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Vacating and remanding a district court decision, the Second Circuit has held (Emily S. Wilson, et al. v. United States) that when a US individual is both an owner and beneficiary of a foreign trust, the individual is liable for a 35% penalty under IRC Section 6677(a) for failure to timely report the receipt of trust distributions. The court rejected the plaintiffs' argument that the individual may only be liable for the 5% penalty under IRC Section 6677(b) that applies to US persons who own foreign trusts (US owners) and fail to report such ownership to the IRS.

Facts

In 2003, Joseph Wilson established a foreign trust valued at approximately $9m. He liquidated the trust in 2007, distributing all of the assets (approximately $9.2m) to himself. Wilson was the sole owner and beneficiary of the trust. When he filed his 2007 information returns reporting foreign trust ownership and distributions late, the IRS assessed a 35% penalty under IRC Section 6677(a), applicable to US persons who receive distributions from a foreign trust. Wilson paid the 35% penalty on the $9.2m distribution but filed a claim for refund of the amount with the IRS, arguing that the correct penalty was 5% under IRC Section 6677(b), which applies to foreign trust owners. He died before his claim was resolved, and his estate filed a refund action in the U.S. District Court for the Eastern District of New York.

Finding that Wilson should only have been penalized as a foreign trust owner, the district court granted summary judgment for the estate, holding that the 5% penalty applied. Because the 5% penalty is calculated based on the gross value of the foreign trust that a US person owns at the end of the tax year and Wilson had liquidated his trust before the end of 2007, the amount of the penalty owed was zero, based on the district court's holding. The government appealed.

Law

For the 2007 tax year at issue in Wilson, IRC Section 6048(b) and (c) required (1) US owners of a foreign trust to ensure that the trust files an annual return and (2) US beneficiaries of the trust file a return reporting any distributions received. The trust annual reporting requirement was satisfied with the completion and filing of the Form 3520-A, Annual Information Return of Foreign Trust With a U.S. Owner. US beneficiaries satisfied their reporting requirement by disclosing the receipt of distributions during a tax year on the Form 3520, Annual Return To Report Transactions With Foreign Trusts and Receipt of Certain Foreign Gifts. A US owner who failed to ensure the timely filing of the Form 3520-A by the foreign trust could expect a penalty under IRC Section 6677(b), equal to 5% of the gross value of the assets of the trust the US owner was treated as owning at the end of the tax year. A US beneficiary who failed to timely file a Form 3520 to report distributions could expect a penalty under IRC Section 6677(a), equal to 35% of the amount of the distribution.

Relevant for current US owners of foreign trusts, Congress amended IRC Section 6048(b) in 2010 to add that US owners must provide any information required by the IRS, in addition to ensuring that the trust files an annual return. Additionally, a minimum $10,000 penalty was added to IRC Section 6677 for failure to report ownership of a foreign trust, or transfers to or distributions from the trust. (See, Hiring Incentives to Restore Employment Act, PL 111-147, enacted March 18, 2010.) Otherwise, the reporting requirements in IRC Section 6048 and the penalty provisions in IRC Section 6677 remain similar to those in effect in 2007. Current US owners continue to satisfy their reporting requirements relating to foreign trusts by filing the Form 3520-A and Form 3520.

Appellate decision

The Second Circuit's de novo review of the district court's grant of summary judgment for the plaintiffs began with an examination of the plain language of the applicable IRC sections. The appeals court found that the plain language of the disclosure and penalty provisions (IRC Sections 6048 and 6677) "unambiguously demonstrates that when an owner of a foreign trust fails to timely disclose a distribution she received as a beneficiary of that trust, she violates [IRC Section] 6048(c) and thereby triggers the 35% penalty under [IRC Section] 6677(a)." Further, the court noted, no language in other parts of IRC Sections 6048 or 6677 "diminishes or eliminates the applicability of the 35% penalty to Wilson as a beneficiary of the trust."

