JOURNAL OF INTERNATIONAL TAXATION26

IRS International Penalty

Pain Relief fromUndisclosed Offshore

Holdings

INTERNATIONAL PENALTIES l MARCH 2014 l JOURNAL OF INTERNATIONAL TAXATION 27

Taxpayers, as well as many tax practitioners,would be hard-pressed to find other areas ofthe tax law that are more complex than thespecial tax regimes and reporting obligations

applicable to U.S. persons with foreign holdings or activities. In addition to sheer

complexity, the level of penalties for noncom-pliance with international information return

reporting requirements can be quite steep, if not draconian. In some instances, espe-

cially when unreported foreign bankaccounts are involved or the governmentasserts that a compliance failure is willful, thetotal level of penalties that can be imposedcan be well in excess of the value of the

unreported accounts or assets. This articlefocuses on helping clients seek relief fromthese civil penalties and, specifically, when

reasonable cause will justify this relief.1

Procedure and Strategy

When can reasonable cause justify penalty relief?

PA U L M A R C O T T E , J R .

International Civil Penalties for Late FilingsA detailed discussion of the reportingrequirements for U.S. persons with for-eign accounts or activities and relatedpenalties for noncompliance is beyondthe scope of this article. However, it ishelpful to have a basic understandingof some of the more significant penal-ties that can arise in this area in terms oftheir potential sting from a financialperspective. Before looking at incometax-type civil penalties, a brief reviewof the penalty structure for non-crimi-nal v iolat ions of the foreign bankaccount reporting (FBAR) rules is inorder since FBAR violations occur quitefrequently in tandem with tax noncom-pliance related to offshore holdings.2

The FBAR information is submittedon Treasury Form TD F 90-22.1(Report of Foreign Bank and FinancialAccounts) and is due June 30 of eachyear with no provision for an exten-sion.3 Penalties for noncompliance withthe FBAR requirements are quite severe.Prior to the American Jobs Creation Actof 2004 (AJCA), there was no civilpenalty for an innocent or non-willfulfailure to file an FBAR.4 This means thatas to FBAR filings for 2003 and earlieryears, no civil penalty applied underpre-AJCA law absent a showing of will-fulness. After the AJCA, for FBARs dueafter June 29, 2005, a non-willful viola-tion can result in a penalty not exceed-ing $10,000 per violation, subject to areasonable cause exception discussedbelow.5 Multiple years of noncompli-ance can result in total penalties thatcan easily consume or exceed the entireaccount balance.6

Distributions from, and transfers to,a foreign trust are reported on IRSForm 3520 (Annual Return to ReportTransactions with Foreign Trusts andReceipt of Certain Foreign Gifts), whichis also used to report the receipt of largegifts from non-U.S. persons. The initial

penalty for failure to file this return fora distribution from a foreign trust ortransfer to a foreign trust is the greaterof $10,000 or 35% of the amount of thedistribution or transfer, with furtherescalating penalties if noncompliancecontinues after notice from the IRS.7

For a failure to report receipt of a largeforeign gift, the penalty is 5% of theamount of the foreign gift for eachmonth that a reporting failure contin-ues up to a maximum of 25%.8 Form3520-A (Annual Information Return ofForeign Trust with a U.S. Owner) isused by a foreign trust with one or moreU.S. persons as deemed owners underthe foreign grantor trust rules to satis-fy the reporting requirements underSection 6048(b). If such a foreign trustfails to timely file this return or it isincomplete, any U.S. person that is adeemed owner is subject to a penalty ofthe greater of $10,000 or 5% of the val-ue of the trust assets (before any liabil-it ies) deemed owned by that U.S.person, determined as of the end of thetax year.9 These penalties can be waivedor avoided if the compliance failure isshown to be due to reasonable causeand not willful neglect.10

The Chief Counsel has indicated thatwhen an individual taxpayer is delin-quent in making these types of foreigntrust filings and dies, the decedent’sestate steps into the shoes of the dece-dent, with the result that the estatebecomes responsible for the penalties.11

The Chief Counsel does distinguishbetween the “initial” penalties underSections 6677 (failure to file informa-tion with respect to certain foreigntrusts), which carry over automaticallyfrom the decedent to the estate, and the“additional” penalties that arise whenthe executor is late in filing the delin-quent Form 3520 or 3520-A. In the lat-ter situation, a case for reasonable causemay be established if, for example, theexecutor can show that the fiduciary dis-covered the foreign trust only recently.

