Saturday, August 25, 2012

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. (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. (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."


  1. Great post Jack,

    There are four additional items that I find very interesting about the facts of this case:
    1) The court acknowledges that the trusts timely filed all forms 3520-A, but does not indicate whether the CPA prepared these returns. If he had prepared these returns, it should have strengthened the taxpayer's contention that the CPA did, in fact, advised him on his reporting obligations.2) The court does not indicate whether the taxpayer reported and paid tax on the amounts contributed to the trusts. Presumably he did report and pay, but we can't tell. 3) The court also does not indicate whether the taxpayer reported and paid income tax on the income generated by the trusts.
    4) The court does not indicate whether the taxpayer had filed FBARS.

    Of course we don't know all the history surrounding the case and whether there are other "bad facts" lurking out there somewhere, however, based on the facts presented it appears that the IRS may be serious about pursuing taxpayers who have established foreign trusts for reasons OTHER THAN tax avoidance (i.e., asset protection in this case).

  2. Thanks, Roy. Your comments are always good and welcomed both for my own enlightenment and for the readers' as well. Just a couple of comments (referring to your numbers above):

    2) I had inferred, as in many of these cases, that the taxpayer did pay tax on the funds contributed. But that is only an inference and may not even be justified by what the court did say.

    3) If the taxpayer paid all the required taxes on the contributions and trust income, the failure to file the Form 3520-A would be just a footfault and not the stuff of the draconian 3520 penalties. There must be something there that is missing in terms of the whole story. Of course, in dealing with a motion for summary judgment, the whole story is usually not told. So we don't have that.

    I don't have enough information for what the IRS may do with failures to file 3520 for asset protection foreign trusts that do not serve a tax noncompliance function (i.e., noncompliance beyond merely failing to file the Form 3520). I would think, however, that if the failure to file the Form 3520 and perhaps the FBAR for the trust were the only failures -- i.e., all assets contributed were taxed and all trust income taxed, the IRS would not be draconian in applying the either the Form 3520 or the FBAR penalties. I don't know that, but that seems to have been the message with the OVD programs -- that if there is no tax noncompliance but mere form footfaults, there will be no penalties.

    Now, for those in the program and considering an opt out, there will be tax noncompliance and therein lies the rub.

    Thanks again,

    Jack Townsend

  3. Jack

    Can the doctor ask for (and insist on) a jury in this case on trial ? On a similar note, can a taxpayer insist on a jury for a civil FBAR penalty ? In a criminal trial, a jury would be required, but I know there are different for civil trials, and I'm not sure if a jury trial would be available for these types of cases. In tax court, no jury is available, but neither FBAR nor 3520 penalties can be litigated in tax court.

    A jury trial certainly involves far more expense for the taxpayer, but where large sums are involved, the taxpayer might prefer a jury trial for a civil case if he/she has a sympathetic case/personal story. I suppose this would be a tactical decision on the part of the taxpayer and his/her attorney.

  4. @d68e720207cd6e170269456b1c7e01b8:disqus , wonderful idea! I love jury trial. I just came out from a jury duty on a criminal case (armed robbery). The evidence was so overwhelming --but still it took 2 hours for us to convince two jurors who had unreasonable doubts.

  5. I have not had to address in my practice whether jury trials are available for the Form 3520 failure to file penalty or for the FBAR penalty. So, I can't answer the question specifically. I hope some reader can.

    I do offer an analytical framework for answering the question. The general rule is that you look to the nature of the remedy now and match it to the closest type of remedy under the common law at the adoption of the Constitution. If closest match would have offered a jury trial at that time (about 1790), then the current remedy offers a jury trial. If the closest match at that time would not have offered a jury trial, then there is no right to jury trial now. The classic extremes were the distinctions between actions at law and actions in equity; the former allowed jury trials and the latter did not. I know a lot of this is legal jargon and is inconclusive, but you might take a look at the Wikipedia entry:

    Having said that, and on that limited framework, I would think a jury trial would be available but admit that I don't know the answer.

    Now, if we can assume that a jury trial is available, the next question is whether a taxpayer would want a jury trial. And, if the taxpayer does not want it, would the Government want the jury trial. In the cases of the 3520 penalty and the FBAR, the Government usually presses the strongest penalties only in cases where there are very bad facts -- some relevant; some not relevant -- against the taxpayer. Hence, in many of those cases, the taxpayer would not want a jury which may have difficulty excluding irrelevant bad facts from consideration. (A related topic is the use of FRE 404(b) bad act evidence in criminal trials to poison the well with the jury.)

    Take for example, the Williams case that has drawn so much attention here. Quite frankly, I think that case would have played poorly before a jury but played well before the district judge in a bench trial.

    Take also the James case. What would a jury of ordinary citizens think about a doctor doing asset planning to escape from the financial consequences of his own malpractice. I am not sure how that would play before a jury, but I would be concerned in making the decision whether to demand a jury when filing the complaint. And then, if I chose to not demand a jury, the Government could demand a jury. (Indeed, while with DOJ Tax, I handled at the trial level only refund cases in which there is a right to jury trial. If the plaintiff (the taxpayer) did not demand a jury, I figured out why he did not demand a jury and, if as was usually the case, a jury would not be good for the taxpayer, I demanded a jury. (By the way, I like jury trials.)


    Jack Townsend

  6. Jack

    Thank you very much for your comments. I think this 3520 case is actually technically a refund case (at least, the judge's holding refers to this as such), so I presume a jury trial would be available for penal3520 penalty cases. I think (although I'm not a lawyer) that a jury trial would be available for FBAR penalties.

