The IRS has a numbered notice for almost any communication they provide to a taxpayer. In some cases, the taxpayer may safely review a communication without taking any further action. For example, the IRS routinely sends a summary of tax debts owed annually to taxpayers as a reminder of outstanding taxes owed. But, in other cases, a taxpayer must act promptly to preserve certain procedural rights permitted under the Internal Revenue Code (the “Code”) or existing IRS guidance. Without a doubt, the IRS CP15 Notice (“CP15”) is one that falls squarely in the latter group, requiring quick action by the taxpayer.
As the name implies, the IRS uses CP15 to notify taxpayers that it has assessed certain civil penalties against the taxpayer. Generally, the CP15 will provide a short (indeed, very short) reason for the imposition of the civil penalty and also will provide the taxpayer with notice of the amount of the assessed civil penalty.
Although the IRS uses the CP15 for various civil penalties, the remainder of this article focuses solely on the IRS’s use of the CP15 for assessment of the civil penalty associated with a taxpayer’s failure to timely file a proper and complete IRS Form 3520, Annual Return to Report Transactions with Foreign Trusts and Receipt of Certain Foreign Gifts (“Form 3520”). Moreover, this article will leave to another day a discussion of the civil penalty for receipt of certain foreign gifts, focusing solely on the reporting obligation applicable to foreign trusts.
What is the Form 3520?
The Form 3520 reporting obligation arises only in certain instances. First, there must be a foreign trust involved in the transaction. Second, only certain types of transactions result in a Form 3520 reporting requirement. To break all of these requirements down even further, taxpayers must generally determine the following:
- Whether the entity at issue a trust?
- If the entity is a trust for federal tax purposes, whether it is foreign or domestic?
- If it is a foreign trust, the transaction with the foreign trust must be reported.
Each of these is discussed more fully below.
What is a Trust?
Regrettably, much of the confusion associated with Form 3520 relates to whether the entity at issue is actually trusted for federal income tax purposes. The guidance is not clear. However, the “check-the-box” regulations provide a starting point. See Treas. Reg. § 301.7701-4(a).
Under those regulations, a trust is generally “an arrangement created either by will or by an inter vivos declaration whereby trustees take title to the property for the purpose of protecting or conserving it for the beneficiaries under the ordinary rules applied in chancery or probate courts.” Id. Thus, “[g]enerally speaking, an arrangement will be treated as a trust under the [Code] if it can be shown that the purpose of the arrangement is to vest in trustees responsibility for the protection and conservation of property for beneficiaries who cannot share in the discharge of this responsibility and, therefore, are not associates in a joint enterprise for the conduct of business for profit.” Id.
Under this broad definition, arrangements in which a person holds title to property or assets for the benefit of another individual may be characterized as trusts for federal income tax purposes. This is particularly so if the individual has certain fiduciary obligations to the individual (i.e., the beneficiary). However, the IRS has also concluded that other arrangements—not typically envisioned as standard trusts—may constitute trusts for federal income tax purposes, such as pension arrangements and superannuation funds. See, e.g., PLR 200508004 (pension); PLR 200807003 (superannuation fund).
To the extent that the taxpayer is comfortable that the entity at issue is not a trust, the analysis for Form 3520 ends. However, even if this is the case, the taxpayer should bear in mind that other U.S. reporting obligations may apply (e.g., Form 5471, Form 8938, etc.).
Is the Trust Foreign or Domestic?
If the taxpayer identifies the arrangement as a trust under federal income tax principles, the next inquiry is whether the trust should be characterized as foreign or domestic. Foreign trusts give rise to Form 3520 reporting requirements; domestic trusts do not.
A trust is considered a domestic trust if it meets two requirements. First, a court within the United States (for these purposes, only the States and the District of Columbia) must be able to exercise primary supervision over the administration of the trust. This is referred to as the “Court Test”. Second, if the Court Test is satisfied, one or more United States persons must have the authority to control all substantial decisions of the trust. This is referred to as the “Control Test”). The regulations provide far more color on these requirements and will not be repeated here. See Treas. Reg. § 301.7701-7.
