The process of adhering to tax rules and regulations in the United States is anything but easy. With so many deadlines and filing requirements, particularly for those living, working, or housing assets outside the United States, it’s almost impossible to keep track of everything required to stay compliant. The risk of penalty makes this process even worse; one wrong step and the IRS is ready and waiting to charge you with criminal and civil penalties that could leave you destitute or embroiled in legal proceedings for years.
Is this the most efficient way to move forward? Experts say no – the IRS’ inability to implement a one-stop shop, so to speak, for international information returns creates a chaotic, inefficient, and expensive process that provides many ways for taxpayers to make potentially hazardous wrong moves. However, as the IRS has arranged things, the most common international penalties found under Sections 6038B, 6038, and 6038D are established as deficiency procedures rather than assessable penalties, creating a web of complication through which taxpayers must wade.
The Difference Between Assessable Penalties and Deficiency Procedures
As outlined in the NFIB v. Sebelius, the difference between a penalty and a tax is not a matter of name but rather a matter of substance. A tax is an amount calculated to be owed based on the tax code and provided information by the taxpayer, while a penalty is an additional amount added to a predetermined tax liability. Penalties are generally determined in one of two ways: through summary assessment or deficiency procedures.
Penalties that can be determined through assessment procedures are largely outlined in Sections 6671 through 6720C and are made without a deficiency determination and are collected in the same manner as taxes. After a penalty assessment, a taxpayer is sent a notice of deficiency to his home address with a deadline for payment. If a payment is not made, a notice of intent to levy or a notice of tax lien will be sent. If action is still not taken and a collection due process hearing is not requested, the IRS will proceed to place a lien until payment is made or the IRS forecloses on a taxpayer’s property to cover the amounts due.
Deficiency procedures, on the other hand, occur when the IRS determines that non-compliance with a particular policy has resulted in a deficiency in tax. Deficiency actions most commonly arise out of accuracy-related penalties in Section 6662 and failure-to-file penalties in Section 6651. When one of these penalties is found to apply to a taxpayer’s situation, the IRS will issue a notice of deficiency, which will detail the tax periods involved, a record of how the deficiency was calculated, the options available, and the last day possible to petition the Tax Court.
Applicable Forms and Code Sections
There are numerous codes and forms that are involved in the determination of deficiencies and penalties for international information returns.
Form 926, Return by a U.S. Transferor of Property to a Foreign Corporation, is an information return that is required under Section 6038B for U.S. taxpayers who transfer property to foreign corporations, partnerships, or individuals who meet certain criteria therein.
Failure to file From 926 can result in several different penalties, including a penalty of 10% fair market value of the property when the exchange occurred or, in the case of a contribution, the gain on a sale that would have occurred had the property been sold at the time of the transfer, which results in a deficiency of tax. This can also lead to an accuracy-related penalty or 40% for the understatement of undisclosed foreign financial assets under Section 6662(j). Property that is not included on Form 926 can no longer be used in conducting activity in a trade or business. Penalties under Section 6662(j) are additional amounts related to an understatement of tax, a form of income tax deficiency, which thus must be determined via deficiency procedures. If the applied penalties are not paid, a notice of lien or levy may be issued.
Form 926 is due with an individual’s income tax filing in April, or October if an extension is filed, for the year the transfer occurred. The statute of limitations on the assessment of a failure-to-file penalty is three years.
Form 5471, Information Return of U.S. Persons With Respect to Certain Foreign Corporations, is an information return required under Sections 6038 and 6046 that provides details about a U.S. person’s involvement with a foreign corporation. This Form requires information like name, address, country of incorporation, undistributed earnings, balance sheet, and details about applicable transactions between the foreign corporation and the taxpayer as well as transactions between the U.S. person and any other entity either controlled or at least 10%-owned by that U.S. person. This Form is also required by those U.S. persons who own or purchase 10% or more of the stock, regardless of class, of a foreign corporation.
Failure to file Form 5471 can potentially result in a $10,000 penalty, a continuation penalty with a maximum amount of $50,000, a reduction of as much as 10% of any foreign tax credit claimed, and an additional continuation penalty of 5% per three-month period. The applicable reductions are not to exceed either the income of the foreign business in the taxable period or $10,000, whichever is greater. As with Section 6038B penalties, a potential 40% accuracy-related penalty may also apply. If these penalties are not paid as stated, the IRS will issue a notice of lien or levy.
As with Form 5471, the number of violations that may apply can result in litigation on several different fronts with somewhat inconsistent determinations, as the IRS will both summarily issue an assessment for the failure-to-file penalty and a deficiency notice regarding the reduction to foreign tax credits.