Reporting of interests in, or transac-tions with, a foreign corporation, includ-ing a controlled foreign corporation(CFC), is usually made on IRS Form 5471(Information Return of U.S. Persons WithRespect to Certain Foreign Corpora-

tions), and for a transfer of property to aforeign corporation, on Form 926(Return by a U.S. Transferor of Propertyto a Foreign Corporation). As an exampleof the steep penalty structure for non-compliance with these corporate infor-mation returns, the failure to file Form5471, or just filing an incomplete form,results in an initial $10,000 penalty. Sub-sequent failure to file a complete formmore than 90 days after IRS notice gener-ates an additional $10,000 penalty each30 days up to $50,000.12 A penalty of 10%of the value of property transferred to aforeign corporation not reported timelyon Form 926 is imposed up to a maxi-mum of $100,000 (there is no maximumfor an intentional disregard of the filingrequirement).13 Reasonable cause is anexcuse for avoiding or abating both ofthese penalties.14 The penalties, like manyothers involving international informa-tion returns, may be imposed even if noincome tax liability is due with respect tothe particular holding that triggers areporting obligation, when a form is filedbut is incomplete, or even when the sub-ject entity is inactive.15

In addition to taxpayers with inter-ests in foreign corporations, reportingmay be required when interests are heldin foreign entities treated as partner-ships for U.S. tax purposes (see IRSForm 8865 (Return of U.S. PersonsWith Respect to Certain Foreign Part-nerships)), as well as when an interestis held in a single-member foreign enti-ty, such as an LLC equivalent that electsto be treated as a disregarded entity forU.S. tax purposes (IRS Form 8858(Information Return of U.S. PersonsWith Respect to Foreign DisregardedEntities)). These international informa-tion return filing requirements contin-ue to expand.16

Assessment Procedures;Taxpayer Ability to ChallengePenalty Before PaymentTypically, the penalties for late-filed orincomplete information-type returns, aswell as FBARs, will turn up in the con-text of an examination of the taxpayer’sbasic income tax return (Form 1040(U.S. Individual Income Tax Return) or

JOURNAL OF INTERNATIONAL TAXATION l MARCH 2014 l INTERNATIONAL PENALTIES 28

PAUL MARCOTTE, JR., is a partner in the Bethesda,Maryland, law firm of Paley Rothman and chairs the firm’sTax Department. He is also the incoming Chair of theMaryland State Bar Association Section of Taxation. Hehas written previously for the JOURNAL. This article is pub-lished with the permission of the Maryland State Bar Asso-ciation’s Maryland Bar Journal, in which an earlier versionappeared.

1120 (U.S. Corporation Income TaxReturn)) and be proposed by the rev-enue agent handling the examination.However, IRS service centers can and doissue computer-generated penaltynotices when certain types of these fil-ings arrive after the due date.17

Many international tax-type penaltiesare “assessable penalties” because they arenot subject to deficiency procedures thattypically apply to income tax returns, sothat payment is required before judicialredress is available.18 As a result, a majorconcern until relatively recently was thata taxpayer did not have the right or abil-ity to challenge an assessment of one ofthese international penalties prior toactually paying it. The IRS now providesfor formal prepayment review of inter-national penalties by its Appeals Officeunder rules that were added to the Inter-nal Revenue Manual (IRM) in 2010.19

For Category 1 taxpayers (those withassets of $100 million or more), Appealsis required to render a decision within120 days of receiving the case underaccelerated procedures for large taxpay-ers.20 If a taxpayer is unsuccessful at theadministrative level (IRS Appeals), thereis no right to further contest the penaltyin court before payment is made.

As discussed above, enforcementauthority of penalties for FBAR viola-tions has been delegated to the Service.The IRS has established procedures forpre-assessment consideration of FBARpenalties by the Appeals office, whichare also in the IRM.21 These rules alsoprovide that Appeals can consider cas-es post-assessment.