    I agree that Williams would have gone over very badly in front of a jury given his admitted tax evader background, and possibly illegal income (kickback from a bribe). I think Dr. James may still do well on a jury trial if he asks for one and if the facts are generally in his favor and there is little tax deficiency (and also the nature of the notice he received from the IRS). Indeed, even the motive for setting up the offshore account could be spun positively by a skilled litigator using phrases such as "protecting against frivolous lawsuits brought by greedy lawyers". Jury members might also dislike the idea of the IRS asserting massive penalties for a foot fault (assuming that is what James conduct really was).

    This brings up another question. Assuming a taxpayer is not interested in a jury trial, and wants to bring a refund lawsuit against the government, would the preferred venue be District Court or the Court of Federal Claims (which would mean no jury, of course) ? Assume there is no real precedent in either the local circuit or the federal circuit which would favor the taxpayer in either venue -- in that case, would the decision of venue be largely a matter of logistics (it might be easier to file in District Court) ?

  7. Here’s some follow up on James, for anyone who may be interested.

    The Government’s motion indicates that the 3520-As were filed by the trustee, not the taxpayer’s accountant and contains no indication that James failed to report any income.
    (Granted that’s not exactly proof, but I would certainly think the Government would have said so quite clearly if James had failed to report.)

    The motion emphasizes that James received a compliance package in connection with the establishment of the trust that addressed tax-filing requirements, including Form 3520, and moreover that James signed a document acknowledging “that I [James] understand that
    establishing a foreign trust can obligate me to file certain Internal Revenue Service and Treasury Department forms, including, but not limited to IRS Form 3520 and IRS Form 3520-A.” In addition, there is, of course, the “foreign trust question” (similar to the “foreign account question”) in the small print at the bottom of Schedule B.

    Notwithstanding receipt of the compliance package and signature of the acknowledgment, I think the Government has gone overboard. First, whatever the technical merits, if in fact James timely paid tax on the trust income, I question the ethics of punishing James, simply because they can. Is he really someone who needs to be punished, for failing to file a form when (if) all of his income was properly reported?

    Second, in the real world, who (other than a tax professional) would remember all of the crap that he received upon establishment of a trust? More than a few perfectly responsible people would be inclined to assume that, if their accountant is given information about the arrangement, the accountant will prepare whatever forms are required. I don't find that to be unreasonable.

  8. Unless there are some other bad facts (significant amount of unreported income, for instance), this penalty seems very harsh, definitely harsher than the different OVD programs. Under those programs, the doctor would simply have had to file delinquent returns and pay no tax. Or even if tax was due, the penalty would have been at most 27.5 % (currently), and likely none in 2006 (before the first OVD program).

    The doctor's penalty seems to be the maximum, 35%. And he has a good reasonable cause defense as well.

    I wonder if this may be an indicator of how the IRS may treat OVD opt outs. For the FBAR penalty, its easy to deny reasonable cause and assess the lower non-willful penalty (as they have done in this case). We have seen some cases where the IRS did accept reasonable cause on opt outs, but the barrier for reasonable cause seemed to be reasonably high.

  9. Certainly not all opt out results in a resolution as good as ij's (immigrant to the US) who has been exempt of penalty. In a comment from this post:
    a user (FinishedAtlLast) commented on his opt opt result, saying that the IRS maintained the In lieu of penalty. I am copying his post below.
    From his description it seems like he should have received the same outcome as ij's. I'd say this one is bad publicity for the IRS and will convince many immigrants to not enter OVDP.
    It is stupid for the IRS not to say that in cases such as ij and FinishedAtlLast, a valid compliance path is to just file amended returns. I still believe that millions are in their cases, and refuse to enter OVDP for the nonsense solution of paying $30K and in taxes and accountant fees for a small amount of taxes due, for something that noone told them they had to do. Many will take the chances of the IRS just discovering them.
    I'd even say that these people might not even choose the go forward solution to minimize their risk. The IRS' attitude goes against compliance. Why are they not realizing it and listening to the Tax Payers' Advocate. It just doesn't make any sense.

    I finished my OVDI opt out process, received my result and signed my closing form 1-2 weeks back. My background is likely not very different from ij, immigrant to the US, small accounts (about the same size as his), small offshore income, no entities, perfect tax record otherwise etc. In fairness, I have lived for a greater period in the US and possibly have a few more negatives than him. My examiner did recommend no penalties for me, but it was rejected by the opt out committee (or at some level of the hierarchy). My original penalty was not that large (small account sizes, but just > 75K). There was one particular item that I disputed in the in program penalty, but they could not adjust it within the program. On my opt out, that particular item was removed (it was not a lot of money). Taxes, interest for closed years are also refunded (again, not a lot of money). The rest of the in lieu penalty stays. My resolution was clearly not as satisfactory as ij's, but here are my general comments

    The IRS was not draconian. We all know that the non willful penalty is ridiculous if applied per account/per year. Even the 10K/year penalty would have been higher than my final penalty. On the other hand, they were not too generous either, since they did apply the rest of the penalty minus the disputed items. Outside the program, there is some flexibility, but there is not much extra transparency. My examiner was very inexperienced with FBAR matters. Its possible that his inexperience contributed to his recommendation being rejected. I cannot say that their rejection of reasonable cause was totally unjustified, but it does seem like they simply thought I would be content if the disputed item were removed and left it at that. I could possibly have continued in Appeals, but the legal costs and time and energy were not justified for the amounts involved. Indeed, some might have said that my initial decision to opt out (largely occasioned by annoyance over the disputed matter) was somewhat quixotic.

    My advise to people considering opt out is to be hopeful, but also realistic. A lot depends on how good your case is, but there is likely to be some aspect of luck of the draw either. And you have to know when to fold them. But for people facing the kind of ridiculous situation that Just Me did (whole house included in penalty), this is an option.


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