By Shamik Trivedi, J.D., LL.M., and Cory Perry, CPA, Washington
This item explores the risks to taxpayers and return preparers alike for certain delinquent or substantially incomplete international information returns that provide information to the IRS to satisfy various reporting requirements under Secs. 6038 and 6038A. While no tax is directly due with the filing of these returns, the failure to timely file or substantially complete these international information returns can result in significant penalties, as well as indefinitely extend the statute of limitation on assessment for the taxpayer's entire return. This item addresses ways to attempt to mitigate these penalties, including the use of reasonable cause and first-time abatement (FTA). It should be noted that similar penalties exist for other international information returns, but they are not discussed in this item.
Congress imposes dozens of penalties for a variety of failures under the Internal Revenue Code. Some penalties relate to understating income or overstating basis, while others relate to the late filing of a tax return or the late payment of tax. The law typically imposes these penalties as a percentage of the tax owed, and they are usually increased if a taxpayer acted intentionally.
In other cases, however, the penalties may have no relation whatsoever to an underlying tax liability. For example, Congress has imposed steep penalties for the failure to timely file or substantially complete certain international information returns, such as Form 5471, Information Return of U.S. Persons with Respect to Certain Foreign Corporations, or Form 5472, Information Return of a 25% Foreign-Owned U.S. Corporation or a Foreign Corporation Engaged in a U.S. Trade or Business. The failure to timely file or substantially complete one of these international information returns may result in a flat $10,000 penalty, per form, per year—even when no income tax was owed with the taxpayer's return.
In addition to carrying monetary penalties, the various failures noted above may have other ramifications. The statute of limitation on assessment—the IRS's time limit for collecting tax from a particular period—may be extended for several years if the failure is significant enough, or even potentially indefinitely in the case of certain international information returns. Of course, if the taxpayer acted fraudulently or never filed the return itself, then the statute of limitation on assessment also may remain open indefinitely.
In some cases, however, a taxpayer may obtain an abatement of penalties by affirmatively arguing reasonable cause. In fewer cases, a taxpayer may obtain an abatement of penalties automatically, through the use of the IRS's FTA administrative penalty waiver procedures outlined in Internal Revenue Manual (IRM) Section 22.214.171.124.6.1.
Although options are available, obtaining relief from the penalties by establishing reasonable cause may be a difficult, time-consuming endeavor and is never guaranteed. Worse still, the statute of limitation on assessment for the taxpayer's entire tax return may be extended or open indefinitely unless the taxpayer takes certain actions. With the IRS systemically assessing many of these penalties, taxpayers have few options but to seek relief or pay the consequences. These, among others, are risks to otherwise compliant taxpayers and their advisers.
As is customary in tax law, resolution of issues can be time-consuming, complex, or in some cases, unavailable. The ability to obtain abatement of penalties imposed under Secs. 6038 and 6038A (collectively, international information return penalties, or IIRPs), and related to late-filed Forms 5471 or 5472, depends on numerous factors. The two primary remedies for IIRPs are FTA and reasonable-cause relief.
FTA: Generally speaking, FTA, which is outlined under IRM Section 126.96.36.199.6.1, allows taxpayers to request abatement of certain failure-to-file penalties (e.g., Sec. 6651(a)(1)). To qualify, taxpayers must (1) have not previously been required to file a return or have no prior penalties (except the estimated tax penalty) for the preceding three years, and (2) have filed, or filed a valid extension for, all currently required returns and paid, or arranged to pay, any tax due. The taxpayer must also not have incurred an unreversed penalty for a "significant amount" during the tax period in the prior three years.
An FTA generally does not apply to "event-based" filing requirements such as with Forms 5471 and 5472. However, notably, the International Department at the Ogden Accounts Management Center will abate IIRPs if the "related Form 1120" penalty has been abated (through either an FTA or some other means of reasonable cause) and the required returns have posted to the IRS Master File. IRM Sections 188.8.131.52.5 and 184.108.40.206.5 generally outline these procedures.
