Reasonable Cause Defense for Failure to File Form 3520 (8/25/12)

In James v. United States, 2012 U.S. Dist. LEXIS 114356 (MD FL 2012), here, the court held that, whether defendant's alleged reliance on his accountant in failing to file Form 3520, Annual Return To Report Transactions With  Foreign Trusts and Receipt of Certain Foreign Gifts, current version here, constituted reasonable cause to avoid the penalty for failure to file was an issue to be determined at trial rather than on the Government's motion for summary judgment.  The penalty involved is Section 6677(a); the reasonable cause exception is in Section 6677(d) ("due to reasonable cause and not due to willful neglect").  Section 6677 in its entirety is here.

The IRS "assessed penalties of $67,200, $281,750, and $230,000, for failure to file Form 3520 in years 2001, 2002, and 2003, respectively."  The opinion is rather cryptic, certainly as to the facts leading up to the assessment, so it is difficult to assess precisely what triggered the substantial penalties.

James, a pain management physician, apparently set up the foreign trusts as an asset protection mechanism against malpractice suits.  (I guess his notion was that he and his family were more entitled to those assets than some patient who suffered from his malpractice.)

James proceeded to create an irrevocable foreign trust in Nevis, West Indies, with First Fidelity Trust Limited (FFT) as its trustee. James initially funded the trust in 2001 with a contribution of $192,000. He made additional contributions of $805,000 in 2002 and $607,146 in 2003.

James urged that he informed his accountant about the trust and relied upon his accountant to advise him and prepare the Forms required from these actions.  The Government argued that "James was put on notice of the requirement to file Form 3520, the Government argues that his reliance on Famiglio cannot constitute reasonable cause."  From the wording of this sentence, it would appear that the Government's argument is that factually James was put on notice and that notice was what made his reliance on the accountant untenable.  The opinion, however, does not flesh that out, and I suppose that whether James really had some independent notice that made reliance on his accountant untenable is really a question of fact.

The Court noted at the inception (emphasis suppied):

The IRS has failed to issue regulations explicating the meaning of "reasonable cause" for failure to file Form 3520. In general, reasonable cause exists when a taxpayer exercises ordinary care and prudence in determining his tax obligations despite his failure to comply. See I.R.M. 20.1.1.3.2 (11-25-2011). Whether reasonable cause exists depends upon all of the facts and circumstances of the case, including the taxpayer's reason for failing to properly file, and the extent of his efforts to comply. Id. Moreover, the Internal Revenue Manual ("IRM") provides that ignorance of the law may provide reasonable cause if: "A. A reasonable and good faith effort was made to comply with the law, or B. The taxpayer was unaware of a requirement and could not reasonably be expected to know of the requirement." I.R.M. 20.1.1.3.2.2.6 (11-25-2011).

As usual in a case involving a failure to file penalty, the Government trotted out United States v. Boyle, 469 U.S. 241 (1985), here.  In Boyle, the Supreme Court rejected a reasonable cause defense for a late filing penalty based on reliance of the attorney who should have known the estate tax filing date and made the filing timely.  The James Court declined to reach the Boyle argument.  (See fn. 1.)  (I should note that I think the Court did reach the argument by denying summary judgment where the Government's point, I think, was that Boyle compelled summary judgment.)

There has been considerable case law on whether reliance on the advice of an expert can constitute reasonable cause for failing to file one's tax returns. It is clear that a taxpayer may reasonably rely on an expert's advice that no return is required; thus, if an expert erroneously advises him that no return is required, or erroneously advises him that it can be filed beyond the due date, reasonable cause may be found. See, e.g., Estate of La Meres v. Comm'r, 98 T.C. 294, 316-17 (1992) (Stating that courts have found reasonable cause for failing to meet a filing deadline where taxpayer made full disclosure to expert, relied on his advice, and did not otherwise know that the return was due.). 

Here, the Court concludes that there is a genuine issue of material fact with respect to whether Famiglio provided James with advice upon which James reasonably relied. The record, viewed in a light most favorable to Plaintiff, shows, among other things, that: (1) James (or his agent) timely provided all required trust forms to Famiglio; (2) James relied on Famiglio to advise him on all matters related to the trust; (3) Famiglio advised him on at least some trust matters (for example, Famiglio advised him how to report loans from the trust for tax purposes and advised him that the trust loans did not result in taxable income); (4) James relied on Famiglio to advise him about making the appropriate filings for the trust; (5) Famiglio failed to so advise him; and (6) James, based on his conversations with Famiglio, believed that he had filed all required forms. 

In addition, Famiglio prepared James's personal tax returns. On Schedule B of his Form 1040 tax returns, it appears that Famiglio answered no to the question "did you [James] receive a distribution from, or were you the grantor of, or transferor to, a foreign trust? If 'yes,' you may have to file Form 3520." Answering "no" to this question could be construed as Famiglio providing advice that James need not file Form 3520, advice upon which James could have potentially reasonably relied. 

Taking all of these allegations as true, the Court concludes that there is a genuine issue of material fact with respect to whether Famiglio provided James with advice that James need not file Form 3520, and whether James reasonably relied upon that advice.

JAT Comments:

1.  The assessments were made in 2006, well in advance of the offshore bank troubles commencing in 2008 with UBS.  The case does illustrate, of course, the type of penalties that can apply if a taxpayer either (i) did not join one of the offshore initiatives and (ii) did join one of the initiatives and opted out.  And, the Government's reliance on Boyle perhaps illustrates that the IRS will be willing to assert the penalty with a bare minimum of facts beyond the failure to file.  Whether a court will ultimately buy into that notion is not known.  But, for now, a taxpayer in one of the offshore initiatives with a fact pattern involving failure to file Form 3520 and significant trust assets might not want to opt out.  The ideal candidate for opt out, of course, is the individual with only individually owned accounts (no entities) with a reasonable story to tell to avoid a willfulness determination (either for the civil fraud penalty or the FBAR penalty).

2.  With the issue going to trial, unless the Government at least has some very bad facts, the case should be settled somewhere between the assessed penalty amount and zero.

3.  I particularly liked the analysis of the no answer to the foreign trust question on Schedule B.  Extending this analysis, in a case where the return preparer was or should have been aware of foreign bank accounts and the return answers the foreign bank account question "no," then that can be "considered * * * advice that [insert name] need not file" the FBAR form, "advice which [insert name] could have potentially reasonably relied."