IRS Position/Guidance—Reasonable Cause ExceptionThe IRS includes the basic rules andunderlying policies for when the IRSwill assert penalties. The basic IRS pol-icy and procedure behind the imposi-tion of penalties are reflected in PolicyStatement 20-1.22 The IRM says that“[p]enalties exist to encourage volun-tary compliance by supporting thestandards of behavior expected by theInternal Revenue Code.”23 The IRMalso says that “[p]enalties advance themission of the Service when they

INTERNATIONAL PENALTIES l MARCH 2014 l JOURNAL OF INTERNATIONAL TAXATION 29

1This article does not discuss criminal sanctionsor a filing failure that may be considered willfulso that a different mitigation strategy may beadvisable. That strategy might entail advising aclient to make a valid and timely disclosure underthe ongoing IRS offshore voluntary disclosureinitiative (OVDI).

2Although the FBAR reporting requirements ariseunder a nontax statute (see note 3, infra), undera current delegation order by the Financial CrimesEnforcement Network (FinCEN), IRS administersFBAR enforcement.

3The Currency and Foreign Transactions Report-ing Act (originally the Bank Secrecy Act), 31U.S.C. section 5314 and related implementingregulation 31 C.F.R. section 1010.350, requirethat U.S. persons make an annual report sepa-rate from their tax return disclosing the exis-tence of foreign accounts. Reporting is requiredfor a financial interest in or signature authorityover a foreign account if the aggregate balanceof all such accounts at any time during the yearexceeds $10,000. See also 31 C.F.R. section1010.306(c).

4P.L. 108-357, October 22, 2004.

531 U.S.C. section 5321(a)(5), as amended by P.L.108-357. If the taxpayer intentionally fails to filean FBAR, the civil penalty is the greater of$100,000 or one-half the account balance foreach year’s violation, in addition to any criminalsanction.

6This is possible because the penalty is appliedper account that is not reported, and the statuteof limitations for assessing civil FBAR penalties issix years under 31 U.S.C. section 5321(b)(1). Thus,if an FBAR is not timely filed for several years,and more than one account is not disclosed ineach year, the penalty will be applied to eachaccount for each year, subject to mitigation guide-lines discussed below. Exposure is greater whenthe nondisclosure is willful.

7Section 6677(a).

8Section 6039F(c). IRS is also permitted to deter-mine whether the gift is taxable for income taxpurposes.

9Sections 6677(b) and (c)(2). See also Notice 97-34, 1997-1 CB 422, as to statements that atrustee of a foreign trust is required to give to aU.S. beneficiary.

10Sections 6677(d) and 6039F(c)(2).

11CCA 201208028.

12Sections 6038(b) and 6679(a). As an additionalpenalty, foreign tax credits can be reduced. SeeSection 6038(c).

13Section 6038B(c).

14Sections 6038(c)(4)(B) and 6679(a)(1). See alsoReg. 1.6038-2(k)(3)(ii) on reasonable cause forForm 5471 purposes. This Regulation also dis-cusses when substantial compliance may excusea penalty for a return that is missing informationor otherwise deemed incomplete.

encourage voluntary compliance….[C]ompliance is achieved when a tax-payer makes a good faith effort to meetthe tax obligations [and reportingrequirements] defined by the Code.”24

As discussed, many of the Code pro-visions authorizing the imposition ofpenalties for late or delinquent interna-tional-type filings recognize that acompliance failure “due to reasonablecause and not due to willful neglect” isan excuse to avoid assessment or to per-mit penalties to be abated. Section6677(d) says that the penalty for failureto file information returns such as Form3520 (used to report distributions froma foreign trust or receipt of large foreigngifts) will not be imposed when the fil-ing failure is due to reasonable causeand not willful neglect. Reg. 1.6038-2(k)(3) allows reasonable cause as aground to avoid penalties for failure totimely furnish information returnsrelated to foreign corporations or part-nerships, such as Form 5471, or whenthe filings are deemed incomplete. Sec-tion 6038D(g) provides a similar rea-sonable cause exception for the latefiling of Form 8938 (Statement of Spec-ified Foreign Financial Assets).25

The Regulations indicate what theIRS generally deems “reasonable cause”under late-filing and payment penaltyprovisions:

(c) Showing of reasonable cause.

