Introduction
This three-part series will focus on IRS civil penalties, mainly as these relate to failure to file international information returns.
The framework for civil penalties is discussed first. The focus will then turn to how the framework relates to failure to file international information returns, including Form 5471 Information Return of U.S. Persons with Respect to Certain Foreign Corporations.
Part One of this series sets out the current IRS penalty framework. It looks at penalty sections of the Internal Revenue Code. It also discusses how one landmark case became authority, defining the doctrine of reasonable cause as defence.
Part Two will focus on penalty cases of U.S. persons with unfiled international information returns. We explore the evolution of case law, post-Neonatology Associates[1].
Part Three will take a deep dive into Form 5471, providing expertise and insight into the most technically difficult of the international information returns U.S. citizens and residents with foreign equity interests must file.
Part One: Civil Penalty Framework
Civil penalties, rules, and procedural requirements are found in sections 6651 through 6751, and section 6038 of the U.S. Code: Title 26 – Internal Revenue Code. Sections 6651-6750 penalties include failure to file penalties, failure to pay penalties, accuracy-related penalties, and civil fraud penalties. These are based on the amount of tax due on a filed U.S. tax return.
The failure to file penalty is 5% of the tax on the return[2], for each month a return is overdue. Where a failure to file is held by the IRS to be associated with some type of fraud, the rate is 15% of the tax on the return for each month a return is overdue.
The failure to pay penalty is 0.5% of the tax due on the return[3], for each month a return is overdue.
Both penalties are capped at 25% of the tax due[4]. A taxpayer who has neither filed a return nor paid the tax does not have these penalties added together, and they will be penalized at the failure to pay rate.
An accuracy-related penalty imposes a 20% penalty on the portion of an underpayment of tax attributable to negligence or disregard of rules or regulations, any substantial understatement of income tax, any substantial valuation misstatement, and other misstatements.
A civil fraud penalty imposes a 75% penalty of the tax due on a return, if the underpayment is attributable to fraud.
Other penalties found in sections 6651 through 6750 include a failure to pay estimated tax penalty, and various other provisions.
Specific sections exist in relation to failure to file international information return penalties. These are:
- section 6677 failure to file information with respect to certain foreign trusts which imposes Forms 3520 and 3520-a penalties. These are the greater of 35% of the gross reportable value of the trust (Form 3520), 5% of the gross reportable value of the trust (Form 3520-a), and US $10,000.
2. section 6038, Information reporting with respect to certain foreign corporations and partnerships, which imposes reporting requirements applicable to Form 5471, 5472, 8865, and Form 8938 filers. The penalty for failure to file any of these forms except Form 5472 is US $10,000 per infraction. Form 5472 attracts a US $25,000 penalty.
Penalty sections 6651 through 6750 were introduced in the 1954 Internal Revenue Code.
IRS enforcement
The IRS imposes penalties using procedures in a penalty handbook, which is in the Internal Revenue Manual. The IRS’ objectives are to apply penalties consistently to encourage compliance with tax law.
Following the enactment of the IRS Restructuring and Reform Act of 1998 (Act), Section 6751 – Procedural Requirements – was added into the Code.
This section contains requirements for penalties to be personally approved and documented by the immediate supervisor of the IRS employee deciding that a penalty be imposed. This section has become of great relevance in the defence of penalties in recent years.
Under the Act, a Taxpayer Bill of Rights was introduced to address concerns raised with Congress over an imbalance of power and criticism of the IRS.
Through this, an IRS Oversight Board was formed. IRS employees could be disciplined for ill-treatment of taxpayers, marking a new era of accountability for the IRS.
As a result of this new accountability, behavioural changes occurred within the IRS. Revenue Agents and Revenue Officers were hesitant in their dealings with taxpayers, which led to a period of relative inactivity in civil penalty enforcement.
