Monday, March 6, 2023
Lesson From The Tax Court: Fill Out The Damn Form
The fuss has focused on FBARs. The FBAR requirements and penalty provisions have been hotly litigated. Recently the Supreme Court issued an opinion in Bittner v. U.S., deciding that the penalties were not as harsh as the government thought they should be.
But forget FBAR. Today’s lesson is about a different, yet equally important, foreign account reporting requirement: the one found in 26 U.S.C. §6048 that relates to foreign trusts. The FBAR stuff is over in 31 U.S.C. §5314. Completely different title.
And today’s lesson is not about penalties. It’s about the assessment limitations period. In Leigh C. Fairbank and Barbara J. Fairbank v. Commissioner, T.C. Memo. 2023-19 (Feb. 23, 2023) (Judge Weiler), we learn that a failure to comply with the §6048 reporting requirement by never filing the proper form---not even during audit---extends the time in which the IRS can assess really old tax deficiencies. How old? Try 15 years old. Regardless of the outcome in Bittner, folks need to learn this lesson! Details below the fold.
Law: The Assessment Statute of Limitations and the §6048 Exception
Section 6501(a) gives the general rule that the IRS must assess a tax liability “within 3 years after the return was filed (whether or not such return was filed on or after the date prescribed).”
Relevant for today is the exception found in §6501(c)(8).
“In the case of any information which is required to be reported to the Secretary pursuant to...[§]6048, the time for assessment of any tax imposed by this title with respect to any tax return, event, or period to which such information relates shall not expire before the date which is 3 years after the date on which the Secretary is furnished the information required to be reported under such section.” (emphasis supplied)
Section 6048 in turn has has two relevant provisions.
First, if a taxpayer is a beneficiary of a foreign trust and receives any distribution from that trust, §6048(c) obligates the taxpayer to file an information return reporting the name of the trust, the aggregate amount of the distribution received that year, and “such other information as the Secretary may prescribe.” The relevant reporting prescription is found on Form 3520 and its instructions which taxpayers are prompted to review by Question 8 on Form 1040, Schedule B. Question 8 asks “did you receive a distribution from, or were you the grantor of, or transferor to, a foreign trust? If “Yes,” you may have to file Form 3520. See instructions.”
Second, if a taxpayer is considered to be the owner of a foreign trust, under the grantor trust rules in §671 et. seq., then §6048(b) requires the taxpayer to “ensure” that the foreign trust files an information return to the IRS reporting, inter alia, its activities and the names of the U.S. persons who received distributions during the year. That is done on Form 3520-A, Annual Information Return of Foreign Trust With a U.S. Owner. Taxpayers are guided to Form 3520-A by the instructions for Form 3520.
Notice that a taxpayer must be the beneficiary or owner of a “trust” entity in order to trigger the §6048 reporting requirements. If the entity the taxpayer is connected to is not a trust, §6048 reporting requirements do not apply. Maybe some other reporting requirements apply, but not these.
So what’s a trust? Well, one logically expects to find the answer in §7701 (“Definitions”) but one does not. The statute defines terms like “person” and “partnerships” and “corporations” but never defines “trust.” It does tell us the difference between a foreign trust and a trust that counts as a “United States Person.” §7701(a)(30), (31) but neither of those provisions define “trust.”
The regulations are more helpful. They tell us two important points about how to tell whether any entity is a “trust” or is something else.
First, Treas. Reg. 301.7701-1(a) tells us that whether any organization is even an entity separate from its owners for federal tax purposes is a matter of federal tax law and does not depend upon whether the organization is recognized as an entity under another jurisdiction’s law..
Second, Treas. Reg. 301.7701-4 tells us that what constitutes a trust is determined by function. That is, a trust might be either a “business or commercial trust” or an “ordinary trust.” The difference is not in the label but in the function. A business trust is “generally are created by the beneficiaries simply as a device to carry on a profit-making business which normally would have been carried on through business organizations that are classified as corporations or partnerships under the Internal Revenue Code.” In contrast, an ordinary trust operate “to protect or conserve the property for the beneficiaries.”