For most penalties, taxpayers generally can request an FTA by telephone or through writing. However, exhibits within the IRM for IIRPs instruct the agent to not accept FTA requests for Sec. 6038 penalties over the phone. Rather, the taxpayer must make those requests in writing to the International Department, which will make its determination on IIRPs consistent with the determination made on the related Form 1120, U.S. Corporation Income Tax Return, according to IRM Section 220.127.116.11.2(5). While these sections of the IRM are dense and difficult to read, practitioners dealing with these types of penalties would do well to review them carefully, as they provide the road map by which the IRS may abate those penalties.
Reasonable cause: The second, and generally more common, remedy for IIRPs is reasonable-cause relief. Both Secs. 6038 and 6038A contain language allowing the IRS to abate penalties assessed under those provisions based on reasonable cause. The determination of whether a taxpayer acted with reasonable cause is made on a case-by-case basis, taking into account all pertinent facts and circumstances. A taxpayer's reliance on the advice of a professional, for example, may constitute reasonable cause, assuming that such reliance was reasonable, under Regs. Secs. 1.6038A-4(b) and 1.6038-2(k)(3). Of course, "reasonable cause" is not specifically defined in the Code or regulations, and so taxpayers must look to other authorities, such as case law and the IRM, when demonstrating reasonable cause and good faith.
IRM Section 18.104.22.168.2(1) describes reasonable cause as being based on all the facts and circumstances and instructs agents to grant relief when taxpayers have exercised ordinary business care and prudence in determining their tax obligations but, nevertheless, failed to comply with those obligations. The IRM defines ordinary business care and prudence as "making provisions for business obligations to be met when reasonably foreseeable events occur." The IRM also instructs agents to take into account a taxpayer's compliance history in determining whether the taxpayer exercised ordinary business care and prudence, among other things.
As noted, taxpayers must often look to case law when demonstrating reasonable cause and good faith. Although there are several ways to establish reasonable cause, the balance of this item focuses on reasonable reliance on a tax adviser. Case law offers numerous examples and legal precedents for taxpayers attempting to prove reasonable cause, only a few of which are discussed below.
In Neonatology Associates, P.A., 115 T.C. 43 (2000), the Tax Court ruled that reliance on a tax professional constitutes reasonable cause if (1) the taxpayer reasonably believed that the tax professional was a competent tax professional with sufficient expertise to justify reliance; (2) the tax professional was provided or had access to all necessary information; and (3) the taxpayer actually relied in good faith on the tax professional.
In Boyle, 469 U.S. 241, 245 (1985), the Supreme Court, in defining reasonable cause, looked to the regulations under Sec. 6651, which relate to the failure to timely file or pay tax, in determining that "[w]hen an accountant or attorney advises a taxpayer on a matter of tax law, such as whether a liability exists, it is reasonable for the taxpayer to rely on that advice." The Court went on to say that the exercise of ordinary business care and prudence does not require the taxpayer to challenge an attorney, seek a second opinion, or "monitor counsel."
Boyle is both a sword for the IRS and a shield for taxpayers in the context of reasonable cause. While the Supreme Court described the reasons for which a taxpayer could reasonably rely on a competent adviser, the case itself turned on the adviser's failure to timely file a tax return. Boyle concludes that "[t]he failure to make a timely filing of a tax return is not excused by the taxpayer's reliance on an agent, and such reliance is not 'reasonable cause' for a late filing under § 6651(a)(1)." Such ministerial acts performed by an adviser would not, therefore, be covered by a reasonable-cause exception.
