The IRS has been aggressively asserting penalties for late filing of international information forms such as Form 3520, Form 3520-A, Form 5471, Form 5472, etc. This has been a very frustrating experience for both the taxpayer as well as the advisor. The following are some comments that have been proven to be useful in resolving penalty abatement requests.
One of the reasons for the increase in penalties may be related to the IRS processing of filings submitted pursuant to the IRS Delinquent International Information Return Submission Procedures. Although the IRS has recently updated its policy on this, it continues to invite taxpayers to make late filings with a reasonable cause statement attached. It now expressly states “penalties may be assessed without considering the attached reasonable cause statement. It may be necessary for taxpayers to respond to specific correspondence and submit or resubmit reasonable cause information”. Many people interpreted the previous guidance on the IRS website to indicate that the delinquent information return procedure could be a penalty-free way to voluntarily come into compliance with little or no IRS push back. Unfortunately, many of the filings submitted pursuant to this procedure were challenged leading to an increase in penalty assessments. If language of this nature was presented earlier a different course of action may have been pursued.
The reality of this situation is that the “reasonable cause” standard (for penalty abatement) can actually be very difficult to meet. In many cases it is difficult to determine if the IRS penalty letter is actually a rejection of the reasonable cause statement or if it is simply a computer-generated document with no human review. The IRS is often quick to assert that a taxpayer has not met the standard. Taxpayers as well as inexperienced advisors are quick to respond with an emotion-based response (such as “I didn’t know”) that does not warrant penalty abatement for reasonable cause under the law. None of this is productive.
We have presented arguments to IRS appeals stating that our interpretation of case law is that it dictates that the standard of reasonable cause has been met when it is shown that the taxpayer has taken steps that a “reasonable person” would take (under the circumstances) to put “procedures” in place to prevent an accident (such as a missed or late filing) from happening. Accidents always happen. However, we have concluded that under the law it is the actions of the taxpayer leading up to the accident that is relevant in meeting the standard of reasonable cause and winning on appeal.
Case law dictates that reliance on a U.S. CPA or lawyer is an indication that the standard of reasonable cause has been met but this is by no means determinative. In other words, putting a CPA / legal team in place are procedures that a reasonable person would put in place to stay in compliance with the rules but not just any CPA or lawyer will suffice. The taxpayer must be able to show that it is someone who is specifically qualified to advise on the matter at hand, not a mere college or law school classmate. In our experience a big-name firm goes a long way in an actual appears hearing. A small, specialized boutique firm can have the same impact as long as the parties are specifically qualified. Based upon matters we have been involved with it appears the IRS does have a point here, as we have seen many people who have hired unqualified (inexperienced) CPA’s specifically knowing that they will not ask probing questions.
Once the qualifications of the advisor are out of the way it is then important to establish with documentary evidence that the advisor was informed of all the facts. Too many taxpayers try to get away with just telling the advisor part of the story. It is equally important to be able to show that the advice was rendered in writing and to show the steps the taxpayer took to implement the advice.
It also helps when the IRS appeals involves an in-person meeting. Phone calls are not as good, and it can be difficult to get a point across through mere written correspondence. Under all approaches it is imperative to keep the arguments limited to legal principles (lack of knowledge generally is not reasonable cause) and to be as prepared and concise as possible.
In a recent (pre Covid-19) meeting an appeals officer conceded that a qualified CPA / legal team may very well be reasonable cause according to case law. But he challenged us to show him a case where a penalty was actually abated because of reliance on a CPA!! The truth is such a case many not actually exist. This was a dangerous challenge because what he was saying was that the IRS may not let it go and that the taxpayer should then pursue the CPA.
In many cases it can become necessary to pursue “mitigation” as an alternative to reasonable cause penalty abatement. Although not ideal as the taxpayer will still owe something, it typically causes the IRS to consider the “risks of litigation” and given the right facts eventually arrive at something that makes a bit more sense.
Pre-COVID-19, it typically took 18 months to get something like this resolved. In this environment taxpayers should be advised up front that the resolution could take quite some time.
It is also worth noting that the Form 3520’s can be particularly troubling as some people believe that IRC § 6039F allows for the IRS to reclassify the amount as taxable income in addition to the civil penalties. We have not actively seen this happen but understand from other practitioners that it can be a risk.
Even in normal times, IRS penalty notices can be a challenge to manage. Even when a discussion with an IRS representative is underway, the IRS has a habit of continuing to issue penalty notices that become more threatening with time. In many cases it is advisable to have the client pay the assessment and then get a refund if successful at appeals.
In conclusion, the best result it likely to occur when the responses are made timely, the arguments are consistent with the law and not emotionally based and when the advisor goes in with an open mind (sometimes mitigation is more practical than full abatement).