The Second Circuit rejected the district court's conclusion that IRC Section 6677(b) substituted 5% for 35% as the penalty applicable to Wilson because he was an owner as well as a beneficiary. "The problem with the district court's analysis is that [IRC Section] 6677(b) leaves untouched the 35% penalty that applies to all other reporting requirements under [IRC Section] 6048, including to a return disclosing distributions required by [IRC Section] 6048(c)," the court explained.

The appeals court found no textual support for the district court's conclusion that when the owner is also a beneficiary, failure to timely report a distribution violates only the owner's obligation under IRC Section 6048(b) and not the beneficiary's obligation under IRC Section 6048(c). The court concluded that because "Wilson's failure to timely report the distribution he received violates [IRC Section] 6048(c) even if that same failure also violates his reporting requirements as an owner under [IRC Section] 6048(b), the 5% penalty under [IRC Section] 6677(b) does not supplant the 35% penalty."

The Second Circuit rejected the district court's assertion that because IRC Section 6677(a) states that a penalty should not exceed the "gross reportable amount," "a taxpayer should not be liable for any two penalties if their combined assessment would add up to more than the gross reportable amount for any one violation." The appeals court noted that IRC Section 6677(c) applies more than one meaning to "gross reportable amount," depending on whether the failure to timely file a report or disclose a distribution is attributable to an owner or beneficiary.

Ultimately, the Second Circuit agreed with the government that the plain language of IRC Sections 6048 and 6677 "requires that when an individual fails to timely report the distributions she received from a foreign trust, the 35% penalty applies; her concurrent status as owner of the trust does not alter this rule."

The Second Circuit also rejected the district court's conclusion that the Form 3520 instructions supported the position that only the 5% penalty applied because the instructions provided that distributions were not required to be reported on the Form 3520 if ownership was disclosed on the form and the trust filed the Form 3520-A. The appeals court indicated, as explained by the government, that the Form 3520 instructions merely provides that if trust distributions have already been reported on the Form 3520-A (which did not occur in this case), as required on that form, the US owner can refer the IRS to the Form 3520-A by checking a box in Part II of the Form 3520 and not provide information about trust distributions again in Part III of the Form 3520.

Implications

The Second Circuit concluded that IRC Section 6048 contains multiple reporting requirements for which the IRS may impose different penalties under IRC Section 6677 if the required information is not timely disclosed on the Form 3520-A and/or Form 3520. Although the court reviewed IRC Sections 6048 and 6677 as they were in effect during 2007, the changes that Congress made to the statutes in 2010 do not affect the applicability of the court's ultimate holding on current US owners of foreign trusts who are also beneficiaries. Indeed, Congress increased the IRS's enforcement authority relating to US owners of foreign trusts in 2010 by imposing additional reporting requirements with respect to ownership of a foreign trust in IRC Section 6048(b) and providing for a minimum $10,000 penalty for failure to report (1) ownership or (2) transfers to or distributions from a foreign trust.

Current US owners and/or beneficiaries of foreign trusts are required to file Form 3520-A and/or Form 3520 to report: (1) ownership of the trust, (2) transfers of property to the trust, or (3) distributions from the trust. Significant penalty risks exist if these forms are not timely and correctly filed. Two separate penalties equal to 5% of the trust's value (with a minimum penalty of $10,000) may be imposed for failure to report information related to the ownership of a foreign trust on the Form 3520-A and Form 3520. Separate penalties of up to 35% of a contribution to a foreign trust or 35% of a distribution from such a trust (both with a minimum penalty of $10,000) may be imposed for failure to report the trust contribution or distribution on the Form 3520. With this level of risk, it is essential that US owners/beneficiaries of foreign trusts are vigilant in satisfying their reporting requirements, carefully reviewing the IRS instructions to the Forms 3520-A and 3520 to ensure they are properly completed.

EY can assist US owners and beneficiaries of foreign trusts in determining their foreign trust reporting obligations.

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