Form 8938, Statement of Specified Foreign Financial Assets, is required under Section 6038D for any taxpayer holding interest in foreign assets worth over an aggregated $50,000, including assets held by a financial institution like stocks, securities, and financial instruments as well as those not held by a financial institution. This form requires information about the asset, where it is held, and the maximum value.
Failing to file Form 8938 results in a penalty of $10,000 as well as a continuation penalty of a maximum of $50,000. As with Sections 6038 and 6038B, a 40% accuracy-related penalty may also apply for an undisclosed understatement that is not properly reported on an income tax return. And, like the other Sections described above, the same issue of both a penalty assessment and a deficiency can apply when Form 8938 isn’t properly filed. Like other Forms, Form 8938 can lead to litigation of these issues, which can be expensive and drag on for years.
The Reasonable Cause Defense
Taxpayers who forget to file, don’t realize they have to file, or do not file for any other reason are often frightened or angry when notices about payment come in the mail from the IRS. However, defenses do apply, and, as with all situations in the U.S. tax system, there’s always a chance to make a case.
A reasonable cause for failing to file can apply for omissions under Sections 6038, 6038B, or 6038D, provided the taxpayer can adequately provide information that explains why, despite ordinary prudence and care in businesses cases, proper paperwork was not provided. Predictably, there aren’t many reasons that the IRS will accept – “I forgot” is not a reasonable cause – but an inability to obtain records may be a valid excuse. Accessibility of records from other countries can vary greatly, and in cases that pertain to a spouse’s or sibling’s holdings, records may be a matter of confidentiality that cannot be breached.
Potentially Applicable Penalties and Additional Amounts Owed
Title 26, Subtitle F, Chapter 68, Subchapter B of the U.S. Code, called Assessable Penalties, gives the IRS freedom to assess additional penalties and collect them in the same manner as they would actual taxes. In the same vein, Title 26, Subtitle F, Chapter 68, Subchapter A, also known as Additions to the Tax and Additional Amounts, allows the IRS to apply penalties for those who fail to file, underpay taxes, understate income, or commit fraudulent acts when filing taxes. These amounts and forms of penalty are not uniform, but are interpreted in roughly the same way: an amount added to the balance of taxes due.
Most penalties are included in Chapter 68, but for those that are not, there is generally a reference to a particular section of the Code within Chapter 68 or a section of the Code that authorizes a penalty with a provision for the Secretary to assess. Some of these additional penalties are as follows:
- In Chapter 61 under Section 6707A(a): Per Section 6011, penalties are permitted for anyone who does not include a reportable transaction on a return in the amounts outlined in subsection (b).
- In Chapter 1 under Section 527(j)(1)(B): As outlined in subtitle F, penalties granted in this section are to be collected in accordance with the policies set in Section 6652(c).
- In Chapter 99 under Section 9707(f): Penalties allowed by the language in this section must be treated in the same way as taxes imposed by section 4980B.
- In Chapter 77 under Section 7519(f)(1): Unless otherwise stated, payments required in this section must be assessed and collected in the same way as a tax imposed by subtitle C.
- In Chapter 61 under Section 6039F(c)(1)(B): If provided demand and notice by the Secretary in the same manner as tax, any U.S. person must pay 5% of the amount of a foreign gift for each month a gift is not properly reported up to 25% of the aggregate amount of gifts.
- In Chapter 61 under Section 6043(d): For issues related to a failure to file, see section 6652(c) or section 6652(1) as applicable.
- In Chapter 61 under Section 6046(f) and Section 6046A(e): Violations in this section should be treated as outlined in sections 6679 and 7203.
- In Chapter 61 under Section 5000A(g)(1): If provided demand and notice by the Secretary except as detailed in paragraph two, penalties under this section should be assessed and collected as those under subchapter B of chapter 68.
This list serves to demonstrate that Chapter 68 is not the be all, end all of penalties, as well as how the Code deals with penalties included or summarized in other sections. There is an exception to the reliance on Chapter 68, however; Sections 6038, 6038B, and 6038D do not cross-reference anywhere and do not specify that penalties are absolutely to be assessed like a tax.
- Section 6038: This Section states that if any U.S. person fails to furnish information with respect to foreign business entities as required in the time prescribed, a penalty of $10,000 for each annual accounting period is applied. Cross-references exist to Sections 7203 in regards to provisions for penalties and Section 7701(a)(30) for the definition of a U.S. person.
