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Assessment of Penalties on Substitute Forms 3520-A

In recent years, several clients have faced heavy penalties for the late filing of Form 3520-A, known as the “Annual Information Return of Foreign Trust With a U.S. Owner.” Surprisingly, these penalties were assessed even when clients had filed a timely substitute Form 3520-A. This practice by the IRS contradicts its own published guidance.

Fortunately, there have been instances where penalties were reversed after filing protests and requesting collection due process with the Independent Office of Appeals.

Form 3520-A Filing Requirement

According to Section 6048(b), Foreign trusts that have U.S. owners are legally obligated to submit Form 3520-A annually. Furthermore, they must furnish a copy of this form to any individual considered the owner of any portion of the trust or to anyone who directly or indirectly receives distributions from the trust. 

If the U.S. owner files Form 3520-A, it is due by the 15th day of the third month after the trust’s tax year ends. For trusts with a calendar-year tax year, the deadline is March 15. An extension can be requested by filing Form 7004, “Application for Automatic Extension of Time to File Certain Business Income Tax, Information, and Other Returns.”

U.S. beneficiaries of foreign trusts must file Form 3520, “Annual Return to Report Transactions With Foreign Trusts and Receipt of Certain Foreign Gifts.” They should attach a copy of Form 3520-A provided by the U.S. owner of the foreign trust. The Form 3520 due date aligns with the taxpayer’s income tax return deadline, and a valid extension on Form 4868 extends the filing deadline for Form 3520.

What if Form 3520-A Isn’t Received?

When the U.S. owner of a foreign trust fails to provide Form 3520-A, taxpayers should follow these steps:

  1. Check if the foreign trust filed Form 3520-A for the current year.
  2. If yes, attach the Foreign Grantor Trust Owner Statement received from the foreign trust.
  3. If the foreign trust did not provide Form 3520-A, complete and attach a Substitute Form 3520-A to the best of your ability. A legal memorandum emphasizes that this step is crucial when the foreign trust did not file Form 3520-A for the current year.

In case a foreign trust fails to file Form 3520-A, the U.S. owner must complete and attach a Substitute Form 3520-A to their own Form 3520 by the due date for Form 3520 (not the due date for Form 3520-A). This action helps avoid penalties related to the foreign trust’s failure to file Form 3520-A. For example, if the U.S. owner attaches a Substitute Form 3520-A by the Form 3520 deadline (e.g., April 15 for individual U.S. owners), it is considered timely filed.

Penalties for Failing to File

Penalties are imposed If a taxpayer fails to timely file Form 3520-A or submits an incomplete form, without reasonable cause. These penalties amount to 5 % of the “gross reportable amount.” Additionally, if the IRS notifies a taxpayer of the failure to file Form 3520-A, and the taxpayer does not rectify it within 90 days, an extra penalty of $10,000 applies for each 30-day period (or fraction thereof) during which the failure persists, up to the gross reportable amount. For Form 3520-A penalties, the gross reportable amount refers to “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.”

When to File Substitute Form 3520-A?

Usually,  Form 3520-A is due on March 15 (three months after the close of the trust’s tax year), unless the taxpayer requests an extension by filing Form 7004. However, for substitute Forms 3520-A, the due date aligns with that of Form 3520. Consequently, a taxpayer who files a substitute Form 3520-A along with their timely filed Form 3520 should not be subject to penalties for late filing of Form 3520-A. The Internal Revenue Manual (IRM) reinforces this policy:

If the foreign trust does not file Form 3520-A, but the U.S. owner completes and attaches a Substitute Form 3520-A for the foreign trust to the U.S. owner’s timely filed Form 3520 in accordance with the instructions for Form 3520, the U.S. owner will not be subject to the penalty for failure to file Form 3520-A.”

Consistent with this guidance, IRS compliance employees are instructed not to assess a penalty if a Substitute Form 3520-A was filed and there is proof that Form 3520 was filed timely.

Why Penalties and How to Challenge Them?

Despite its own guidance, the IRS systematically assesses penalties of 5 % of the reported value of foreign trusts for late filing of substitute Forms 3520-A that were, timely filed along with Forms 3520. it appears that personnel at the IRS service center have been directed to impose penalties on all Forms 3520-A filed after March 15, unless the taxpayer filed a Form 7004 extension request.

The IRS’s failure to recognize the substitute Form 3520-A for what it is, causes significant hardship for taxpayers who face these penalties and must navigate the complex system for challenging them. When a taxpayer receives a Form 3520-A penalty or any other foreign information return penalty, they should be allowed an opportunity to appeal by submitting a protest with Appeals within 30 days of the notice of the penalty determination. The IRM ensures that taxpayers are entitled to prepayment appeals review, meaning the IRS should not attempt to collect the penalty while the appeal is pending. However, practitioners handling these cases know that taxpayers may still face enforced collection during the appeal process, often receiving collection notices even before the appeal period elapses.

If the IRS issues a notice of intent to levy, the taxpayer can submit a request for collection due process (CDP) and challenge the penalty in that forum. Since there has not yet been an opportunity for review of the penalty, Appeals can address the matter. If Appeals does not grant relief during the CDP hearing, the taxpayer may seek review of that determination by filing a petition in the Tax Court for lien or levy action under section 6330(d).

Interestingly, the IRS’s failure to comply with the IRM can lead to an ironic outcome. When the IRS proceeds with enforced collection despite a timely appeal and issues a notice of intent to levy, the taxpayer may benefit because the CDP determination becomes subject to prepayment review in the Tax Court. Otherwise, a disappointed taxpayer would have to pay in full and then seek a refund before obtaining judicial review. This is because foreign information return penalties fall under the category of “assessable penalties,” meaning they are “paid upon notice and demand” and are not subject to deficiency procedures.

Avoiding Penalties on Substitute Forms 3520-A

When it comes to Form 3520-A penalties, understanding the specific context of timely filed substitute Forms 3520-A is crucial. Fortunately, taxpayers who file these substitutes on time should not require judicial review. Here’s why:

Appeals and Relief:

Taxpayers have obtained relief from these penalties through Appeals and Collection Due Process (CDP) procedures.  Unfortunately, engaging in this battle often results in significant professional fees and stress.

Proactive Measures:

Tax advisers can take steps to avoid penalties:

  • File Form 7004: Even though not required, if the taxpayer expects that the U.S. owner of the foreign trust won’t file Form 3520-A before the general deadline, filing Form 7004 can provide an extension.

Note on Form 3520-A:

  • Indicate that it is a substitute Form 3520-A.
  • Explain that the taxpayer is filing the substitute under IRS instructions because the U.S. owner of the foreign trust did not provide the form.
  • Emphasize that, according to IRS guidance, the return is considered timely.
  • By providing this explanation with the return, taxpayers can avoid penalty assessments related to Form 3520-A.

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