would not systematically assess them. It is noteworthy that this limited relief was in no way a recognition of the harsh consequences to taxpayers from the systematic assessment of penalties. The only stated reason for the relief was that there are better uses of IRS resources given its backlog after the pandemic and budget constraints, stating “[t]he Treasury Department and the IRS have determined that the penalty relief described in this notice will allow the IRS to focus its resources more effectively, as well as provide relief to taxpayers affected by the COVID-19 pandemic.” Notice 2022-36 did not come close to alleviating the burdens on taxpayers who want to be compliant by filing delinquent foreign information returns.

There are no other programs or procedures available for a taxpayer who has not understated their income to file a delinquent foreign information return without being subject to penalties. Other than Notice 2022-36, which was of limited utility, the IRS has not offered a method of self-correcting with reduced penalties. Instead, the only option for a taxpayer who wants to come into compliance is to file late and incur penalties. Theoretically, a taxpayer could make a voluntary disclosure, but the penalty of 50% of the unreported offshore asset makes this option untenable, and the voluntary disclosure procedure is intended to apply in situations where the taxpayer has acted willfully and has concern about criminal liability, which is not the case where a taxpayer missed a filing deadline but does not owe any additional tax.

The IRS’s Streamlined Filing procedures are not available for taxpayers who do not owe any additional tax related to their non-compliance. This is an oddity of the current system – that a U.S. taxpayer who lives in the U.S., and has not reported income from a foreign asset is offered an opportunity to self-correct in exchange for payment of the tax and a reduced penalty of 5% of the value of the unreported foreign asset, while a taxpayers who lives in the U.S. and has not underreported their income will be subject to the maximum amount of penalties.

It is also important to note, as Les discussed in Tax Court To Consider IRS Procedure For Imposing Information Reporting Penalties, that foreign information return penalties are “assessable penalties,” meaning that they are “paid upon notice and demand” and are not subject to the deficiency procedures, and thus cannot be challenged in Tax Court (with one narrow exception under Collection Due Process if the taxpayer is not offered review by the IRS Independent Office of Appeals).Despite the IRM allowing for pre-payment review, the IRS sometimes initiates enforced collection before the taxpayers have completed their appeal, and frequently sends collection notices, including notices of intent to levy, before the taxpayers’ deadlines to submit a protest has even passed. This means that the taxpayer will receive a notice and demand for the payment and will not have any pre-assessment right to challenge the penalty or raise any defenses. The taxpayer should receive Appeals review, and also has a right to pay the penalty and bring a claim for refund, and then bring a suit in district court or the federal court of claims if the IRS denies the refund. Full payment and the Flora rule can impose a significant barrier. Moreover, these procedures are burdensome, and also may not be successful, as the taxpayer will have the burden of providing reasonable cause, which is the only defense available if the penalty was otherwise properly assessed.

This article does not discuss these procedures or likelihood of success, but merely notes, for the purposes of the issue under discussion (i) other than the returns filed under Notice 2022-36, the IRS frequently systematically assesses penalties for late filing of certain foreign information returns; (ii) the burden is on the taxpayer to challenge the penalty and raise any defenses; (iii) it is unlikely that the IRS or Appeals will abate the penalty without a strong showing of reasonable cause; and (iv) for most taxpayers, the only possibility for judicial review will be after they pay the penalty in full and file a refund claim.

In tomorrow’s post, we will discuss the ethical standards that practitioners must address when faced with a client’s failure to comply with the information reporting obligations discussed today.

Filed Under: Circular 230, Civil Penalties Tagged With: Megan Brackney

Problems Facing Taxpayers with Foreign Information Return Penalties and Recommendations for Improving the System (Part 3)

January 8, 2020 by Guest Blogger 3 Comments

We welcome back Megan Brackney for part three in her three-part series discussing penalties imposed on foreign information returns. Today, she brings of stories of clients who have faced these penalties demonstrating the problems caused by the manner in which the penalties are being imposed and she brings suggestions of how to improve the system. Keith

The Gifts That Keep on Giving

Two young people moved to the U.S. as students. They met in graduate school and married. After graduation, they were offered jobs and were sponsored by their employers so that they could stay in the U.S. While they were students, their parents from their home country sent them money to help pay for their expenses in the U.S. After they became U.S. taxpayers, they received a few more gifts, totaling more than $100,000. They told their CPA about these gifts, and even showed him copies of their bank statements so that he could see the wire transfers from their parents’ non-U.S. accounts. The CPA told them that because these were gifts and not subject to taxation, they did not need to be reported. The CPA did not advise them of the Form 3520 filing requirement for gifts from foreign persons that exceed $100,000 in the aggregate during the tax year. Neither of the taxpayers had any knowledge of the Form 3520, and genuinely believed that they were filing their returns correctly.