(1)…. If the taxpayer exercised ordi-nary business care and prudence andwas nevertheless unable to file thereturn within the prescribed time,then the delay is due to a reasonablecause. A failure to pay will be consid-ered to be due to reasonable cause tothe extent that the taxpayer has madea satisfactory showing that he exer-cised ordinary business care and pru-dence in providing for payment of histax liability and was neverthelesseither unable to pay the tax or wouldsuffer an undue hardship (asdescribed in [Reg.] 1.6161-1(b)] if hepaid on the due date. In determiningwhether the taxpayer was unable topay the tax in spite of the exercise ofordinary business care and prudencein providing for payment of his taxliability, consideration will be givento all the facts and circumstances ofthe taxpayer’s financial situation.26

The IRM says that “[t]he ordinarybusiness care and prudence standardrequires that taxpayers make reasonableefforts to determine their tax obliga-t ions…. Reasonable cause may beestablished if the taxpayer shows igno-rance of the law in conjunction withother facts and circumstances.”27 TheIRM says that the level of complexity ofa tax or compliance issue is a factor thatshould be considered in evaluating rea-sonable cause based on ignorance of thelaw.28 The IRM lists circumstances thatmay give rise to reasonable cause toexcuse the imposition of penalties, suchas death or serious illness, natural disas-ters, and undue hardship.29

The Chief Counsel has stated that thesame criteria used to evaluate whetherpenalties under Section 6651 for a late-filed corporate return (Form 1120)should be excused for reasonable cause

also generally apply to the Section 6038penalty for a late-filed related interna-tional tax information return used toreport an interest in a foreign corpora-tion (Form 5471), since the Code penal-ty provisions use similar language andshould be construed consistently.30 Thesame rationale should extend to penal-ties under other Code provisions relat-ing to late fi ling of internationalinformation returns by individuals.

FBAR Reasonable Cause Standards and Mitigation GuidelinesThe requirement to file an FBAR report-ing foreign accounts originates under afederal statute other than the InternalRevenue Code, so the question is whetherthe same reasonable cause standards thatapply to income tax also apply to FBAR-

related penalties for non-willful viola-tions. The FBAR statute says in relevantpart that no penalty will be imposed fornon-willful violations when (1) reason-able cause exists, and (2) the “amount ofthe transaction or balance in the accountat the time of the transaction was proper-ly reported.”31 The second part of thestatute requiring proper reporting leavessome room for interpretation, but the IRSappears flexible in stating that the accountbalance is considered “properly reported”if it is ultimately reported on a delinquentFBAR filed with an examiner.32

The IRS has indicated that generalnegligence principles apply in deter-mining whether FBAR penalties fornon-wil lful v iolat ions should beimposed, including the standards appli-cable under Reg. 1.6664-4. Althoughthis is an income tax Regulation, theIRS says that these rules may be helpful

in determining whether an FBAR viola-tion was due to reasonable cause.33

Since the statutory FBAR penaltiesare maximums, the IRS has developedguidelines for agents conducting FBARexaminations, as they are to exercisediscretion and not apply the statutorymaximum automatically whenever anon-willful violation occurs.34 Theguidelines for violations occurring afterOctober 22, 2004, apply when (1) thetaxpayer has no prior history of crimi-nal tax or FBAR violations; (2) all fundsin the foreign accounts are from legal-source income; (3) the taxpayer hascooperated; and (4) the civil fraudpenalty has not been asserted withrespect to any income tax underreport-ing associated with the accounts. Whena reporting failure is non-willful, if themaximum aggregate balance in allaccounts not properly disclosed does

JOURNAL OF INTERNATIONAL TAXATION l MARCH 2014 l INTERNATIONAL PENALTIES 30

Penalties for international information returns may be

imposed even if no incometax is due for the holding thattriggers a reporting obligation

not exceed $50,000 (Level I—NW), theguideline penalty is $500 for each unre-ported account, not to exceed a totalpenalty of $5,000 for all violations. Anintermediate guideline penalty (LevelII—NW), when maximum balancesexceed $50,000 but not $250,000, is$5,000 for each unreported account, notto exceed 10% of the maximum accountbalance during the year. If the monetaryaccount thresholds under these initialguideline levels are exceeded (LevelIII—NW), the guidelines indicate thatthe recommended penalty is the statu-tory maximum.

