In the case of Wilson, et. al. v. United States, Case No. 2:19-cv-05037, US District Court, Eastern District of New York,[1] the Court found that the sole owner/beneficiary of a trust could only be assessed the 5% penalty under §6677 as the owner.  The Court denied the IRS’s attempt to impose the 35% penalty under that section on distributions received.

The issue involves the requirement under IRC §6048 for information reporting by certain foreign trusts.  If a party fails to file the required reports, penalties are imposed under IRC §6677.

Generally, IRC §6677 requires a beneficiary failing to report a distribution from the trust on Form 3520 to pay a penalty equal to 35% of the distribution amount.  However, IRC §6677(b) modifies the penalty in the case of the owner of the trust who fails to file such a report, imposing a 5% penalty on the balance in the trust at year end when a report is not filed.

The case notes the following information about the facts of this case:

…Joseph Wilson established an overseas trust in 2003. Wilson named himself the grantor of the trust and was its sole owner and beneficiary. The singular purpose of the trust was to “place assets beyond the reach of his then-wife, who he had reason to believe was preparing to file a divorce action against him.” (She did.) Wilson funded the trust with approximately $9 million in U.S. Treasury bills, accruing annual interest of 5% or less. All principal had previously been taxed in the United States.

From 2003-2007, Wilson filed “various income tax and information returns” with the IRS, reporting the trust's assets and the interest it accrued. In 2007, upon conclusion of the divorce proceedings, Wilson terminated the trust and transferred the assets — at that point $9,203,381 — back to his bank accounts in the United States.

Despite general compliance with IRS requirements, Wilson was late in filing his Form 3520 for calendar year 2007. Form 3520 is an annual report disclosing distributions from a foreign trust, with different requirements for trust grantors/owners and for trust beneficiaries. After Wilson filed his 2007 Form 3520, the IRS assessed a late penalty of $3,221,183, representing 35% of the distributions from the trust during the 2007 calendar year. Because Wilson had transferred 100% of his trust's funds back to his own domestic accounts during 2007, the penalty also amounted to 35% of his total trust assets.[2]

The taxpayer paid the penalty the IRS asked for, but filed a claim for refund on two separate bases:

• That there was reasonable cause for the taxpayer’s untimely filing of Form 3520; and

• That, since Joseph Wilson was the owner of the trust, the proper penalty was the penalty for the owner failing to report the trust (the 5% penalty); not the penalty on unreported distributions of 35%.[3]

The IRS agreed that the 5% penalty would apply to Joseph as the owner, but argued that the two penalties are separate and can be applied independently.[4]

IRC §6048 clearly required the filing of the Form 3520 to report at least some information about the trust for 2007 and Joseph White had not filed that information return.  The opinion summarized the law on the consequences of failing to file such an information return as follows:

Penalties for violating the provisions of 26 U.S.C. § 6048 are codified under 26 U.S.C. § 6677. Subsection (a) of that statute prescribes the penalty for untimely filing “any notice or return required to be filed by section 6048.” In relevant part, 26 U.S.C. § 6677(a)(1) states:

[T]he person required to file such notice or return shall pay . . . 35 percent of the gross reportable amount. . . . At such time as the gross reportable amount with respect to any failure can be determined by the Secretary, any subsequent penalty imposed under this subsection with respect to such failure shall be reduced as necessary to assure that the aggregate amount of such penalties do not exceed the gross reportable amount (and to the extent that such aggregate amount already exceeds the gross reportable amount the Secretary shall refund such excess to the taxpayer).

That provision is modified by 26 U.S.C. § 6677(b)(2), which provides that “subsection (a) shall be applied by substituting ‘5 percent’ for ‘35 percent’” for returns required to be filed by the owner of a foreign trust.[5]

The Court then starts its analysis of how the penalty rules are going to apply in this case where the taxpayer is both a beneficiary of the trust and the owner of the trust:

At the outset, it is imperative to understand that a person in Wilson’s situation — i.e. a sole grantor/owner and sole beneficiary of a foreign trust — would have only been required to file a single Form 3520 for fiscal year 2007. So the question then becomes, whether 26 U.S.C. § 6677 permits a single person untimely filing a single IRS form to be penalized as two different people — as an owner and as a beneficiary.

The opinion rejects the IRS’s view that both penalties could apply in this situation, arguing such a holding is contrary to the plain language of the statute:

A plain language reading of 26 U.S.C. § 6677 counsels that a trust owner cannot be penalized as a beneficiary for violating a provision of 26 U.S.C. § 6048(b). There is a clear instruction under 26 U.S.C. § 6677(b)(2) to “substitute” 5% for 35%, not to choose between the two or to simply apply a 5% assessment without reference to an otherwise applicable penalty. Therefore, the statute mandates that the 5% replace the 35% whenever there is a “case of a return required under section 6048(b).”

When a foreign trust owner is required to file Form 3520, it falls under 26 U.S.C. § 6048(b)’s purview of “such information as the Secretary may prescribe with respect to” an owner of a foreign trust. Undeniably, then, a violation of that section should be treated under 26 U.S.C. § 6677(b)(2)’s substitution clause, which replaces “35 percent” with “5 percent.” But even if this were not inescapably evident, “in case of doubt [in the interpretation of statutes levying taxes,] they are construed most strongly against the Government, and in favor of the citizen.” Gould v. Gould, 245 U.S. 151, 153 (1917).

Moreover, the Government’s argument, if accepted, would result in an irreconcilable textual conflict. Section 6677(a)(1) of Title 26 states that once the Secretary determines the gross reportable amount “with respect to any failure,” the Secretary must ensure that the taxpayer’s penalties under § 6677 “do not exceed the gross reportable amount.” Although this language is primarily concerned with subsequent late fees, the underlying directive appears to limit all penalties for a violation to no more than the “gross reportable amount.” Therefore, it follows that 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.

But that would be the case if the Government got its way. Because the gross reportable amount for an owner’s untimely filing Form 3520 under § 6677(c)(2) is “the gross value of the portion of the trust’s assets at the close of the year,” Wilson’s $0 in trust assets at the end of 2007 yields a $0 gross reportable amount. Any additional penalty resulting from the same “failure” would violate the statute. The Government seeks $3,221,183 above $0, which violates the statute.[6]

And the Court finds in this case the proper penalty is 5% of the zero balance in the trust at the end of the tax year, noting:

Plaintiffs next ask the Court for summary judgment as to whether “the 5% penalty should properly be based on the amount of the [trust’s] account balances, if any, at the close of 2007, pursuant to [26 U.S.C. §] 6677(c)(2).” It should. Because Wilson is treated as the owner of the foreign trust for the purpose of his Form 3520 filing, he is liable for penalty under 26 U.S.C. § 6677(b) for a violation of 26 U.S.C. § 6048(b)(1). Under 26 U.S.C. § 6677(b), the proper assessment is “5% of the gross reportable amount.” The gross reportable amount for “a failure relating to section 6048(b)(1)” is “the gross value of the portion of the trust’s assets at the close of the year treated as owned by the United States person.”[7]

[1] Wilson, et. al. v. United States, Case No. 2:19-cv-05037, US District Court, Eastern District of New York, https://ecf.nyed.uscourts.gov/doc1/123116103015 (Pacer registration required)

[2] Wilson, et. al. v. United States, pp. 1-2

[3] Wilson, et. al. v. United States, p. 3

[4] Wilson, et. al. v. United States, pp. 9-10

[5] Wilson, et. al. v. United States, pp. 9-10

[6] Wilson, et. al. v. United States, pp. 11-12

[7] Wilson, et. al. v. United States, pp. 13-14