A few years later, the taxpayers switched to a new CPA and again mentioned the gift issue, and she told them that they should have been filing Forms 3520 after they became U.S. taxpayers. She prepared three Forms 3520 with statements explaining their reasonable cause, and the taxpayers filed them. There was no audit or inquiry by the IRS and no tax due as a result of the error, and other than this understandable omission, they have a perfect compliance history. The CPA was not aware of the Delinquent International Information Return Submission Procedures, but the taxpayers’ submission nevertheless substantially complied with the requirements for that procedure.

Soon after their good faith attempt to self-correct, the IRS assessed the maximum amount of penalties on both taxpayers pursuant to I.R.C. § 6039F – 25% of the amount of the gifts they had received. The IRS issued separate notices for the three years so that there were three different deadlines for the appeals, and thus three separate appeals.

These notices were entitled “Notice of Penalty Charge.” The Notices stated merely that “you have been charged a penalty under Section 6039F of the Internal Revenue Code for Failure to File Form 3520 to Report Receipt of Certain Gifts” and did not provide any other information or explanation. As the word “charge” does not appear in the Code or Regulations, a lay person would not know from this notice whether there has actually been an assessment of the penalty.

The only information provided about how to challenge the penalty was to state that the taxpayer could submit a written request for appeal within 30 days from the date of the notice which, “should reflect all facts that you contend are reasonable cause for not asserting this penalty.”

The notice does not contain any information about collection while the appeal is pending but contains the following statement: “If you do not wish to appeal this penalty, there is nothing you need to do at this time. You may later dispute the penalty by paying the penalty and then filing a claim.” A reasonable layperson could interpret this to mean that the taxpayer does not have to pay the penalty until after his or her appeal. And, indeed, as noted in the previous column, Internal Revenue Manual 8.11.5.1 states that taxpayers are afforded pre-payment appeals. The notice does not explain any of this, however, and yet the IRS will only suspend collection activity if the taxpayer separately notifies Collections that he or she has filed an appeal (and frequently not even then).

Moreover, from the notice, there is no indication that the IRS obtained managerial approval of the penalty, as is required by I.R.C. § 6751(b), and no indication that the IRS considered the reasonable cause defense submitted along with the Forms 3520.

The taxpayers timely submitted an appeal to each penalty, explaining again that they had reasonable cause for failure to file foreign information returns, i.e., that that they retained a competent CPA to prepare their returns, that they gave him full and complete information, and they reasonably relied on his advice that nothing needed to be done to report the gifts from their parents.

Despite the timely appeals, the IRS has continued sending collection notices. In response to Notice CP504, the taxpayers requested that the IRS place a hold on collection pending the appeal. The IRS did not respond, but moved forward with issuing the notice of intent to levy on one tax year. The taxpayers were forced to file a CDP request to prevent enforced collection while Appeals considers their reasonable cause defense. The taxpayers are frightened that the IRS will file a notice of federal tax lien, which would be devastating as they are trying to buy a house right now.

In the meantime, for one of the tax years, the IRS sent the taxpayers a notice stating that it was rerouting the taxpayers’ correspondence (the timely filed appeal) to the Frivolous Correspondence Department. The taxpayers promptly responded with a letter explaining that their appeal was not frivolous, and that they had a right to Appeals review, and that the IRS cannot refuse to forward their protest to Appeals. They have received no further communications regarding the appeal.

For another tax year, the taxpayers received a cryptic letter from the Service Center, responding to their correspondence (with the same date as the appeal for that year), by stating “We reviewed the information you provided and determined that no action is necessary on your account.”

The taxpayers have not received any further communications from Appeals. We have tried to find someone at the IRS who has this file, but have had no luck. Although the Service Center told me that their case is assigned to the field, no one at that office has specific responsibility over it. As of the date of publication of this column, the taxpayers have been waiting for over a year for an Appeals conference. Meanwhile, the IRS collection machinery rolls on, without regard to the fact that the taxpayers have never had any Appeals review of the assessments.

