Go to Top

Rejecting An IRS Trust Grab

IRS building exterior.
photo by David Boeke

Many Americans have quaint ideas about the Internal Revenue Service – ideas such as “the IRS always knows and follows the law,” or “paying your taxes properly means you won’t have any problems with the agency.”

Sometimes these naive assumptions are true, but sometimes not so much. In occasional, egregious cases, the tax collectors get so focused on collecting that they don’t care much about whether taxes are actually owed, or whether the law really gives them the right to collect anything at all.

Consider the case of the late Joseph A. Wilson. Back in 2003, Wilson (who was then very much alive) believed his marriage was in trouble and that his wife was contemplating divorce. To put himself in a stronger position in the forthcoming negotiations, he transferred more than $9 million in U.S. Treasury obligations to an offshore trust, naming himself as the sole beneficiary. The trust was a “grantor” trust under federal tax rules, meaning Wilson was also treated as the owner for income tax purposes.

His wife did, indeed, divorce him. Wilson paid the appropriate income taxes while the money was parked overseas. In 2007, after divorce proceedings ended, he brought the money back to the United States.

Wilson’s decision to move money offshore and put it in trust was perfectly legal. Americans are allowed to keep money wherever we want. But Congress and the IRS long ago lost patience with people who used overseas accounts to evade taxes by hiding income and assets. In addition to simply reporting income on tax returns, Americans – including those who, unlike Wilson, actually live overseas – face a variety of strict information reporting requirements. They also face the potential of draconian penalties for failing to comply with them.

Wilson and his financial advisers stumbled over one of those requirements when he returned the money from his overseas trust in 2007. He was late in filing IRS Form 3520, which is used to report a variety of transactions involving foreign trusts and their U.S. creators and beneficiaries.

Wilson never evaded or owed any taxes. Even so, the IRS imposed a 35% penalty on the amount distributed to Wilson that year – meaning on the entire balance of the trust. The total bill, including interest, came to about $3.5 million.

But Wilson was not only the trust’s beneficiary. Under the grantor trust rules, he was also its owner, and of course he was a U.S. person. In that situation, the primary responsibility for reporting transactions with the foreign trust falls to the owner. The penalty for an owner who fails to file the necessary report is 5%, not 35%. And the penalty is computed on the trust’s balance at the end of the year in question. In 2007, that year-end balance was zero. Which means the IRS stands to collect – nothing.

This is the conclusion that U.S. District Judge Brian M. Cogan reached in the case, which was continued by Wilson’s estate following his death. Cogan rejected the IRS position that the penalties on beneficiaries and trust owners operate independently of one another, even when they apply to the same person and when the required report would have been filed on a single Form 3520.

It was a victory for Wilson’s heirs, but they had to follow a long and circuitous path the get there. To get a tax case in front of federal courts other than the Tax Court, taxpayers must pay at least part of the balance assessed by the IRS and then put in a claim for refund. The IRS has six months to act on the claim before the taxpayer can sue.

In the Wilson case, the IRS successfully argued that the initial claim for refund was defective. After paying the full assessed balance – which prevented further interest from accruing – Wilson had to file a second claim, wait another six months, and then bring the suit that ultimately ended up in Cogan’s Brooklyn court.

The government, as you might guess, is not happy with Cogan’s ruling. It has filed an appeal with the 2nd U.S. Circuit Court of Appeals. Even if it loses there, the precedent would be binding on the IRS only in the circuit’s jurisdiction of New York, Connecticut and Vermont. Sometimes the IRS will issue a notice that it accepts (“acquiesces” in legal terms) the way the courts have decided an issue. I wouldn’t count on it doing so in this situation – not unless multiple circuits rule against the Service, anyway.

That’s not a sure thing. While Cogan (a George W. Bush appointee, who took senior status earlier this year after deciding the Wilson case) used sound logic, other courts will surely note that in situations like Wilson’s, Cogan’s reading effectively means there is no penalty for filing Form 3520 late – or not filing it at all. There is a good chance they will look for an alternative way to construe the statute, reasoning that this is probably not the result Congress intended.

None of this has anything to do with tax evasion, or tax collection. There is not even a hint that Wilson was trying to cheat the government. But in its ham-handed approach to the legitimate issue of Americans using offshore tax dodges, the Service has gotten into the penalty-collection business, rather than the tax-collection business.

Don’t assume that it will always do so fairly and legally. And don’t assume that merely declaring your income and paying your taxes will be enough to satisfy the agency’s collectors, either.

Larry M. Elkin is the founder and president of Palisades Hudson, and is based out of Palisades Hudson’s Fort Lauderdale, Florida headquarters. He wrote several of the chapters in the firm’s recently updated book, Looking Ahead: Life, Family, Wealth and Business After 55. His contributions include Chapter 1, “Looking Ahead When Youth Is Behind Us,” and Chapter 4, “The Family Business.” Larry was also among the authors of the firm’s book The High Achiever’s Guide To Wealth.

The views expressed in this post are solely those of the author. We welcome additional perspectives in our comments section as long as they are on topic, civil in tone and signed with the writer's full name. All comments will be reviewed by our moderator prior to publication.

, , , , , , ,