- Section 6038B: This Section states that if any U.S. person fails to provide the information described in subsection (a) as stated in the regulations, a penalty equal to 10% of the fair market value of the applicable property at the time of the exchange will apply. If a contribution was made instead, gain must be recognized on the amount that would have been received had the property sold for fair market value on the date of the action.
- Section 6038D: This Section states that if any U.S. person fails to provide the information described in subsection (c) in the ways described, a $10,000 penalty will be required.
While these sections don’t cross-reference to Chapter 68, they do provide the IRS with the authority to assess the outlined penalties as if they were taxes. Section 6038(f) does make reference to Section 7203, a criminal provision that allows the failure to file, pay, or supply information to result in a misdemeanor that carries a fine of $25,000 for individuals and/or imprisonment of up to one year.
In addition to serving as outliers in regards to Chapter 68, Sections 6038, 6038B, and 6038D are also subject to deficiency procedures. As any amounts derived by these sections are not Assessable, it is actually more appropriate to consider them additional amounts under Section 6214 rather than penalties. All three of these Sections can trigger a 40% accuracy-related penalty under Section 6662 on any amount of underpayment from the understatement of foreign financial assets, adding to the amount reported on an income tax return.
It is also important to note that the forms required by these sections are intrinsically tied to income tax returns, leading to the conclusion that there should be no separation between the forms themselves and the return. Further supporting this, penalties under Section 6038D are often included on the IRS Transcripts of Account for Form 1040 rather than simply appearing on a Civil Penalty Transcript. These penalties directly affect an income tax return; Section 6038 allows for the reduction of a foreign tax credit, while Section 6038B requires the recognition of gain as if a contributed piece of property had been sold. These kinds of actions change the ways in which information on Form 1040 should be presented.
The statute of limitations also parallels a standard income tax return; Section 6051(c)(8)(A) clearly states that the time for assessment of tax imposed for any tax return or the period of time to which information relates won’t expire before three years after the date on which information is received. In essence, this details how connected these forms are – after all, many of the same policies apply.
The Tax Court should, in theory, have jurisdiction over international penalties due to the cases over which the Tax Court is permitted to preside, but the Court has historically abstained from resolving conflicts related to deficiency proceedings. For example, in Smith v. Commissioner, the Tax Court decided that it did not have adequate jurisdiction to evaluate a Section 6707A penalty.
In determining the relevance of this, it is worth considering the differences between Section 6707A and Sections 6038, 6038B, and 6038D penalties. In the aforementioned case, the Tax Court found that penalties under Section 6707A are assessable penalties and while some assessable penalties are included in deficiency proceedings, there are no obligations to include these particular penalties in such a procedure. In this particular ruling, the Court stated that it has never before exercised a judgment in which assessable penalties did not relate to deficiency procedures. Section 6707A’s statute of limitations varies as well; no reference to tax returns or tax periods is made. This implies that only the assessment of tax associated with a particular transaction is important here, as opposed to tax in any specific period or on any one return. Further adding fuel to this fire, accuracy-related penalties do not arise from Section 6707A violations.
Collection Due Process Proceedings Challenges in the Current System
If we accept the premise that Section 6038, 6038B, and 6038D violations are assessable rather than subject to deficiency proceedings, this raises questions in a collections due process (CDP) hearing.
The ability to challenge summarily assessed penalties is quite limited in a CDP hearing, extending only to a situation in which a taxpayer did not receive a statutory notice of a deficiency for the liability in question or was otherwise unable to dispute the penalty. Thus, if a taxpayer fails to file Form 5471 and in response receives a summarily assessable penalty and an accompanying notice of deficiency, there may be no issue to dispute because a notice was sent and there was previously ample opportunity to debate said penalty. As such, there may be no stance to be taken if any of these penalties accompany a deficiency procedure.
Sections 6320 and 6330 in particular may give rise to CDP hearing rights due to notices of lien and levy, but the terms of this entitle a taxpayer to only a single hearing with respect to the taxable period. This limitation to a single hearing can also preclude arguments related to penalties if a hearing has already been held for the same tax year for res judicata, or other issues that have already been closed.
However, there may be potential here – res judicata could potentially also be used to argue that the IRS can’t assess more penalties in a period once a hearing has been completed and tax issues for that year have been settled. In this case, the taxpayer could argue that Appeals should conduct a de novo review complete with a notice of determination, after which he can claim that the determination is final. However, the IRS could state that there is no allowance for a second hearing and that the taxpayer can instead challenge by paying the amount requested and then suing for a refund.
It is also interesting to note that the IRS has previously issued regulations that may conflict with the concept of a single hearing. These rules allow for multiple hearings for different kinds of taxes or when the tax has changed and the circumstances of a hearing are different. However, as this is directly contradictory, counting on this strategy may not pay off.