Welcome to the Machine

This taxpayer is a non-U.S. Person who is the sole shareholder of several U.S. real estate holding companies. Due to some serious health issues, including dementia and loss of hearing, he fell behind on filing returns. His son began taking over the business, discovered that returns had not been filed, and starting filing Forms 1120, which included Forms 5472, and a reasonable cause statement explaining his father’s health problems and his inability to file returns on time. The entities filed the Forms 5472 for years which there was no tax due and owing pursuant to the Delinquent International Information Return Submission Procedures. For the years in which tax was due, the entities filed the returns in the ordinary course but attached reasonable cause statements.

The IRS’s response to these various filings has been haphazard. For many of the Forms 5472, no penalties were imposed at all. There is no discernible pattern – sometimes tax was due, sometimes it was not; sometimes the year at issue was the first year of correction, sometimes it was a later year. The taxpayers have no complaints about not getting penalties on these years, but it does make one wonder whether the IRS just failed to catch them, or if someone evaluated the reasonable cause defense and agreed that penalties would not be appropriate, and if this is the case, why penalties were imposed for other tax years with identical facts.

For the rest of the Forms 5472, the IRS sent out notices assessing penalties for $10,000 per form for each of late-filed Forms 5472. The Tax Cuts and Jobs Act of 2017 (“TCJA”) increased this penalty to $25,000 for each late-filed or incomplete Form 5472. On almost all of the notices, the tax year was mistakenly stated. The entities are fiscal year taxpayers, with their tax years ending on different dates, such as June 30, or September 31. The U.S. companies’ fiscal year, was, of course, stated on the front of the Forms 1120, and thus that information was available to the IRS. However, the IRS identified the penalty period for all years as ending on December 31.

In any event, the notices of penalty were on a different form than those issued to the taxpayers described above. These notices had a heading stating, “We Charged You A Penalty.” This notice provided thirty days to notify the IRS if “you don’t agree with the penalty assessment,” and provided instructions on presenting a reasonable cause statement under penalties of perjury. The notice does not explain whether this submission would be an appeal or a request for abatement. Like the notice to the other taxpayers, this notice does not provide any information about collection or indicate whether managerial approval has been obtained or acknowledge that the taxpayer had already submitted a statement of reasonable cause under penalty of perjury. And again, there is no concept of a “charge” under the Internal Revenue Code, and it would not be clear to a lay person trying to interpret this notice what this meant.

In response to these notices, the entities requested abatement of penalties on the ground of reasonable cause, and the IRS granted several of these requests, with no explanation. It is possible that for some of these penalties, the IRS was applying a concept of First Time Abatement, since they were the first tax years with non-compliance. The First Time Abatement provisions of the Internal Revenue Manual do not refer to foreign information return penalties, but I suspect that this relief may have been granted for these entities, and I have heard, anecdotally, from other practitioners, that their clients have received this relief.

For the penalties on which the IRS denied the request for abatement, the IRS provided an explanation for the denial and obtained proper managerial approval under I.R.C. § 6751(b). In the letter denying the abatements, the IRS stated that the taxpayer could appeal the decision. It is unclear why these taxpayers were provided with a two-step procedure – request abatement, and then appeal of the denial of the abatement request — while the taxpayers described above were told to go directly to Appeals. In any event, the IRS provided these entities with 60 days in which to submit an appeal, and the entities have done so, but several months later, they still have not heard from Appeals.

In the meantime, on all of the remaining penalties, the IRS has sent collection notices, and each time, the entity responded with a request a hold on collection pending its appeal. The IRS did not directly respond to any of this correspondence, but for some of the entities, the IRS seems to have stopped sending notices. For other entities, the IRS issued final notices of intent to levy. Despite already having one appeal pending, these entities were forced to submit CDP requests to avoid levy.

In addition, for several of the penalty assessments, the IRS filed notices of federal tax lien. As noted, the Code section that authorizes the penalty for failure to file the Form 5472 is I.R.C. § 6038A. However, on several of the notices, the IRS stated that the penalty had been assessed under I.R.C. § 6038. This is close, but not quite right – this is the penalty for failure to file Form 5471. On one of the notices of federal tax lien, the IRS did not even get close, but identified the penalty as being assessed pursuant to I.R.C. § 6721 (trust fund recovery penalties). And, as noted above, the IRS assessed the penalties for tax years ending December 31, even though the entities’ tax years do not end on December 31, but at the close of their fiscal year. As these notices were improper and inaccurate, and the taxpayer’s Appeals had not been heard, the entities had to file CDP requests challenging the federal tax lien filings.

