5 Percent, Not 35 Percent, Penalty Applies to Late Reported Foreign Trust Distributions

(Parker Tax Publishing December 2019)

A district court held that only the 5 percent penalty under Code Sec. 6048(b), and not the 35 percent penalty under Code Sec. 6677(a), applied to a taxpayer's failure to timely report distributions he received from a foreign trust of which he was the sole owner and sole beneficiary. According to the court, there is a clear instruction under Code Sec. 6677(b)(2) to substitute 5 percent for 35 percent in applying the penalty when the trust beneficiary is also the trust owner and the IRS cannot choose between the two penalties. Wilson v. U.S., 2019 PTC 453 (E.D. N.Y. 2019).

Joseph Wilson established an overseas trust in 2003. Wilson named himself the grantor of the trust and was its sole owner and beneficiary. The singular purpose of the trust was to place assets beyond the reach of his then-wife, who he had reason to believe was preparing to file a divorce action against him, which she subsequently did. Wilson funded the trust with approximately $9 million in U.S. Treasury bills, accruing annual interest of 5 percent or less. All principal had previously been taxed in the United States.

From 2003-2007, Wilson filed various income tax and information returns with the IRS, reporting the trust's assets and the interest it accrued. In 2007, upon conclusion of the divorce proceedings, Wilson terminated the trust and transferred the assets, which were approximately $9 million at that point, back to his bank accounts in the United States. Despite general compliance with IRS requirements, Wilson was late in filing his Form 3520, Annual Return to Report Transactions with Foreign Trusts and Receipt of Certain Foreign Gifts, for calendar year 2007. Form 3520 is an annual report disclosing distributions from a foreign trust, with different requirements for trust grantors/owners and for trust beneficiaries.

Under Code Sec. 6677, a civil penalty applies to a late filed Form 3520. Under Code Sec. 6677(a), the penalty is the greater of $10,000 or 35 percent of the gross reportable amount. Code Sec. 6677(b) provides a special rule in the case of a return required to be filed under Code Sec. 6048(b) - a return required by a U.S. owner of a foreign trust. In that case, the owner is liable for the penalty referred to in Code Sec. 6677(a) except that "5 percent" is substituted for "35 percent."

After Wilson filed his 2007 Form 3520, the IRS assessed a late penalty of $3.2 million, representing 35 percent of the distributions from the trust during the 2007 calendar year. Because Wilson had transferred 100 percent of his trust's funds back to his own domestic accounts during 2007, the penalty also amounted to 35 percent of his total trust assets. Wilson paid the penalty and then applied for a refund on the basis that the IRS's determination was based on its erroneous position that the trust distributions were made to Wilson as the trust beneficiary. However, Wilson argued, although he was the named beneficiary of the trust, he was also the sole owner/grantor and therefore, under Code Sec. 6048(b), only a 5 percent penalty applied.

Wilson passed away while waiting for the refund. His estate then pursued the refund claim in a district court asserting that (1) reasonable cause existed for Wilson's untimely filing of Form 3520; and (2) in assessing a 35 percent penalty, the government was relying on an erroneous position that, pursuant to Code Sec. 6048(c), Wilson, as the beneficiary of the trust, was subject to a 35 percent penalty on the amount of the trust distributions not timely reported in Form 3520. In so asserting, the estate argued, the government was ignoring Code Sec. 6048(b). In these circumstances, the estate said, any responsibility for failing to timely report, in Form 3520, the 2007 distributions from the trust fell on the grantor/owner under Code Sec. 6048(b) - not Code Sec. 6048(c). Thus, under Code Sec. 6048(b), only a 5 percent penalty applied.

The district court agreed with the estate and held that only the 5 percent penalty under Code Sec. 6048(b) applied to the failure to timely report the 2007 distributions from the trust. The court rejected the government's argument that, in addition to being penalized under Code Sec. 6048(b), Wilson could be independently be penalized as a beneficiary under Code Sec. 6048(c). The court noted that Code Sec. 6677(a) is modified by Code Sec. 6677(b)(2) and because Wilson was the owner of the foreign trust, there was no doubt both that Code Sec. 6048(b) applied to him and that his violation of Code Sec. 6048(b) would result in a 5 percent penalty under Code Sec. 6677(b). The court said that a person in Wilson's situation - i.e. a sole grantor/owner and sole beneficiary of a foreign trust - would have only been required to file a single Form 3520 for fiscal year 2007. So the question, the court said, is whether Code Sec. 6677 permits a single person untimely filing a single IRS form to be penalized as two different people - as an owner and as a beneficiary.

According to the district court, the plain language reading of Code Sec. 6677 counsels that a trust owner cannot be penalized as a beneficiary for violating a provision of Code Sec. 6048(b). There is a clear instruction under Code Sec. 6677(b)(2), the court observed, to substitute 5 percent for 35 percent, not to choose between the two or to simply apply a 5 percent assessment without reference to an otherwise applicable penalty. Thus, the court concluded, the statute mandates that the 5 percent replace the 35 percent whenever there is a case of a return required under Code Sec. 6048(b).

Finally, the court said that certain aspects of Form 3520 itself imply that a foreign trust owner who receives distributions from his own trust should be treated as an owner - and not as a beneficiary - for failures related to the Form's filing. The court cited Part III of the instructions for the 2007 Form 3520 which implies that Form 3520 disregards the beneficiary status of the trust owner in favor of his owner status, at least for the limited purpose of tracking distributions to the owner. Thus, the court concluded, the IRS could assess only the 5 percent penalty under Code Sec. 6677, not both or either the 5 percent and/or 35 percent penalty, for Wilson's untimely filing of his 2007 Form 3520.

For a discussion of information reporting for transactions with foreign trusts, see Parker Tax ¶203,165.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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