IRC 6038 & Reasonable Cause for Form 5471 Penalties

Foreign Nationals & Expats

Houston Tax Attorney

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IRC 6038 Penalties in Dewees v. United States

Dewees v. United States, 16-cv-01579 (D.C. 2017) is a difficult case. The IRS appears to have been unusually tough on this taxpayer.

Dewees is a U.S. citizen living in Canada, where he operates a consulting business. Because the business is incorporated abroad, Dewees was required to furnish certain annual information about the company to the IRS. Unfortunately for Dewees, he neglected to do so for over a decade.

U.S. citizens who hold controlling interests in foreign corporations must annually file IRS Form 5471, which discloses certain ownership and financial information about the corporation. In addition, U.S. citizens living abroad must disclose holdings in foreign bank accounts over certain thresholds by filing a Report of Foreign Bank and Financial Accounts (“FBAR”).

In 2009, Dewees learned that he had failed to comply with these requirements, and, on the advice of a tax specialist, applied to participate in the IRS’s Offshore Voluntary Disclosure Program (“OVDP”). OVDP is intended to encourage taxpayers who have not disclosed their offshore assets, and who are not already under investigation by the agency, to voluntarily comply with applicable disclosure requirements. In return for their disclosures, the program offers taxpayers compromise terms on penalties for outstanding taxes, assurance that the IRS will not refer the matter to the Department of Justice for criminal prosecution, and finality regarding previous non-disclosures.

IRC Section 6038 authorizes the IRS to impose penalties for the failure to file various international information forms such as Forms 8938, 8621, 5471, 8865, 8858, 5472, 926, and 3520. In this case the taxpayer failed to file FinCEN 114 (FBAR) to report foreign financial assets and Form 5471 to report his interest in a foreign corporation.

The IRS assessed a penalty of $185,862 against Dewees for not filing FBARs from 2003 to 2008, but did not at that time calculate a penalty for Dewees‘ failure to file Form 5471…Dewees refused to pay the assessed penalty and withdrew from the OVDP.

In September 2011, the IRS notified Dewees that it had assessed a different penalty of $120,000 against him for failing to file Form 5471 from 1997 to 2008. Section 6038(c) of the Tax Code authorizes the IRS to impose a $10,000 penalty for each missed filing.

The total penalty was based entirely on Dewees‘ failure to file; he was not liable for any unpaid taxes.

A person in this situation who has no unpaid taxes but has failed to report one or more international information returns may file the delinquent information returns with a statement of facts that establish reasonable cause for the failure to file.

Reasonable Cause

The taxpayer does not need to use the OVDP or the Streamlined Filing Compliance Procedures to file delinquent or amended tax returns to report and pay additional tax, but who:

  • have not filed one or more required international information returns,
  • have reasonable cause for not timely filing the information returns,
  • are not under a civil examination or a criminal investigation by the IRS, and
  • have not already been contacted by the IRS about the delinquent information returns

should file the delinquent information returns with a statement of all facts establishing reasonable cause for the failure to file.

As part of the reasonable cause statement, taxpayers must also certify that any entity for which the information returns are being filed was not engaged in tax evasion.  If a reasonable cause statement is not attached to each delinquent information return filed, penalties may be assessed in accordance with existing procedures.

  • All delinquent international information returns other than Forms 3520 and 3520-A should be attached to an amended return and filed according to the applicable instructions for the amended return.
  • All delinquent Forms 3520 and 3520-A should be filed according to the applicable instructions for those forms.
  • A reasonable cause statement must be attached to each delinquent information return filed for which reasonable cause is being requested.

Information returns filed with amended returns will not be automatically subject to audit but may be selected for audit through the existing audit selection processes that are in place for any tax or information returns.

Dewees probably should not have entered the OVDP process in the first place if he had no unreported income. There was no evidence of any tax evasion and did not need immunity from criminal prosecution. He might have had better results simply filing the delinquent information returns. Where taxpayers do have unreported income and there is lack of willfulness, they may file under the streamlined filing compliance procedures (these procedures were not available at the time).

U.S.-Canada Tax Treaty & International Tax Collections

U.S. expats often wonder what recourse the IRS has to collect on a tax deficiency or penalty where the expat’s assets are located abroad. Generally a country has no sovereign right to unilaterally to seize foreign assets. However, pursuant to a tax treaty or convention, the U.S. may enforce its tax debt collections. And that’s exactly what occurred in Dewees.

In May 2015, the Canadian Revenue Agency notified Dewees that it was holding his Canadian tax refund in abeyance due to his outstanding $120,000 debt to the IRS. This international collection assistance is permitted by Article XXVI(A) of the United States-Canada Income Tax Convention.

Taxpayers who have not been compliant with reporting international forms such as Forms 8938 or 5471 and who have no additional taxes due, or where the additional taxes are minimal, may become compliant by filing the delinquent returns with reasonable cause statements. We have done exactly that for some clients and the IRS has not assessed penalties. Where there are taxes owed and factors for establishing reasonable cause are not strong, the client should consider the streamlined filing compliance procedures if the failure to report foreign assets and omission of foreign income was not willful.