In a more recent case, Specht, No. 15-3095 (6th Cir. 2016), aff'g No. 1:13-cv-00705 (S.D. Ohio 2015), the tax adviser assured the taxpayer that an extension to file had been obtained. However, the taxpayer never asked for proof that the tax adviser had in fact obtained an extension, and the assurances turned out to be false—a request for extension had never been filed. Following Boyle, the court found that "complete reliance" on a tax adviser to carry out a nondelegable act such as filing a timely return, rather than circumstances beyond the taxpayer's control, is not reasonable cause. The court found that this holds true even if the taxpayer otherwise may have exercised ordinary business care and prudence. But what of an adviser who determines that a filing responsibility does not exist, or an adviser who fails to notify a taxpayer of an existing filing obligation?
That answer may turn on the complexity of the return the taxpayer is filing. Practically, as Boyle suggests, all taxpayers should know of their responsibility to file an income tax return. The failure to timely file is the sole responsibility of the taxpayer, which cannot delegate it to an adviser. The responsibility to file an information return, such as a Form 5471, and navigate the complex international information-reporting rules, however, would appear to be something a lay taxpayer would never have an inclination to know. In fact, these rules often mystify even the most seasoned practitioners.
There are generally two situations under which a taxpayer fails to timely file an international information return: (1) The taxpayer obtained a tax adviser who filed the income tax return but failed to attach the required international information returns; or (2) the taxpayer obtained a tax adviser who failed to timely file the underlying income tax return—perhaps because a request for extension had never been filed.
In the first situation where the taxpayer timely filed its income tax return, but its adviser failed to file the appropriate international information return, the remedies are reasonably clear. The IRS's "Options Available for U.S. Taxpayers with Undisclosed Foreign Financial Assets," available at www.irs.gov, offers taxpayers with delinquent international information returns a procedure to submit those filings without an immediate penalty under certain circumstances. These procedures, found under the fourth option listed under this program (Option 4), replace frequently asked question (FAQ) No. 18 of the Offshore Voluntary Disclosure Program (OVDP).
If the taxpayer does not qualify for Option 4 (as discussed further below), the taxpayer may also seek relief by making an affirmative showing of all the facts alleged as reasonable cause for the failure in a written statement filed with the district director containing a declaration that it is made under penalties of perjury. The statement must establish that the taxpayer has substantially complied with its requirements (Regs. Sec. 301.6723-1A(d)(3)).
Option 4 provides the simplest avenue to submit delinquent international information returns for those taxpayers that (1) have not filed one or more required international information returns; (2) have reasonable cause for not timely filing the information returns; (3) are not under IRS civil examination or criminal investigation; and (4) have not already been contacted by the IRS about the delinquent returns.
A taxpayer that submits a delinquent filing under Option 4 will not be automatically subject to audit, penalty, or review, but the IRS may still select it for examination through "the existing audit selection processes that are in place for any tax or information returns."
Importantly, under Option 4, taxpayers must make delinquent filings on an amended return, attaching the delinquent information returns to the amended return with a statement of all facts establishing reasonable cause for the failure to file and a required certification filed under delinquent international information return submission procedures asserting that the entity for which the information return relates was not engaged in tax evasion. This is a departure from FAQ No. 18, which did not require a taxpayer to show reasonable cause or certify that the taxpayer was not involved in tax evasion, and specifically excluded those late filings, assuming the proper procedures were followed, from penalty.
Under the second scenario, where a taxpayer has failed to timely file an original income tax return, upon which an information return would be attached, the remedies are much less clear. When an original return has not been timely filed, seemingly the taxpayer would not be eligible for filing under Option 4 because the plain language describing Option 4 requires an "amended" tax return. This situation poses significant risk to a taxpayer and adviser, given the ability of the IRS to impose systemically assessed penalties on late-filed returns and taxpayers' inability to request relief under reasonable cause when the late return is the result of a missed or late extension.
Seemingly similar circumstances, from the taxpayer's perspective, can result in drastically different results. Under the first scenario, there is a clear path for relief, but under the second, an FTA may be the only option, and as discussed further below, may not always be available.