The importance of function is seen in a very helpful Chief Counsel memorandum,
IRS Chief Counsel Attorney Memorandum 2009-012 (Oct. 27, 2009). There, the question was whether two types of entities created under the laws of Lichtenstein were trusts for U.S. tax purposes. The memorandum explains that, generally speaking, one type of Lichtenstein entity would be classified as a trust (a Lichtenstein Stiftung) and the other type would not (a Liechtenstein Anstalt). But the memo repeatedly cautions that its very generalized findings were in response only to the information given. Thus, while it concludes an Anstalt is generally not a trust, it cautions “It is important to analyze the facts and circumstances of each Anstalt to determine whether a particular Anstalt was established primarily to conduct a trade or business or to protect and conserve assets for the designated beneficiaries of the Anstalt.” Likewise, while it concludes that a Stiftung is generally a trust, it cautions “it is important to analyze the facts and circumstances of each case to determine whether a particular Stiftung was established to protect and conserve property of the Stiftung or alternatively, was created as a device to carry on a trade or business.”
The tax years at issue are 2003-2009. Importantly, the taxpayer here timely filed their returns for all of those years. During the tax years at issue, Mrs. Fairbank held a beneficial ownership interest in a Lichtenstein Anstalt called Xavana Establishment. Xavana Establishment, in turn, opened account 0857 at UBS, a massive Swiss bank (formerly known as Union Bank of Switzerland before its merger with Swiss Bank Corporation). Finally, Mrs. Fairbank was sole shareholder in a British Virgin Islands corporation, Xong Services, Inc. Xong opened an account with Neue Privat Bank (NPB), another Swiss bank. The account was funded with a deposit from Xavana’s USB account.
As a result of the IRS successful efforts to pry the names of accountholders from USB, it discovered Mrs. Fairbank’s various interests and opened an examination in 2012. During the examination, Mrs. Fairbanks provided all the information asked of her, apparently finishing that production in March of 2014.
Since Mrs. Fairbank timely filed returns for the tax years at issue (2003-2009) that meant the last year’s assessment statute expiration date was in April 2013. And yet the IRS issued an NOD for all the tax years at issue on April 12, 2018, proposing to assess a deficiencies totaling over $100,000 for those years and §6662(a) accuracy related penalties totaling almost $22,000. Wow. That’s waaaaaay after the three year period! So the taxpayers petitioned the Tax Court and asked the Court to knock out the NOD for being too late. The IRS said the NOD was timely because §6501(c)(8) kept the assessment limitation period open since the Fairbanks had failed to comply with the §6048 reporting requirements.
The taxpayers offered two reasons why the NOD was late. First, they said they had no duty to report under §6048 because the foreign entities were not trusts but were businesses. Therefore, §6501(c)(8) did not operate to keep the assessment SOL open. Second, relying on the "is furnished to..." statutory language I bolded above, they said that they did comply with §6048 when they furnished all the relevant information during the audit, ending in March of 2014. Therefore, the three year clock started running again in March 2014 and the April 2018 NOD was still too late.
The Tax Court rejected both arguments, giving us our lesson: fill out the damn form.
Lesson: Failure to File Form 3250 or 3250-A Keeps Those Years Open
Judge Weiler easily rejects the taxpayer’s claim that Xavana Establishment was not a trust for U.S. tax purposes. He reviews the organizing documents and dives into the history of how Xavana Establishment came to be. It turns out it was a vehicle for Mrs. Fairbank’s ex-husband to pay support after their 1982 divorce. Her ex was a former-CPA-turned-oil-broker-turned-tax-evader. He fled the U.S. to New Zealand in the early 1980’s to avoid paying taxes on multiple millions of income. As part of their divorce, he paid substantial sums in child and other support to her (she retained custody of their four kids) but he apparently insisted on doing it through a Lichtenstein entity and a USB account. That was the basic story of Xavana Establishment which was created in 1983. Judge Weiler explains it all in detail and shows how Mrs. Fairbanks took substantial amounts of distributions and was, for U.S. tax law purposes, the beneficial owner of Xavana. That triggered her duty to file both Form 3520 and Form 3520-A.