Taxpayers with unreported offshoreaccounts or other holdings may consid-er penalty relief under the current IRSoffshore voluntary disclosure initiative(OVDI), which was reopened in Janu-ary 2012 with no set deadline.35 TheOVDI program (Continued on page 61)

INTERNATIONAL PENALTIES l MARCH 2014 l JOURNAL OF INTERNATIONAL TAXATION 31

15For a simplified filing procedure for dormant for-eign corporations, see Rev. Proc. 92-70, 1992-2CB 435.

16See Marcotte, “Update on FBARs, OVDI, FATCA,and Emerging Trends in Cross-Border Tax Enforce-ment,” 24 JOIT 40 (November 2013), which dis-cusses the recent FATCA reporting requirementsfor individuals in IRS Form 8938 (Statement ofSpecified Foreign Financial Assets) and relatedpenalties for noncompliance.

17In fall 2008, the IRS announced in a notice on itswebsite that penalties for late or incomplete 5471filings would be assessed automatically begin-ning January 1, 2009.

18See Section 6677(e) on the penalty for late-filedForms 5471 and CCA 201226028 on the penaltyfor late-filed Forms 8938 as to unavailability ofdeficiency procedures. See also CCA 201150029,which indicates that penalties under Section 6677are not a “divisible” tax, with the result that theentire penalty must be paid before a judicial chal-lenge can be undertaken. Penalties related toFBARs do not arise under the Internal RevenueCode and so are not subject to income tax defi-ciency procedures. See Williams, 131 TC 54(2008).

19IRM section 8.11.5.1.

20IRM section 8.11.5.2. The accelerated proceduresalso apply to other taxpayers that are designatedCategory 1 by mutual decision of IRS Complianceand Appeals.

21IRM section 8.11.6.

22IRM section 1.2.20.11.

23IRM section 20.1.1.2(1), which is the beginningof the “IRS Penalty Handbook” that serves as acompilation of official guidance to IRS personnelon imposition of penalties.

24IRM sections 20.1.1.2.1(5) and (6).

25The last sentence of Section 6038D(g) says thatreasonable cause does not exist when the reasonfor a compliance failure is that a foreign jurisdic-tion would impose a penalty (including criminalsanctions) for disclosing information required bythe Code.

26Regs. 301.6651-1(c)(1) and 301.6656-1.

27IRM section 20.1.1.3.2.2.6.

28IRM section 20.1.1.3.2.2.6(2)(e).

29IRM section 20.1.1.3.2.2.1 et seq.

30CCA 200748006.

3131 U.S.C. section 5321(ii).

32IRM section 4.26.16.4.4(2).

33IRM section 4.26.16.4.3.1(3).

34See “Normal FBAR Penalty Mitigation Guidelinesfor Violations Occurring After October 22, 2004,”IRM section 4.26.16.4, Exhibit 4.26.16-2.

35See Baker & McKenzie Voluntary DisclosureSteering Committee, “IRS Preliminary Guid-ance for Post-September 9, 2011, Voluntary Dis-closures: OVDI 2011+?,” 23 JOIT 59 (March2012).

(Continued from page 31) may give tax-payers more certainty as to the overalllevel of penalties and possibly a lowerlevel than otherwise would be avail-able.36 Alternatively, a taxpayer maywant to come in under OVDI to reducethe risk of more severe consequences,such as criminal prosecution, but “optout” of the offered penalty frameworkand assert reasonable cause, so that no(or very little) penalties should apply.

Judicial Authorities—Reasonable Cause Based on Complexity of the LawWhile ignorance of the law is usuallynot an excuse in most areas of the law,it can give rise to reasonable causeunder the tax law where other factorsthat the IRM and the courts recognizeare present.37 As a relatively recentexample, at least regarding internation-al tax filings, Congdon is instructive.38

The individual taxpayer owned (direct-ly and indirectly) offshore entitiesengaged in helping clients set up off-shore trusts or other entities. As a resultof an audit of his personal return, theIRS determined that the original Form5471 included with his return was sub-stantially incomplete. The governmentsued the taxpayer seeking to reduce thepenalties to judgment. In denying thegovernment’s motion for summaryjudgment, the court held that there wasa genuine dispute as to whether therewas reasonable cause to excuse assess-ment of penalties for filing an incom-plete Form 5471.