Systemically assessed penalties
As described in IRM Sections 22.214.171.124.1 and 126.96.36.199.2, beginning in March 2013, the IRS automatically assesses penalties under Secs. 6038 and 6038A on late-filed Forms 1120, on which are attached Forms 5471 or 5472. Similarly, beginning in March 2014, automatic penalties apply to late-filed Forms 1065, U.S. Return of Partnership Income, with Forms 5471 and 5472 attached. The assessment results in the IRS's issuing a CP215 notice to the taxpayer, which would then require the taxpayer to respond with a valid argument for reasonable cause, submit a qualified request for an FTA, or pay the penalty.
Those IRM sections also contain decision trees for agents to follow. As one may expect, most of the branches of those decision trees end with a denial of reasonable-cause relief. Accordingly, it is important for taxpayers to be ready with the correct, well-articulated argument.
The imposition of a systemically assessed penalty may occur on one of two types of late-filed tax returns: those with tax shown and those without. Late-filed returns with tax shown, necessitating the payment of tax with the late-filed return, would be subject to failure-to-file and/or failure-to-pay penalties imposed under Sec. 6651. As many taxpayers know, those penalties may be abated under an FTA. Further, the accompanying Sec. 6038 or 6038A penalties, if imposed due to such a systemic assessment, may also be abated by an FTA, assuming the taxpayer otherwise qualifies.
However, where the late-filed income tax return does not have any tax due, the taxpayer may not have a Sec. 6651 penalty to address and may not be able to so easily remove the systemically assessed Sec. 6038 or 6038A penalties through an FTA. An FTA provides relief for penalties imposed under Sec. 6651(a)(1), 6698(a)(1), 6699(a)(1), 6651(a)(2), 6651(a)(3), or 6656—essentially for those penalties that relate to a failure to file, failure to pay, or failure to deposit. Accordingly, as discussed above, if no such penalty exists on the income tax return, then an FTA does not apply to the "event-based" penalty of an international information return.
This leaves taxpayers and advisers in a delicate position. Consider the following example:
Example: EuroCo, a French company based in Paris, manufactures certain products and maintains a U.S. branch through an office it keeps in Kansas City. The U.S. branch has a single employee who attempts to make sales in the United States. The U.S. branch does not turn a profit and is effectively controlled by EuroCo's management in France. EuroCo relies on French tax advisers, who fail to advise the company that the U.S. branch has a filing requirement in the United States. Several years later, with sales taking off in the United States, EuroCo decides to engage a U.S. tax adviser. The U.S. tax adviser determines that the U.S. branch should have been filing a Form 1120-F, U.S. Income Tax Return of a Foreign Corporation, as well as Forms 5472 to report certain related-party transactions.
The U.S. branch in this example has not only delinquent income tax returns, but also delinquent Forms 5472. The statute of limitation for assessment under Sec. 6501(c)(8) has not begun to run until and unless the income tax returns and the Forms 5472 are filed for each year. The U.S. branch's U.S. tax adviser determines that in each of the years that the branch should have filed, the branch did not incur a tax liability because of current losses or net operating loss carryforwards. The adviser files the Forms 1120-F late and attaches the appropriate Forms 5472.
The U.S. branch at this point will likely receive a CP215 notice imposing a $10,000 penalty for each year that it failed to file Forms 5472 and for each form that the branch was required to attach. An FTA will not be available to the U.S. branch because there is no underlying failure-to-file penalty on the Form 1120-F, since there is no tax liability. The U.S. branch will have to assert that its French tax advisers failed to properly advise it of the filing requirement. This process will likely result in the first-level reasonable-cause submission being dismissed by the International Department, based on a broad reading of IRM Exhibit 21.8.2-2(3), which states that "[o]rdinary business care and prudence requires the taxpayer to determine their tax obligations when establishing a business in a foreign country." Moreover, "reliance" is a category that the IRM gives a blanket denial of reasonable cause under Exhibit 21.8.2-2(9).