Collateral Estoppel Complications
As noted, there are concerns related to res judicata that taxpayers may need to keep in mind. However, there may be additional issues to note related to collateral estoppel. Even if res judicata does not fully stand in the way of litigating a tax year in which previous issues have been resolved, issue preclusion, more formally known as collateral estoppel, may come into play. Collateral estoppel (CE), known in modern parlance as issue preclusion, is a common law estoppel doctrine that prevents a person from relitigating an issue. One summary is that, “once a court has decided an issue of fact or law necessary to its judgment, that decision … preclude[s] relitigation of the issue in a suit on a different cause of action involving a party to the first case.” See, “San Remo Hotel, L.P. v. City and County of San Francisco, Cal., 545 U.S. 323 (2005). The rationale behind issue preclusion is the prevention of legal harassment and the prevention of overuse or abuse of judicial resources. See, Larson, Aaron (3 November 2017). “Issue Preclusion and Claim Preclusion: How Prior Litigation Can Block Your Claim”
For example, if a penalty related to a failure to file Form 8938 is assessed in addition to an accuracy-related penalty, the taxpayer likely would use the same reasonable cause defense in response to both. If the reasonable cause defense is denied by the Tax Court in the case of disputing one half of the problem, collateral estoppel may prevent this course of reasoning from being raised again. Thus, issues need to be litigated together or potentially not at all.
Difficulties may also arise when the same issue leads to the IRS simultaneously levying a penalty while litigating the same issue in Tax Court. This is both distracting and can put undue hardship on the taxpayer as one of these will likely take precedence over the other. If this occurs, the taxpayer and his representative may want to file a motion under Rule 55 to keep the IRS from moving forward with assessment and collection. This can effectively reallocate the taxpayer’s time to make sure both issues get fair attention.
Considerations Regarding Statute of Limitations
In general, the statute of limitations for assessing tax is three years. The IRS has a separate statute of limitations for international information returns, but in considering these, taxpayers may have questions.
Is Filing the Correct Form Necessary?
First, taxpayers may wonder whether requisite Forms need to be filed at all, or whether simply providing the information requested is adequate. Section 6501(c)(8)(A) states that the statute of limitations begins when the information required to be reported is received – which differs from other statutes that specifically mention filing a return. This lends credence to the idea that the rules in Sections 6038, 6038B, and 6038D can be met without actually filing the Forms outlined therein. This is particularly important for Section 6038D because this Section requires information that is duplicated across several Forms, providing grounds to argue that if an FBAR and Schedule B are filed, Form 8938 may not actually be required for the statute of limitations to begin. There may also be a distinction here to note in Beard v. Commissioner. This case stands for the idea that filing at all constitutes a valid return, even if the correct form is not used. This, in conjunction with Section 6501(c)(8)(A), is important to know as otherwise, the statute of limitations would essentially be open indefinitely until Forms 926, 5471, or 8938 are submitted.
While the arguments behind this situation are logically sound, no one has yet successfully argued this and had it accepted by the Court. As such, it is advised to file all returns as required and potentially make this argument only if something should be missed in the course of tax preparation.
What Is the True Statute of Limitations?
While the statute of limitations language appears to apply to Sections 6038, 6038B, and 6038D on the surface, a deeper reading may imply differently. Section 6501(c)(8)(A) contains language that says “…the time for assessment of any tax imposed by this title with respect to any tax return, event, or period…” but the penalties imposed by these Sections are not actually a form of tax. Of course, it could be argued that “tax” here is used as a colloquial reference to tax, interest, fees, and penalties, but this is not actually clearly stated.
If Section 6501(c)(8) does not apply, the catchall five-year statute stated in Section 2462 of the U.S. Code may be argued in its place. Intended to prevent taxpayers from undue hardship in areas in which a statute of limitations is unclear, this part of the Code is explicitly written to cover just about any potentially vague situation.
Again, it is important here to point out that this logic has not yet been argued, and may or may not hold up in litigation.
Navigating the Challenges of International Information Returns
The current system for penalties related to international information returns is inefficient at best and costly and complicated at worst. With so many convoluted and complex policies related to assessing penalties and determining amounts due as well as the roadblocks in place for those attempting to fight back against the IRS, few taxpayers are in a position to make headway if mistakes are made.
As always, the more accurate taxpayers are in initial filings, the better. Due to the circumstances surrounding these penalties, it’s always better to prevent potential problems than to have to find a way to navigate them in the future.