The taxpayer alleged that he misun-derstood his filing category status andthat including information as to thesubject holdings on his Form 1040 (asopposed to reflecting them on Form5471) was sufficient and he did not omitany income on his return. He also indi-cated that he spent approximately 200hours trying to fill out these forms. Thecourt said:

The IRS gives some examples ofwhat might be considered reasonablecause…. Ignorance of the law, in and

of itself, does not constitute reason-able cause…. However, reasonablecause may be established if the tax-payer shows ignorance of the law inconjunction with other facts and cir-cumstances. Some factors to be con-sidered include the following: thetaxpayer’s education, if the taxpayerhas been previously subject to thetax, if the taxpayer has been penal-ized before, if there were recentchanges in the tax forms or lawwhich a taxpayer could not reason-ably be expected to know, and thelevel of complexity of a tax or com-pliance issue.

The Court finds that there is a gen-uine dispute regarding whetherPlaintiff acted with ordinary busi-ness care and prudence. Althoughignorance of the law alone is not suf-ficient to constitute reasonable cause,Plaintiff also alleges other factorssuch as his inexperience in tax mat-ters, and the complexity of the areaof law. Combined, those factorscould be found by the finder of factto const itute reasonable cause.Although Plaintiff has obtained hisMaster’s in Business Administration,he had little to no instruction in thearea of accounting, tax law, orfinances…. Plaintiff had never beenpenalized for a violation of section6038 prior to this occasion. Finally,Plaintiff paid the correct amount oftax and disclosed all the information,albeit on the wrong form…. Thesefacts illustrate that a genuine issue offact exists regarding whether Plaintiffacted with ordinary business careand prudence, and therefore,whether Plaintiff had reasonablecause for his failure to file a substan-tially complete Form 5471.

A similar result can arise when a tax-payer’s situation or facts are complex.Dillin, 56 TC 228 (1971), involved a for-mer U.S. citizen and his wife who hadbeen living in Texas and domiciledthere prior to the tax years in question.In 1958, the taxpayer rendered serviceslocally there and was to receive pay-ment over three years beginning in1963. Shortly before receiving the firstpayment, the taxpayer renounced hisU.S. citizenship and he and his wifetook up residence in the Bahamas, withthe wife retaining her U.S. citizenship.The taxpayer husband erroneouslybelieved that by becoming a nonresi-

dent alien (NRA) and using the cashmethod of accounting, his receipt of thedeferred compensat ion paymentswould not be taxable. The Tax Courtfound that the payments to the husbandwere taxable on receipt, since they wereconsidered U.S. source. In addition, thetaxpayer’s wife was held subject to taxon half of that income under Texascommunity property rules. However,the court refused to uphold the imposi-tion of failure-to-file and negligencepenalties due to the complexity of ques-tions of law and fact.

Practice note. For individuals whohave recently emigrated to the UnitedStates and obtained permanent resi-dent status, or who have been natural-ized citizens for just a short time, thepotential for compliance failures is notunusual if they continue to maintainholdings in their home country or else-where outside the United States. Thisis quite common when these personscome from countries that do not taxtheir citizens on a worldwide basis. Inthese instances, when the IRS assertspenalties for late-filed informationreturns or FBARs, practitioners shouldconsider whether reasonable cause canbe asserted based on ignorance ofthese rather specialized tax rules byquite innocent newcomers to the Unit-ed States.