So, the U.S. branch may appeal the decision of the International Department by timely filing a protest. The likelihood of obtaining a face-to-face meeting with a field Appeals Officer is low, given recent changes in the IRS Appeals Division procedures, generally found under IRM Section 8.6.1, and so the U.S. branch will be relegated to a Campus Appeals telephone conference where the substantive argument will be that EuroCo's French tax advisers failed to advise the company of its U.S. tax obligations. Such reliance hardly seems reasonable and is certainly not the strongest argument for the IRS to accept. After thousands of dollars of professional fees and many months of time having passed, the U.S. Branch may be out of luck.
Or consider another example, a nightmare scenario whereby a U.S. tax adviser has properly advised a taxpayer of all relevant filing obligations, including its international information returns, and, through an inadvertent error, the taxpayer's Form 7004, Application for Automatic Extension of Time to File Certain Business Income Tax, Information, and Other Returns, is never filed. As a result, the taxpayer fails to timely file 30 Forms 5472 and 10 Forms 5471. The tax adviser, believing the return has been properly extended, files the return on or before the extended due date.
Because the taxpayer did not properly extend the return, it will receive a CP215 notice imposing a penalty of $400,000. Assuming the taxpayer was fully paid in or in a loss position, an FTA will not be available as the IRS will not impose a Sec. 6651 penalty on the income tax return. Moreover, the standard set in Boyle renders it virtually impossible for the taxpayer to obtain relief under the reasonable-cause options set forth above. Here, there is an otherwise compliant taxpayer, who owes no tax, files its return in what would otherwise be a timely manner, and has exercised ordinary business care and prudence. Nevertheless, the $400,000 penalty will stand, and the taxpayer and tax adviser will suffer the consequences. The same holds true if the taxpayer was responsible for filing the extension and, due to an internal administrative error, never filed it.
IRM Section 188.8.131.52 states that "penalties exist to encourage voluntary compliance by supporting the standards of behavior required by the Internal Revenue Code." Penalties provide the IRS with an important tool to achieve voluntary compliance by taxpayers. Systemically assessing penalties against taxpayers under the scenarios set forth above does not seem to enhance voluntary compliance especially because the taxpayers voluntarily submitted the returns. Nor should the taxpayers be on uneven ground when an adviser fails to include a required form as compared to an adviser who fails to properly extend a return.
Things to consider
As described previously, the impact of IIRPs can be dramatic and unexpected. IRM Section 184.108.40.206.1 provides that penalties are supposed to "support and encourage voluntary compliance," even though they may "serve to bring additional revenues into the Treasury and indirectly fund enforcement costs." Nonetheless, "these results are not reasons for creating or imposing penalties." Yet, the IIRPs effectively do just that.
Systemically assessed penalties throw a taxpayer into the IRS's labyrinth, exposing the taxpayer not just to the monetary penalty imposed by statute, but also to the administrative costs imposed by bureaucratic inertia. A business taxpayer with a single Form 5471 penalty may want to seriously consider simply paying the penalty rather than attempting to abate it, given the time and costs involved.
For advisers, the routine act of filing a tax return or an extension may be complicated by a taxpayer's international dealings. That simple task may turn complex through an inadvertent failure. Such risks challenge not just taxpayers but also their advisers. Should advisers change their procedures to account for potential missed extensions or filings? Should taxpayers request transcripts from the IRS verifying receipt of an extension filed by an adviser?
For its part, the IRS has been, at least on the surface, receptive of such considerations. Yet, the impact on taxpayers and tax advisers, coupled with the growing number of cases in Campus examination and Appeals related to such penalties, draws questions as to whether the intended goal of providing transparency for ownership in foreign assets by domestic taxpayers, or by ownership of domestic taxpayers by foreign entities, is somehow outweighed by the significant cost and burden from such strict and automatic enforcement. This is especially true for taxpayers who may not have any actual tax liability.
If anything, advisers must be vigilant to spot situations where penalties may be imposed, especially if the ability to abate those penalties is burdensome or impossible.