To the extent that trust fails either the Court Test or the Control Test, the trust will be deemed a foreign trust for federal income tax purposes. Applicable law and the language of the trust arrangement itself are important for making these determinations.
Is the Transaction Reportable?
If a foreign trust is involved, taxpayers with certain interactions with the foreign trust may have certain reporting obligations for federal income tax purposes. The statutory text of Section 6048 provides most of the guidance in these instances.
Generally, under Section 6048, a United States person or estate representative must file a Form 3520 in three instances. First, a Form 3520 is required if there is a United States person or a United States estate with a “reportable event.” See I.R.C. § 6048(a)(3). For these purposes, a “reportable event” means: (i) the creation of any foreign trust by a United States person; (ii) the transfer of money or property (directly or indirectly) to a foreign trust by a United States person (including by reason of death); and (iii) the death of a U.S. citizen or resident if the decedent was treated as the owner of any portion of the foreign trust under the grantor-trust provisions in the Code or if any portion of the foreign trust was included in the decedent’s gross estate. Exceptions may apply to the extent a transfer was for fair market value (with special valuation rules applicable) or if the transfer of property went to certain deferred compensation and/or charitable trusts. Reporting persons include either a grantor of the foreign trust (if the grantor created an inter vivos foreign trust); the transferor of property or cash to a trust (unless the transfer was due to death); or in all other cases, the executor of an estate. See I.R.C. § 6048(a)(4). See I.R.C. § 6048(a)(4). Accordingly, unsuspecting executors who are unfamiliar with the decedent’s worldwide assets must be particularly careful to ensure that they timely file an accurate Form 3520 on time with the IRS.
A Form 3520 is also required in two other instances outside the above “reportable events.” More specifically, a United States person (e.g., a foreign trust beneficiary) must file a Form 3520 if the person receives a distribution from a foreign trust in any tax year. See I.R.C. § 6048(c). In addition, and according to IRS guidance and the Form 3520 instructions, a United States person must file a Form 3520 to the extent that they are treated as owning any portion of a foreign trust in any tax year.
Although the above transactions cover the gauntlet of transactions that must be reported on a Form 3520, taxpayers should also be aware that an IRS Form 3520-A, Annual Information Return of Foreign Trust With a U.S. Owner, must be filed in certain instances where a foreign trust fails to file the Form 3520-A with the IRS.
Back to the CP15
To the extent a taxpayer fails to file a Form 3520 where the taxpayer is otherwise required to do so, the taxpayer may receive CP15. Generally, the CP15 states that the taxpayer may submit a reasonable cause statement contesting the civil penalty within 30 days from the CP15 date. And, if the taxpayer submitted a reasonable cause statement already to the IRS, the CP15 will instruct the taxpayer that he or she may file a protest with the IRS Independent Office of Appeals. Taxpayers with the resources and desire to pay the civil penalty also have the option of paying the civil penalty assessment in full and filing a claim for a refund with the IRS. Either way, it is generally advisable to file a submission with the IRS contesting the civil penalty, although, in certain instances, there may be strategic reasons to wait for the Collection Due Process (“CDP”) notice that will follow upon non-payment of the civil penalty.
Defenses to Form 3520 Civil Penalty
There can be a litany of valid defenses against the Form 3520 civil penalty assessment. For example, the standard reasonable cause defense applicable to other civil penalties applies in this context as well. See I.R.C. § 6677(d). Generally, taxpayers will want to be careful of what reasonable cause defenses they elect to use with a particular eye to those the IRS tends to accept more than others. In addition, the taxpayer may consider raising certain procedural defenses, such as whether the IRS complied with Section 6751(b) of the Code. For example, see here. Other defenses may apply as well, which should be timely, concisely, and properly raised before the IRS.
Taxpayers who file a late Form 3520 should know that the IRS generally imposes the Form 3520 late-filing penalty systemically. That is, IRS computers generally flag the late-filed Form 3520 and issue a CP15 notice as a matter of course. Although the IRS’s actions are automatic in this regard, the taxpayer’s next moves are not. Taxpayers who receive a CP15 in these instances should consider at least consulting with a tax advisor to determine the best course of action in responding to the CP15.