Judicial Authorities—When Is Reliance on ProfessionalAdvisors “Reasonable Cause”?In the seminal penalty case of Boyle, 469U.S. 241 (1985), the Supreme Courtmade the following observation as tothe IRS official guidance and in partic-ular when penalties can be excusedwhere a taxpayer relies on a profession-al advisor:

The administrative regulations andpractices exempt late filings from thepenalty when the tardiness resultsfrom postal delays, illness, and otherfactors largely beyond the taxpayer’scontrol…. The principle underlyingthe IRS regulations and practices—that a taxpayer should not be penal-ized for circumstances beyond hiscontrol—already recognizes a range

INTERNATIONAL PENALTIES l MARCH 2014 l JOURNAL OF INTERNATIONAL TAXATION 61

International Penalties

of exceptions which there is no rea-son for us to pass on today. This prin-ciple might well cover a filing default bya taxpayer who relied on an attorney oraccountant because the taxpayer was, forsome reason, incapable by objective stan-dards of meeting the criteria of “ordinarybusiness care and prudence.” [Internalcitations omitted, emphasis added.]

The Supreme Court’s decision inBoyle has been cited in numerous casesfor the proposition that reliance on anadvisor constitutes reasonable causeeven though, under the facts in Boyle, theCourt concluded that an executor couldnot rely on his counsel for failure to meetan estate tax filing deadline since no spe-cial training was required to ascertainwhen a return was due.39 In NeonatologyAssociates, P.A., 115 TC 43 (2000), aff ’d299 F.3d 221 (CA-3, 2002), the Tax Court

indicated that to qualify for relief basedon reliance on a tax advisor, the taxpay-er must show that (1) the advisor was acompetent professional; (2) the advisorwas provided with all necessary infor-mation; and (3) the taxpayer reasonablyrelied on the advisor in good faith.

Some courts continue to distinguishbetween a professional advising a clientas to a deadline for a tax filing, which isviewed as not requiring any specializedknowledge, and the more basic issue asto whether a return is due in the firstplace, although the judicial decisionsare not uniform.40 Also, the IRS, in Reg-ulations under Section 6664(c) (thereasonable cause exception for accura-cy related penalties), as well as recentjudicial authorities, require the tax advi-sor to be independent and not a pro-moter or otherwise conflicted.41 At thesame time, a taxpayer is generally notrequired to challenge or second-guessadvice from a competent advisor.42

As discussed above, a consistent lineof cases has refused to impose penaltieswhen there has been good faith relianceon a professional tax advisor or expert.A good example of how reasonablecause based on reliance of a profession-al adviser applies in this area is a recentfederal district court decision, James,110 AFTR2d 2012-5587 (DC FL, 2012)(unpublished), denying the governmentsummary judgment.

The taxpayer was a physician whoset up an offshore trust for quite legiti-mate non-tax-avoidance purposes (i.e.,asset protection against possible futuremalpractice claims). He failed to fileForm 3520 reporting the trust for sever-al years and was assessed over $500,000in late-filing penalties, which he paidand filed a refund action against thegovernment to recover. As grounds forthe refund, he asserted reasonable causebased on his accountant’s failure toadvise him of the filing requirement.The facts in the opinion indicate thatthe accountant was fully familiar withthe trust, had seen the trust documen-tation, and had discussed the trust fromtime to time with Dr. James. The dis-trict court highlighted that in prepar-ing Dr. James’ personal return, theaccountant answered “no” to the ques-

JOURNAL OF INTERNATIONAL TAXATION l MARCH 2014 l INTERNATIONAL PENALTIES 62

36See note 16, supra.

37See IRM section 20.1.1.3.2.2.6.

38108 AFTR2d 2011-6340 (DC Tex., 2011), report andrecommendation adopted 108 AFTR2d 2011-6343(DC TX., 2011).

39See Estate of La Meres, 98 TC 294 (1992); Sim-Air U.S.A Ltd., 98 TC 187 (1992); Colton, TCM1995-275.

40See Knappe, 713 F.3d 1164 (CA-9, 2013) (execu-tor of estate relied on erroneous advice of CPAthat a 12-month extension of due date for estatetax return was possible; court distinguishedSupreme Court’s holding in Boyle—tax filingdeadlines are not substantive issues under thetax law where a taxpayer can rely on advice of aprofessional, since obligation to file a return is notdelegable); see also Baccei, 632 F.3d 1140 (CA-9,2011) (taxpayer could not rely on CPA’s erroneousadvice as to extension to pay estate tax). Cf.Estate of Lee, TCM 2009-84 (reasonable causefound where executor relied on attorney’s advicethat a second six-month extension to file anestate tax return could be granted).

