Emily S. Wilson et al. v. United States
On July 28th, 2021 the second circuit appellate court ruled in favor of the IRS, vacating a district court decision that ruled in favor of a taxpayer. In this case, John Wilson funded a foreign trust with 9 million USD in 2003. Wilson was the only beneficiary and was the only individual with an ownership interest in this trust. In 2007, he fully distributed the funds from the trust to himself. He then failed to timely file a Form 3520 and a Form 3520-A for the distribution from the trust and the trust ownership. The IRS imposed a penalty of over 3 million on this distribution. Wilson paid the penalty and proceeded to contest it(he died while contesting this penalty and his estate has moved forward with this case), the district court granted summary judgment for Wilson, removing the 35% penalty on the distribution, and the appellate court vacated this summary judgment.
Form 3520 and Form 3520-A Reporting Obligations Brief Overview
We’ve previously talked about Form 3520 and Form 3520-A in the context of foreign retirement plans (https://www.oconnorlyon.com/blog/2020/9/25/foreign-retirement-plan-reporting-form-3520-a-form-3520-form-8938-and-fbars?rq=3520) and in the context of foreign grantor trusts (https://www.oconnorlyon.com/blog/2020/9/25/foreign-grantor-trusts-form-3520-form-3520-a-and-revenue-procedure-2020-17?rq=3520)
Basically, if you have an ownership interest in a foreign trust, make a contribution to a foreign trust, or if you receive a distribution from a foreign trust as a beneficiary, you have an informational reporting obligation. Form 3520-A is required when you are the owner of a foreign trust, bearing in mind that U.S. persons are generally considered the owner of any trust to which they contribute money//assets. Form 3520 is subdivided into four parts, part 1 is to report contributions to a foreign trust, part 2 captures your ownership of a foreign trust, part 3 contains information on distributions from foreign trusts, and part four is not related to foreign trusts(this section is used to report gifts received from foreign individuals).
There are now exceptions to these reporting obligations for certain ‘eligible individuals’ with ‘‘applicable trusts’ (you can read more about this exception here: https://www.oconnorlyon.com/blog/2020/9/25/revenue-procedure-2020-17-form-3520-form-3520-a-relief?rq=3520)
When you are required to file these forms, failure to file them completely and accurately or a failure to file them on time, will result in the application of significant penalties. The applicable penalties vary based on the specific mistakes/oversights/failures. The applicability of these penalties is the primary issue in the Wilson case.
Note that the informational reporting requirements come from Internal Revenue Code Section 6048 but the penalties are imposed through Internal Revenue Code Section 6677. If you have received a notice relating to your Form 3520 or Form 3520-A filing obligations, the code section mentioned on the notice will be IRC 6677. **
Wilson’s 3520 and 3520-A Penalties
Wilson failed to satisfy his informational reporting obligation with regard to his ownership of the trust as well as the obligations relating to the distribution he received from the trust. Wilson did file both Form 3520 and Form 3520-A but he did not file them on time. The penalty for failing to satisfy the informational reporting obligations as an owner is 5% of the trust’s value. Failure to report distributions is subjected to a 35% penalty applied to the amount of the distribution. When a trust fully distributes its assets, the 35% penalty is an incredibly steep price to pay for failing to do the required informational reporting. Wilson took the position that, as the sole-owner of the trust, the only applicable penalty was the 5% penalty.
There are a couple of other facts worth noting. Wilson didn’t entirely fail to file his 3520 and 3520-A, he just filed both late. Additionally, when an owner of a foreign trust timely files the required information, they do not have to duplicatively report that information on part III of form 3520 (for the distributions from the trust)* This means that had the 3520-A been timely filed, even if there were deficiencies with the 3520, the 3520-A reporting would have reduced the applicable penalty from 35% to 5%.
Part III of Form 3520 has also been changed in the intervening years to add a bit of clarity: “Note: If you received an amount from a portion of a foreign trust of which you are treated as the owner, only complete lines 24 and 27” This is important for grantors of foreign trusts because the other components of part III are used to calculate the tax associated with the distribution, and owners will have already paid tax on the income within the trust when that income occurred.
In the Wilson case, the appellate court made the correct decision but this decision is based on some bad law. Potentially having a 35% penalty apply to distributions of funds that should all have already been included in a taxpayer’s income is egregious. Bear in mind that all foreign held funds are also subject to FBAR and Form 8938 reporting (and penalties if this reporting isn’t timely and accurately done). This means that the late filing of all of Wilson’s filings could potentially have resulted in up to a 90% penalty on the foreign trust amount (50% from the FBAR, 35% on the distribution, and 5% for the ownership).
This case hasn’t been decided and the appellate court vacating this decision does not mean that Wilson cannot prevail, but he will have to do so on other grounds and with other arguments as the appellate court has definitively stated that the IRS is able to impose the 35% penalty on individuals in situations similar to Wilson’s.
*Quoting the 2nd Circuit appellate court: “If the owner of a foreign trust received a distribution and completes Part II of Form 3520, and the trust has filed Form 3520-A, the instructions for Form 3520 state ‘do not separately disclose distributions again in Part III.’ “
**When the IRS attempts to impose a 3520 or 3520-A penalty on an individual, he/she will have several opportunities to contest the application of the penalty. The individual will first timely respond to the notice they received with their initial arguments for reasonable cause // removal of the penalty. If the IRS rejects the reasonable cause argument, the taxpayer will then have an opportunity to appeal that decision. Lastly the taxpayer has court rights. Once an individual reaches the stage of appealing a penalty via court rights, the process can become very expensive quite quickly and they should honestly assess their chances of prevailing in comparison to the costs of pursuing it further. In the Wilson case, the amount at issue is over 3 million dollars, making it a lot easier to justify pursuing the issue via litigation.