The entities have not received any response to their appeals, many of which have been pending for more than a year.

Perfection is the Enemy of Good

The next taxpayer is a high net worth individual who is the grantor of a foreign trust with significant assets. Since the formation of the trust, he has always timely filed Forms 3520 and Forms 3520-A and reported all income related to the trust. At some point, the country codes stating where the trust was administered and what law applied were not included on the Form 3520, although that information is included in other parts of the form. The IRS caught this error on the Form 3520 for one year and assessed a multimillion-dollar penalty pursuant to I.R.C. § 6677. There was no tax non-compliance related to this error – it was a minor and inconsequential technical error on a timely filed return. The taxpayer did not notice this minor error during his review of his returns and he certainly did not instruct his CPA not to fill out these items on the form. Other than this minor foot-fault, the taxpayer has an excellent compliance history.

The notice was entitled “Notice of Penalty” charge, and provided for 30 days to appeal or request abatement and directed the taxpayer to correct the errors within 90 days or be subjected to additional penalties. The language of the notice was unclear as to whether the taxpayer would be able to appeal if the request for abatement was denied. To be on the safe side, the taxpayer submitted an appeal to the IRS explaining that the taxpayer had reasonable cause for the error based on reliance on his CPA, and that penalties were not appropriate because he substantially complied with the Form 3520 filing requirement.

There is no indication from the notice that the IRS obtained managerial approval under I.R.C. § 6751, and the notice did not provide any information about suspending collection. Before the 30-day deadline for the appeal, the IRS sent Notice CP504, taking the first steps toward enforced collection action, despite the fact that the taxpayer’s time to appeal had not yet elapsed. The Appeal is pending, unless the IRS changes its practices, despite the timely appeal, which should be successful, the taxpayer may have a federal tax lien filed against him and may receive a notice of intent to levy and be forced to submit a second appeal through CDP.

Suggestions for Improving Penalty Enforcement Procedures

Below are a few simple suggestions for the IRS that would go a long way toward fair and efficient administration of the Internal Revenue Code penalty provisions.

1. Stop systematically assessing these penalties. These are significant penalties and it is important that they only be assessed in appropriate cases.

2. Consider that a taxpayer voluntarily self-corrected. Instead of encouraging voluntary compliance, the IRS is severely penalizing taxpayers without any proper purpose. The message that the IRS is sending to taxpayers is not to attempt to resolve issues voluntarily and self-correct, as the IRS treats taxpayers who come forward to correct past non-compliance in the same manner – as harshly as possible – as those whom the IRS identifies as non-compliant.

3. Apply concepts of substantial compliance. Missing a line on a form should not warrant the highest level of penalty assessment where there is no tax due or other harm to the government.

4. Formally adopt a First Time Abatement policy for foreign information return penalties that is applied consistently among taxpayers.

5. Find a way to follow the Internal Revenue Manual. Wait until the time has elapsed for filing an appeal before commencing collection action, and upon receipt of the appeal, immediately stop collection. If there is no system in place to cause this to happen automatically, create one, or, at a minimum, add a line to the notice telling the taxpayer that if they receive a collection notice, they should notify the office that sent the notice that they have timely filed an appeal of the penalty. Then, instruct Collections to suspend collection activity once they receive notification that an appeal has been filed.

6. Train IRS personnel in the Service Center and Collection about these penalties, so that they know what they are and how the procedures are different than those that may apply to the usual situations they see with taxpayers who have income tax liabilities so that they are able to respond to taxpayers who call for assistance.

7. Use consistent language in the penalty notices. There is no reason for there to be different versions of the notices that taxpayers receive when foreign information penalties are assessed.

8. Use language that tracks the statute. There is no such thing as a penalty “charge” in the Internal Revenue Code or Treasury Regulations. It is an assessment, and it is misleading to call it something else.

9. Clearly describe how the taxpayers may submit their reasonable cause defenses to the IRS, and state that if the IRS denies abatement, they may request an appeal.

10. Notify taxpayers that they can request additional time to appeal and explain the process for doing so, or provide a longer time period and make it consistent for all taxpayers.