The taxpayers tried to use the Chief Counsel memo I describe above to say that Xavana Establishment could not be a trust because it was a Lichtenstein Astalt, which the memo had concluded were businesses. The memo says nothing of the kind, as I explained above. I would have been embarrassed to make that argument!
The taxpayer’s second argument was stronger. Look again at §6501(c)(8). Notice that it distinguishes between “reporting” the information and “furnishing” the information. That is, it suspends the SOL if the taxpayer fails to report the requirement information but then says that once “the Secretary is furnished the information required to be reported.” a new 3 year period begins. The taxpayers argued that, sure, they may not have reported the information, but they did furnish it and since the NOD came more than three years after that, it was too late.
That’s a strong textualist argument. Judge Weiler totally dodges it by noting that the taxpayers failed to explicitly link the information they furnished the IRS to the information required to be reported on Form 3520 or Form 3520-A. Op. at 24, note 31. He concludes that Mrs. Fairbank’s failure to file the relevant Forms kept the assessment period open, regardless of what information she may or may not have provided on audit. Curiously, Judge Weiler asserts that his conclusion “is consistent with those of other courts that have considered this issue.” Op. at 24. He cites to two cases, but neither of them considered this “reported” vs. “furnished” argument because both were about §6677 penalties and not about §6501(c)(8). So it’s not clear to me what he means.
Bottom Line: To comply with §6048 your client must file the required forms to re-start the assessment limitations period, even during an audit. Don’t worry about duplicating the information. Fill out the damn form and hand it to the Revenue Agent!
Comment: What Was Not At Issue: Penalties
Taxpayers who fail to comply with §6048 are also subject to pretty harsh penalties under §6677. The penalties start with the greater of $10,000 or 5% of the amounts that should have been reported. §6677(b). After 90 days, then comes an additional $10,000 penalty for every subsequent 30 days of non-compliance. §6677(a). Ouch! Oh, but the maximum penalty appears to be 100% of the amounts that should have been reported. Id. Phew! Here, for example, the NOD said that the Fairbanks should have reported $20,000 for the 2003 tax year. So their §6677 penalty would be the max: $20,000.
But you won’t likely see this come up in Tax Court, because §6677(e) says the IRS can assess without having to follow the deficiency procedures. So penalty contests will likely come up in federal district court because the taxpayer will have to pay the penalty and then ask for a refund. See e.g. Rost v. United States, 44 F.4th 294 (5th Cir. 2022), where the taxpayer was hit with $1.4 million in §6677 penalties. He knocked out half in a CDP hearing, then paid the balance and sued for refund. He lost. Here, we do not know what penalties, if any, the IRS has assessed against the Fairbanks for their failure to report.
Comment 2: Reporting v. Furnishing
I think the taxpayer’s second argument has legs. Generally speaking by the time the IRS has a taxpayer under audit, it’s too late for the taxpayer to say they are complying with any reporting requirement. And you don’t want a rule that lets taxpayers hide information in hopes they escape audit only to then be able to avoid the consequences of that behavior by producing it during audit.
But that’s not the effect of reading §6501(c)(8) the way the taxpayers here argued it should be read. They will still get hammered by the §6677 penalty for failing to “report.” But once they are under audit and have “furnished” the IRS the information they would have given via the relevant form, then they are not avoiding any consequences. And, in fact, giving the IRS 3 years to complete an audit is reasonable and consistent with the general rule of §6501(a). If the IRS needs more time it can always ask the taxpayers to agree to an extension.
In short, the text favors the taxpayers’ argument and is consistent with the statutory scheme. If I were an appellate court in this case I would want to be sure the taxpayers had an opportunity to show that the information they furnished during audit was the same information they would have reported on the Form.
Bryan Camp is the George H. Mahon Professor of Law at Texas Tech University School of Law. He invites readers to return each Monday (or Tuesday if Monday is a federal holiday) to TaxProf Blog for another Lesson From The Tax Court.