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How Joseph Wilson Escaped the Clutches of the IRS and Its Form 3520 Penalties

Alicea Castellanos, CPA
Published Date:
Aug 1, 2020

Even if you’re not a classic film buff, you may know of the “damsel in distress” film genre from the era of silent movies: A villain decked out in a curlicue mustache kidnaps a pretty woman—the significant other of his archenemy—and ties her to the railroad tracks. As the train comes clickety-clacking down the track, the hero, a handsome man on a white horse, rescues the damsel in the nick of time. He also captures the villain and saves the day.

In 2019, the field of international tax released its own production of the classic damsel in distress film via the case of Wilson v. United States. The villain was played by the IRS, the damsel in distress was Joseph Wilson, and the hero was the district court.

The Plot

In the case at hand, Joseph Wilson was the sole owner and beneficiary of a foreign trust created in anticipation of a divorce. He wanted to protect these assets in an offshore account to avoid having the funds equitably distributed between himself and his soon-to-be ex-wife. Upon divorce settlement, Wilson repatriated the assets, $9.203 million. 

But he filed Form 3520 late.

Form 3520 is an informational form created as a result of IRC section 6048. The regulation stipulates that a US person who is the owner of a foreign trust must report activities and transactions of the trust for the taxable year. A U.S. beneficiary of a foreign trust who received a distribution must likewise report the distribution.

Both owners and beneficiaries are required to file the form. IRC section 6677 imposes a penalty equal to 35% of the amount distributed upon the beneficiary for failing to timely file. Furthermore, the regulation imposes a 5% penalty on the value of the assets at the end of the year on the owner for the foreign trust for failing to timely file.

In Wilson, the IRS imposed a 35% penalty to the tune of $3,221,183. Wilson paid the penalty and subsequently filed a claim for refund. He asserted that his late filing was due to reasonable cause, and that as a sole owner of the trust, the IRS at best could impose only the 5% penalty. 

The IRS motioned for dismissal of the claim for refund based on the premise that it did not apprise the IRS of the exact basis for the claim. The court ruled in favor of Wilson upon denial of the motion for dismissal, stating the IRS had sufficient information alerting them to the claim and to compute the correct penalty.

The Resolution

The court in Wilson decided that the IRS overstepped its authority in imposing a 35% penalty for the filing of a late Form 3520.

In citing it reasoning, the court reviewed the language of IRC section 6677. Pursuant to statute, if the owner and the beneficiary of the trust are the same person, only one Form 3520 is required. Section (b) of the statute provides that when the owner and beneficiary are the same, the 5% penalty is substituted for the 35% penalty. The court rejected the IRS claim that both penalties should be imposed.

The court also stated that under IRC section 6677(a)(1), penalties assessed may not exceed “the gross reportable amount.” As trust owner, the gross reportable amount for Wilson at the end of the year was zero. The penalty assessment was far in excess of the amount that could be assessed. The Court also granted Wilson’s motion to find that as owner of the trust, he is liable for a 5% penalty on the amount of the trust assets at the end of 2007, which was zero.

The Review

The main reason this case erupted as it did is because the IRS automatically applies these penalties—a  practice that stands in opposition to delinquent international information return filing procedures (DIF).

This is because a taxpayer with reasonable cause should be allowed to make such a statement prospectively and not be subject to an automatic assessment of penalties. In practice, however, agents at the IRS were not considering these reasonable cause statements. As a result, they were automatically assessing the penalties without any communication or dialogue between the IRS and the taxpayer before the assessment.

Such practice flies in the face of the spirit of delinquent filing procedures posted on the IRS website, which states in part:

“Information returns filed with amended returns will not be automatically subject to audit but may be selected for audit through the existing audit selection processes that are in place for any tax or information returns.”

For the past decade, the IRS has successfully run programs allowing taxpayers to disclose their foreign assets. These programs have been collectively referred to as offshore voluntary disclosure programs (OVDP). In September 2018, the window of opportunity for disclosure ended. With that, taxpayers have been limited as far as compliance options for previous noncompliance. Furthermore, the end of this OVDP era has allowed for the IRS to step in and be aggressive in its pursuit of the imposition of penalties for late filings. 

An environment where the IRS is aggressively pursuing collections lends itself to practices otherwise deemed unfair and prejudicial. These practices include not even considering reasonable cause statements before assessment. Seemingly, the court in Wilson became wise to such practices and, in its interpretation of the statute, provided the taxpayer justifiable and equitable relief.

This case is a red alert for taxpayers and international tax practitioners alike to be on the lookout for the imposition of civil penalties for a late-filed Form 3520. A heavy tax bill will be met with less consternation knowing that a statement for reasonable cause was in all probability overlooked by the IRS. This is because many agents do not have a working familiarity with the intricacies of applicable statutes in the evolving area of law that is Form 3520 practice.

So, tax filers and their associated representative should know the ins and outs of these laws, the law’s applicability to the facts of the case, and the mechanics of relevant trust provisions. Then, any questions or concerns expressed by an IRS agent will be met with satisfactory responses. In effect, time-consuming tax litigation as experienced by the claimant in Wilson will be deemed unnecessary and effectively avoided.

Alicea Castellanos, CPA, is the CEO and Founder of Global Taxes LLC. She has more than 17 years of experience in U.S. taxation of individuals from around the world. Prior to forming Global Taxes, she founded and oversaw operations at a boutique tax firm and worked at a prestigious global law firm and CPA firm. Ms. Castellanos specializes in U.S. tax planning and compliance for non-U.S. families with global wealth and asset protection structures that include non-U.S. trusts, estates and foundations that have a U.S. connection, as well as foreign investment in U.S. real estate property.


Please note: This content is intended for informational purposes only and is not a replacement for professional accounting or tax preparatory services. Consult your own accounting, tax, and legal professionals for advice related to your individual situation.