At this point, there have been very few court decisions addressing reasonable cause and other defenses to foreign information return penalties, and none addressing the IRS’s procedures. This may be because the increase in systematic assessments is fairly recent, and it also may be because for Forms 5471, 8938, and Forms 5472 (until the TCJA increased it), the penalty of $10,000 per form did not warrant the cost of federal litigation. The IRS should not take advantage of the fact that most people will not go to court to challenge these penalties, but should take immediate action to ensure that they are being applied in an appropriate manner, and that taxpayer’s right to challenge the IRS’s position and be heard, the right to appeal an IRS decision in an independent forum, and the right to a fair and just tax system are being honored and protected. As can be seen by the cases discussed in today’s post, the IRS is not taking steps to protect these rights.

Filed Under: Civil Penalties, Information Returns Tagged With: Megan Brackney

Problems Facing Taxpayers with Foreign Information Return Penalties and Recommendations for Improving the System (Part 2)

January 7, 2020 by Guest Blogger Leave a Comment

We welcome back Megan Brackney for part two in her three-part series discussing penalties imposed on foreign information returns. Keith

Reasonable Cause

For all of the foreign information return penalties, reasonable cause is a defense. See I.R.C. §§ 6038, 6038A(d)(3), 6038D(g), 6039F(c)(2), 6677(d); Treas. Reg. § 1.6038-2(k)(3)(ii). The IRS applies the same standards for reasonable cause for failure to file income tax returns under I.R.C. § 6651 to failure to file foreign information returns, i.e., the exercise of ordinary business care and prudence. See e.g., Chief Counsel Advisory 200748006.

In determining whether taxpayers satisfy the reasonable cause standard, the IRS also applies the holding of United States v. Estate of Boyle, 469 U.S. 241 (1985), to the failure to file foreign information returns. Boyle articulates a non-delegable duty to file tax returns. In that case, the executor of an estate relied on a tax advisor to file the estate tax return, but the advisor missed the deadline. The Supreme Court explained that determining the due date and ensuring that the return was filed did not require any special tax expertise, and that taxpayers have a non-delegable duty to make sure that their returns are timely filed. Any other rule, according to the Supreme Court, would not be administrable. Id. at 249.

However, the Supreme Court specifically contemplated that a taxpayer can rely on a tax professional’s advice as to whether to file a particular return. As stated by the Supreme Court, “Courts have frequently held that ‘reasonable cause’ is established when a taxpayer shows that he reasonably relied on the advice of an accountant or attorney that it was unnecessary to file a return, even when such advice turned out to have been mistaken.” Id. at 250. Other courts have reached similar conclusions. See e.g., Estate of Liftin v. United States, 101 Fed. Cl. 604, 608 (2011) (an expert’s advice concerning a substantive question of tax law as to whether a return was required to be filed was reasonable cause). Accordingly, a taxpayer should be able to rely on the advice of a tax professional as to whether a foreign information return is required (as opposed to merely meeting a known deadline).

Challenging Foreign Information Return Penalties

Foreign information return penalties are “assessable penalties,” meaning that they are “paid upon notice and demand” and are not subject to the deficiency procedures, and thus cannot be challenged in Tax Court (with one narrow exception discussed below). I.R.C. § 6671(a).

The Internal Manual states that the taxpayer is entitled to post-assessment, but pre- payment, Appeals review of the penalty. See Internal Revenue Manual 8.11.5.1. As we will see, the IRS does not automatically suspend collection activity in order to provide taxpayers with this pre-payment right to appeal, and routinely fails to respond to taxpayers’ requests to suspend collection during their appeals. I have recently learned that the IRS’s failure to suspend collection may be due to an error in inputting the right code. In one case, the Service Center told me that the collection hold had mistakenly been put on the 1040 account, rather than the civil penalty account. I do not know how often this occurs, but it is concerning that a taxpayer could be subject to levy because of this type of an error.

In any event, as we will see below, the notice of the right to appeal is cryptic, provides a short time to submit the appeal, and does not provide the taxpayer with information on whether or how to extend this deadline if the taxpayer needs more time.

If the appeal is unsuccessful, the taxpayer’s only option for judicial review is to pay the penalty in full and file a refund claim, and if the refund claim is not granted (or acted upon within six months of receipt by the IRS), the taxpayer could then file a refund action in federal district court or the court of claims. See I.R.C. § 7422; 28 U.S.C. § 1346(a)(1).