41See Reg. 1.6664-4(c); Canal Corp., 135 TC 199(2010); Paschall, 137 TC 8 (2011).

42See Boyle, discussed above. The rationale is thatto require otherwise would defeat the purposeof seeking tax advice in the first place.

JOITMarch 2014

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House AD

tion on Form 1040, Schedule B (Interestand Ordinary Dividends)—“did youreceive a distribution from, or were youthe grantor of, or transferor to, a foreigntrust?” The form says that if the answeris “yes,” “you may have to file Form3520.” The court indicated that inanswering “no” to this question, theaccountant, by preparing the return,could be construed as advising Dr.James that Form 3520 was not required.

The government argued that Dr. James(1) did not rely reasonably rely on theaccountant’s advice, and (2) had improp-erly delegated the responsibility to fileForm 3520 to his accountant. The courtnever reached the merits of these argu-ments, instead denying the government’smotion for summary judgment and hold-ing that there was a genuine issue of mate-rial fact as to what advice the accountantprovided and whether Dr. James had rea-sonably relied on that advice.

An earlier Tax Court decision, Hud-son, TCM 1992-91, involved a Canadiannational who obtained permanent res-ident status in the United States, but

failed to withhold under Section 1441on alimony payments to two formerNRA spouses and interest paid on aloan from a Canadian lender that hadnot claimed exemption from withhold-ing. Although the Tax Court upheld thetax withholding assessment, it refusedto allow penalties for negligence andfailure to file and make tax depositsbecause the taxpayer was a relative new-comer not familiar with the U.S. tax sys-tem and, more importantly, because thetaxpayer’s accountant testified in opencourt that he was aware of the pay-ments, but did not advise the taxpayerthat any withholding was required.

To assert a claim of reliance on anadvisor, the taxpayer must prove that itactually received advice on a substan-tive tax issue and relied on that advicein the first place. New York GuangdongFinance, Inc., TCM 2008-62, aff ’d 588F.3d 889 (CA-5, 2009), is a case wherethat was not shown. Penalties wereimposed for late filing of Form 1042(Annual Withholding Tax Return forU.S. Source Income of Foreign Persons)

to report withholding tax on interestpaid under cross-border loans withChinese government-controlled foreignaffiliates of the U.S. taxpayer. The tax-payer claimed that it relied on advice ofa former officer (also a CPA) that theinterest payments were exempt bytreaty, but the officer appears to havegiven no specific advice that Form 1042did not need to be filed. It did not helpthat the relevant Regulations requiredForm 1042 to be filed even when pay-ments are exempt from withholding.

In CCA 200645023, the IRS indicat-ed that there was no reasonable causeto excuse a corporate parent’s late-filedForm 5741 for its subsidiaries when theparent failed to follow the advice of itsown professional advisor that the formwas required.

Practice note. The Service routine-ly scrutinizes claims for penalty reliefrelated to delinquent internationalinformation returns when reliance on atax advisor is asserted as the ground forreasonable cause. In particular, the Serv-ice demands proof that the advisorknew of the undisclosed account oractivity for which a return was not filedtimely. This often results in the taxpay-er blaming the advisor or return prepar-er, with the advisor/preparer in turnclaiming that the taxpayer never dis-closed the account or holding in the firstplace. In many situations, the advisor orpreparer will not cooperate with the tax-payer in providing an affidavit to theService to establish reasonable causeabsent prior indemnification or anagreement not to sue from the taxpayer.

ConclusionPenalties for noncompliance regardinginternational income tax filings andFBARs can be significant, if not stagger-ing, but relief can be obtained providedthat reasonable cause can be establishedto the satisfaction of the IRS. At the sametime, and given ongoing efforts by thegovernment to combat offshore tax eva-sion, when it comes to asserting reason-able cause based on reliance on aprofessional advisor, the IRS requiresstrong proof of the claim and quite fre-quently is willing to litigate these cases. �

JOURNAL OF INTERNATIONAL TAXATION l MARCH 2014 l INTERNATIONAL PENALTIES 64