The Continuing Saga of U.S. Tax Classification of Foreign Trusts and Related Penalty Issues
In Greek mythology, Cerberus, a three-headed dog, was known as the guardian of the underworld. In more recent literature, a Fluffy three headed dog was used to guard a stone. Why use a three headed dog? Maybe because the fear of being bitten once just isn’t enough to scare everyone. Such is the lesson to be learned from Fairbank v. Commissioner, T.C. Memo. 2023-19 (“Fairbank”), where the Court discussed three issues relevant to the taxpayers: (1) the classification of a Swiss Establishment; (2) the necessity of filing Forms 3520 and 3520-A as relevant to the statute of limitations applicable to the case; and(3) reasonable cause for the abatement of penalties. As you may surmise, things did not go well for the taxpayers in this fight with a three headed dog.
As has been discussed previously, one of the most challenging aspects of assisting clients with international tax planning is determining the right entity to use for that client’s situation and the classification of such entity for U.S. tax purposes.1 In Fairbank, the Internal Revenue Service (the “IRS”) was arguing that a Swiss Establishment was a foreign trust, while the taxpayers were arguing that it was an association taxable as a foreign corporation.2 The Court in Fairbank analyzed the facts and circumstances surrounding the Swiss Establishment and determined that it was properly classified as a trust for U.S. tax purposes. Going further, the Court then determined that the Swiss Establishment was, as a result of its terms, a foreign grantor trust for U.S. tax purposes.3 Having now made these determinations, the Court was able to turn to issues relating to Forms 3520 and 3520-A.
Being faced with penalties for Forms 3520 and 3520-A, the taxpayers then argued that there was compliance with the relevant filing obligations based on information provided in the taxpayers’ returns and that the applicable statute of limitations had expired.4 The IRS countered that the applicable statute of limitations is tolled until the Forms 3520 and 3520-A are filed.5 Although the Court acknowledged the case law on point relating to situations where adequate information filed by a taxpayer may constitute the filing of a return, the Court goes on to conclude that, in this situation, there was not a filing for purposes of closing the statute of limitations.
Finally, the taxpayer argued that “reasonable cause” exists for the abatement of penalties for failure to file the Forms 3520 and 3520-A. The taxpayers’ argument looked to reliance on a tax professional in preparing the taxpayers’ otherwise timely filed U.S. income tax returns. The Court, in rejecting the application of “reasonable cause,” cited the taxpayers’ involvement in the Swiss Establishment and the taxpayers answering “no” to certain questions when asked by the tax professional and/or on their Form 1040.
As you can see, and unfortunately, the U.S. tax law that applies to foreign entities (and the related classification as a trust or corporation) remains an issue of interest to the IRS. The Fairbank case illustrates how the wrong classification or filing (or lack thereof) can attract potentially draconian penalties (for which “reasonable cause” may not apply for purposes of abatement) and may allow the IRS to keep the applicable statute of limitations open indefinitely. As such, clients and their advisors would be prudent to involve Hercules, three bold first year wizarding students, or competent U.S. tax professionals (such as the tax advisors at Bilzin Sumberg), to help them plan in advance to avoid, or to otherwise guide them through, this complex landscape.
[1] For a further discussion of the classification and penalty issues relevant to the Fairbank case, please consider: https://www.bilzin.com/we-think-big/insights/publications/2021/12/navigating-pandoras-hallelujah-mountains-civil-law. For a discussion of another Form 3520 and Form 3520-A penalty case, please see: https://www.bilzin.com/we-think-big/insights/publications/2021/08/tax-and-wealth-services-17.
[2] Although there are many difference between the taxation of a foreign trust and a foreign corporation, the details of which go beyond this brief update, one large difference arises in the context of penalties for the failure to file Forms 3520 and 3520-A (applicable to foreign trusts), and Form 5471 (applicable to foreign corporations). What is important to note is that, although the minimum penalty for each of these forms is $10,000, the penalties for Forms 3520 and 3520-A can be much greater then this based on a percentage of the assets involved in requisite filing.
[3] An understanding of the distinction between a domestic and a foreign trust is, of course, crucial. In this regard, a trust is foreign for tax purposes if it is not classified as a domestic trust. Internal Revenue Code Section (“§”) 7701(a)(31)(B). A trust is considered a domestic if two factors are present: (a) a court within the U.S. is able to exercise primary supervision over the administration of the trust; and (b) one or more U.S. persons (e.g., a U.S. citizen or income tax resident alien) have the authority to control all substantial decisions of the trust. § 7701(a)(30)(E). For a further discussion of this issue, as well as the classification (and issues relevant to) a foreign trust being classified as a grantor trust, please consider: https://www.bilzin.com/we-think-big/insights/publications/2021/02/tax-and-wealth-services-7 and https://www.bilzin.com/we-think-big/insights/publications/2021/01/tax-and-wealth-services-5.
[4] The general statute of limitations is three years from the date of filing a return. See § 6501.
[5] See § 6501(c)(8).