This lasted until 2017 when the IRS Large Business and International unit launched a campaign targeting foreign trusts. Filers of Late-filed Forms 3520 and 3520-a were automatically hit with penalties under section 6677.
Despite protesting these penalties, individuals have had mixed success appealing the penalties under Section 6677 reasonable cause.
A brief amnesty period post-COVID allowed relief from penalties imposed on late-filed international information returns. In 2022, the IRS Office of the Associate Chief Counsel issued Notice 2022-36 Penalty Relief for Certain Taxpayers Filing Returns for Taxable Years 2019 and 2020. Filers could file their income tax returns and information returns by September 30, 2022, without being penalized.
Development of Reasonable Cause Defence
Throughout the penalty sections mentioned above, the taxpayer can apply for penalty abatement if they can demonstrate that they had reasonable cause and good faith for failure to comply.
Reasonable cause involves looking at all the facts and circumstances and requires taxpayer to show that they exercised ordinary business care and prudence. The test is done on a case-by-case basis. The burden of proof is on the taxpayer.
These provisions exist in the following areas of the Internal Revenue Code:
- section 6664C accuracy related penalties,
- section 6651A, failure to file or pay,
- section 6724 a, information reporting penalties
- section 6676 erroneous claim for refund or credit,
- 6677 failure to file an information return of a foreign trust.
Most of the penalty sections, including 6677, include language to the effect that failure to file was due to reasonable cause and not wilful neglect.
First time abatement provisions contained in the Internal Revenue Manual are frequently used by taxpayers for penalty abatement of failure to file, failure to pay,
The reasonable cause provisions contained in section 6664C were put to the test with a landmark case in 2002.
The 2002 case of Neonatology Associates vs. the Commissioner of IRS (Neonatology) developed the principles of reasonable cause. Now, note that this case involved an understatement of taxable income, not unfiled international information returns. The significance of this will be explained in Part Two.
In Neonatology, upon reliance of their tax preparer a deduction for life insurance contributions to Voluntary Employees, Beneficiary Association (VEBA) was promoted throughout the medical profession as an allowable Section 162 deduction from gross income.
The taxpayers argued that since they relied on lawyers, accountants, actuaries, in taking a deduction on their return, the IRS could not penalize. They argued using section 6664© reasonable cause and good faith. The IRS argued that since the taxpayers paid a fee and bought a product, if they didn’t understand it, why would they have placed reliance on their advisers to start with.
The taxpayers lost the case and incurred accuracy-related penalties. The case was appealed to the Tax Court. The Tax Court decision was appealed, and the third circuit court upheld the tax court’s decision.
The judge wrote a long opinion which changed the landscape. Whilst the taxpayers lost in this case and incurred accuracy related penalties, a three-limbed test emerged in the defence of reasonable cause.
The three limbed test is:
- That the preparer is competent in the field.
- The taxpayer provided complete, accurate information to the preparer, and,
- The taxpayer relied on tax advice provided by the tax preparer.
As regards the need to rely on tax advice, this does not mean that the taxpayer needs to actively seek advice on their filing requirements, either from the tax preparer or from another tax professional.
It simply indicates that by providing information to their preparer, it is inferred that tax advice is being provided.
Neonatology Associates set a precedent. Whilst the case involved the validity of a deduction from gross income, Part Two of this series will dive into how this case has been applied to failure to file penalties imposed on international information returns, including form 5471.
We have been helping clients file international information returns including Form 5471 since 2010. If you require assistance with meeting your U.S. tax and reporting filing obligations, please contact us for further information.
[1] Neonatology Associates vs. Commissioner of Internal Revenue U.S. Court of Appeals for the Third Circuit, 2002.
[2] Tax due after all credits and deductions and which results in a liability of the taxpayer upon filing the tax return.
[3] Tax due after all credits and deductions and which results in a liability of the taxpayer upon filing the tax return.
[4] Where fraudulent failure to file is involved, the penalty is capped at 75% of the tax due on the return.