If the IRS does not offer Appeals rights before issuing a final notice of intent to levy, the taxpayer can file a CDP request with IRS Appeals, and at that point, should be able to raise defenses to the penalties, such as he or she acted with reasonable cause. I.R.C. § 6330(c)(2)(B); Treas. Reg. § 601.103(c)(1); Interior Glass Systems, Inc. v. United States, 927 F.3d 1081, 1087 (9^th Cir. 2019). If Appeals does not grant relief during the CDP hearing, the taxpayer could file a Petition for Lien or Levy Action Under I.R.C. § 6330(d), in the United States Tax Court.

Procedures to Get Into Compliance

The IRS has established the Delinquent International Information Return Submission Procedures, which may be helpful for some taxpayers in avoiding penalties, but there is no guarantee. A taxpayer is eligible to use these procedures if he or she has reasonable cause for not timely filing the information returns, is not under a civil examination or a criminal investigation by the IRS, and has not already been contacted by the IRS about the delinquent information returns. Under this procedure, the taxpayer sends in the delinquent return as directed by the IRS, along with a statement of facts establishing reasonable cause for the failure to file.

The IRS makes no express promises on the outcome under these procedures, but it is generally understood by tax practitioners that the IRS will not assess penalties if there is no tax liability related to the failure to file and the taxpayer has reasonable cause. Nevertheless, we have seen the IRS assess penalties against taxpayers who have submitted their foreign information returns under these procedures, but as the IRS provides no acknowledgement that the taxpayer attempted to use the procedure, it is unclear if this is due to mistakes in processing or is intentional.

The Delinquent International Information Return Submission Procedures are not difficult to locate if you already know to look for them. However, there is no reference to these procedures or links to them on the other pages of the IRS’s website that discuss the foreign information return penalties themselves. The average layperson, and even many tax practitioners, are not aware of the procedures. On several occasions, clients have come to us after they have received notices of penalty assessments for late filing of Form 5471 or 3520, when no tax was due and they had a reasonable cause defense to late-filing, because their CPA’s filed the forms without a reasonable cause statement in the form required by the Delinquent International Information Return Submission Procedures.

For individuals who made non-willful errors in their foreign information reporting, the Streamlined Voluntary Filing Compliance Procedures, may provide some relief. Also, for taxpayers who acted willfully, or are concerned that that the IRS will view their non-compliance as willful, the IRS’s voluntary disclosure practice may be an option.

Even though these procedures are available to allow certain taxpayers to limit their penalty exposure, they are not a substitute for the IRS applying the penalty provisions as required by the Internal Revenue Code and following its own administrative procedures.

Part III will explore some examples of foreign information return horror stories. Unlike other genres of horror, these stories do not derive from rare events, but represent the day to day conduct of the IRS in this area. These are not isolated examples, and I could have described numerous other cases of my own clients, and on an almost daily basis, I hear similar stories from other attorneys and CPA’s who are seeing the systematic assessment of significant and, sometimes life altering, penalties against taxpayers for negligible errors and delinquencies.

Filed Under: Civil Penalties, Information Returns Tagged With: Megan Brackney

Problems Facing Taxpayers with Foreign Information Return Penalties and Recommendations for Improving the System (Part 1)

January 6, 2020 by Guest Blogger 5 Comments

We welcome guest blogger Megan L. Brackney who is a partner at Kostelanetz & Fink, LLP in New York City, and focuses her practice in civil and criminal tax controversies. Over the past couple of years, she and her colleagues have seen a significant influx in foreign information reporting penalties and have represented hundreds of taxpayers against the IRS on these issues. She provides us with the wisdom gained from her experience. Megan and I serve together as vice chairs of the ABA Tax Section. I can tell from the experience of working with her what a great lawyer and counselor she is. Keith

The IRS has been assessing more and more foreign information return penalties on taxpayers. It is difficult to find statistics on this point, as the IRS’s reports on tax penalties lump all “nonreturn” penalties into one category, which includes failure to file Forms 1099, 8300, and other information returns, along with foreign information return penalties. Even without the statistics, tax controversy practitioners know this to be true, as we have clients coming in with these assessments every day. Many of these penalties are being systematically assessed, meaning that a penalty is automatically issued whenever there is a late-filed form or a form is missing information, without regard to the individual circumstances of the taxpayer. In many cases, the penalties are wildly disproportionate to the taxpayer’s mistake, and serve no purpose other than to discourage taxpayers from voluntary compliance.

