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Second Circuit Federal Court Ruling on Foreign Trust Penalties

Posted by Brandon Keim | Oct 19, 2021 | 0 Comments

In many cases, foreign trusts aren't subject to U.S. income tax. But under 26 U.S.C. § 6408, foreign trusts with a U.S. beneficiary are subject to reporting and tax requirements. A recent decision by the U.S. Court of Appeals for the Second Circuit handed the government a victory in its attempt to assert penalties on foreign trusts.

Owner & Beneficiary of a Foreign Trust

When Joseph Wilson, the owner, and beneficiary of a foreign trust, failed to file his 2007 taxes on time, the IRS assessed a 35% penalty that applies to beneficiaries of foreign trusts. Specifically, Wilson failed to file his Form 3520 "Annual Return to Report Transactions With Foreign Trusts and Receipt of Foreign Gifts," and the trust failed to file Form 3520-A "Annual Information Return of Foreign Trust With a U.S. Owner for 2007." The penalty for a trust owner failing to report is typically a 5% penalty. Because Wilson liquidated the trust, a 5% penalty would have been zero. When the IRS imposed the 35% penalty, it totaled $3.2 million in penalties, representing 35% of the trust's distributions in 2007. Wilson paid the penalty. 

When Wilson died, his estate applied for a refund, arguing that the IRS should have instead applied the 5% penalty that applies to owners of foreign trusts. Meaning Wilson should have paid $0 in penalties rather than $3.2 million. The federal district court granted the plaintiffs partial summary judgment, agreeing that the IRS should have imposed a 5% penalty rather than the 35% penalty.  

Second Circuit Appeal

The government appealed the district court's decision, and the U.S. Court of Appeals for the Second Circuit overruled the district court. In its decision, the Second Circuit noted that the statute's plain language imposes a 35% penalty for foreign trust beneficiaries who fail to report. The court stated that no part of the statute eliminates that penalty for beneficiaries who also happen to be trust owners. Rather, each section of the reporting statute contained separate penalties for each violation. As the Second Circuit's decision stands, there may be nothing preventing the IRS from stacking owner and beneficiary penalties on top of one another. The decision means that future beneficiary-owners of foreign trusts that fail to report could face the 35% beneficiary penalty and the 5% owner penalty.

Hire a Skilled Tax Attorney

Whether you're facing simple or complex tax issues, you need professional guidance. Don't end up with the IRS after you because of a controversial tax reporting matter. If you need help, call Senior Partner, Tax Controversy Attorney, and former IRS attorney Brandon A. Keim at (602) 200-7399 or contact him online to discuss your options.

About the Author

Brandon Keim

A Certified Tax Law Specialist, CPA, partner at Frazer Ryan Goldberg & Arnold LLP, and former Senior IRS Trial Attorney, Brandon Keim holds an LL.M. in Taxation from Georgetown University Law Center.

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