The increase in penalty assessments has also increased the workload of IRS Appeals and there are significant delays in resolution. As will be discussed below, while these appeals languish without any response or action, the IRS continues to move forward with enforced collection. This is a waste of the taxpayer’s resources to be constantly receiving notices and attempting to call and correspond with the IRS, and sometimes filing multiple appeals because they have to resort to Collection Due Process (“CDP”) to stop the IRS from levying on their assets before their appeals are heard. This is also a waste of resources for the IRS, and further burdens Appeals, as more CDP requests come in on cases that are already assigned to Appeals.

The IRS has caused this chaos from overreacting to taxpayers who have filed late or incomplete foreign information returns while at the same time, not allocating additional resources to Appeals to deal with the additional volume, or instructing Collections and Service Center personnel as to how to handle these cases. There are some very simple administrative fixes to these issues, which I will recommend at the end of this column.

To provide some context, and hopefully to bring some order to the chaos, this column tells the stories of three taxpayers who have faced assessment of devastating foreign information return penalties and have been unable to get the IRS to consider their defenses, followed by ten recommendations for improvement.

Background on Foreign Information Return Penalties

Before talking about these three illustrative cases, below is some basic information about foreign information return penalties.

Types and Amounts of Penalties

Foreign information return penalties include penalties for failure to file:

Form 5471 (Information Return of U.S. Persons with Respect to Certain Foreign Corporations)
Form 5472 (Information Return of a 25% Foreign-Owned U.S. Corporation or a Foreign Corporation Engaged in a U.S. Trade or Business)
Form 8938 (Statement of Specified Foreign Financial Assets)
Form 8858 (Information Return of U.S. Persons With Respect to Foreign Disregarded Entities (FDEs) and Foreign Branches (FBs))
Form 926 (Return by a U.S. Transferor of Property to a Foreign Corporation); Form 8865 (Return of U.S. Persons With Respect to Certain Foreign Partnerships)
Form 3520 (Annual Return to Report Transactions with Foreign Trusts and Receipt of Certain Foreign Gifts)
Form 3520-A (Annual Information Return of Foreign Trust with U.S. Owner), and other forms. (Note that Penalties for failure to file FinCen Form 114 (the “FBAR”) are not assessed under Title 26 (the Internal Revenue Code), but Title 31 (the Bank Secrecy Act). See 31 U.S.C. § 5321. The rules for assessment and collection of FBAR penalties are contained in 31 U.S.C. § 5321. This column focuses only on the Title 26 foreign information return penalties and does not address the IRS’s enforcement of FBAR penalties.)
See I.R.C. §§ 6038(c)(4)(B), 6038A, 6038B, 6038D(d), 6039F(c), 6677. These penalties are related to the failure to file, or the incomplete filing, of these foreign information returns, and are not related to any tax deficiency. Accordingly, the IRS can – and frequently does – assess these penalties even where there is no tax due as a result of the failure to file or the incomplete form.

The penalties for not filing Forms 5471, 8938, 8858, and 8865 (to report ownership in a foreign partnership) are $10,000 for the initial failure to file the form, and an additional $10,000 for every 30-day period, or part thereof, after the IRS has notified the taxpayer of the failure to file, up to a maximum of $50,000, meaning that the IRS can assess penalties of up to $60,000 for each form.

Beginning with the 2018 tax years, the penalty for failure to file Forms 5472 have been increased to $25,000 per failure, an additional $25,000 with every 30-day period, or part thereof, after the IRS has mailed a notice of failure, with no outer limits.

The penalty for failure to report a transfer to a foreign corporation on Form 926, or failure to report a transfer to a foreign partnership on Form 8865, is 10% of the fair market value of the transferred property, up to $100,000.

The penalties for failure to file Form 3520-A to report a gift from a foreign person or inheritance from a foreign estate is 5% of the amount of such foreign gift/inheritance for each month for which the failure to report continues up to 25% of the foreign gift/inheritance.

The penalty for not reporting a transaction with a foreign trust on Form 3520 is 35% of the “gross reportable amount,” increasing by $10,000 for every thirty days for which the failure to report continues up to the “gross reportable amount.” The “gross reportable amount” is the transfer of any money or property (directly or indirectly) to a foreign trust by a U.S. person, or the aggregate amount of the distributions so received from such trust during such taxable year. I.R.C. § 6677(c).

As with all penalties, the IRS is supposed to obtain proper managerial approval before assessment. I.R.C. § 6751(a)(2) (“no penalty under this title shall be assessed unless the initial determination of such assessment is personally approved (in writing) by the immediate supervisor of the individual making such determination or such higher level official as the Secretary may designate.”)