As filing season heats up, taxpayers and preparers need to be aware of the many foreign reporting requirements. There is a lot more to know than an FBAR and a box on Schedule B. Failure to know and follow the rules can be costly. Edward S. Flume, a U.S. citizen residing in Mexico, had ownership interests in two Mexican corporations, but failed to file Forms 5471 and was hit with $10,000 penalties for 9 years, including multiple $10,000 penalties for 2 years. Flume v. Commissioner, T.C. Memo. 2017-21.
Mr. Flume had a 50% ownership in one corporation, later reducing his interest to 9%. In a second corporation, he and his wife each owned 50%, but later claimed they each only owner 9% despite total control of a UBS account in the corporation’s name. Backdated documents supporting their reduced ownership did help them. Mr. Flume had a tax preparation firm in Mexico prepare his returns, but he failed to inform them of his corporations.
Mr. Flume timely filed his tax returns for the years at issue, but did not file Forms 5471. The IRS audited Mr. Flume’s ownership of foreign corporations and assessed penalties for failure to file Forms 5471 under IRC §6679(a) for one year, and under IRC §6038(b) for the remaining years. Mr. Flume didn’t pay and the IRS issued a Notice of Intent to Levy. Mr. Flume requested a CDP hearing challenging the underlying liability. The IRS sustained the collection action and Mr. Flume petitioned the Tax Court.
Taxpayers are required to file Form 5471 if they fall into one or more of several categories. The Court discussed the legal requirements in detail as follows:
“Section 6038(a)(1) imposes information reporting requirements on any U.S. person, as defined in section 957(c), who controls a foreign corporation. A person controls a foreign corporation if he owns or constructively owns stock that is more than 50% of the total combined voting power of all classes of voting stock or owns more than 50% of the total value of shares of all classes of stock. Sec. 6038(e)(2). A U.S. person must furnish, with respect to any foreign corporation which that person controls, information that the Secretary may prescribe. Sec. 6038(a)(1). Form 5471 and the accompanying schedules are used to satisfy the section 6038 reporting requirements. The Form 5471 must be filed with the U.S. person’s timely filed Federal income tax return. Sec. 1.6038-2(i), Income Tax Regs.
Additionally, the information reporting requirements prescribed in section 6038(a)(1) also are imposed on any U.S. person treated as a U.S. shareholder of a corporation that was a CFC for an uninterrupted period of 30 days during its annual accounting period and who owned stock in the CFC on the last day of the CFC’s annual accounting period. Secs. 951(a)(1), (b), 6038(a)(4); see also Rev. Proc. 92-70, sec. 2, 1992-2 C.B. 435, 436. A U.S. shareholder, with respect to any foreign corporation, is a U.S. person who owns under section 958(a), or is considered as owning under section 958(b), 10% or more of the total combined voting power of all classes of stock entitled to vote of the foreign corporation. Sec. 951(b).
Section 6046 requires information reporting by each U.S. citizen or resident who is at any time an officer or director of a foreign corporation, where more than 10% (by vote or value) of stock is owned by a U.S. person. Sec.6046(a)(1)(A). The stock ownership threshold is met if a U.S. person owns 10% or more of the total value of the foreign corporation’s stock or 10% or more of the total combined voting power of all classes of stock with voting rights. Sec. 6046(a)(2). A U.S. person who disposes of sufficient stock in the foreign corporation to reduce his interest to less than the stock ownership requirement is required to provide certain information with respect to the foreign corporation. Sec. 1.6046-1(c)(1)(ii)(c), Income Tax Regs.”
The penalties for failing to timely file a Form 5471 are $10,000 per corporation per annual accounting period. If notified by the IRS of the failure, additional penalties of up to $50,000 can apply.
Mr. Flume was required to file Form 5471 for various reasons depending on the year. To avoid the penalty a taxpayer must demonstrate reasonable cause. As the Court points out, there are no regulations defining reasonable cause in the Form 5471 context, but court cases have generally required a taxpayer to demonstrate that he exercised ordinary business care and prudence, but was unable to file within the required time. United States v. Boyle, 469 U.S. 241, 246 (1985). A taxpayer can also demonstrate reasonable cause by relying on his tax adviser. The taxpayer must show that the adviser was competent, the taxpayer provided necessary and accurate information, and that he actually relied in good faith on the advice.
Mr. Flume argued that his preparer failed to advise him to the Form 5471 requirement. The only problem for Mr. Flume was that he didn’t inform his preparer that he had foreign corporations until one of the later years at issue.
Although this case is a Form 5471 case, there are lessons to be learned for all foreign reporting issues. The relationship between a taxpayer and his or her tax preparer is crucial. If you do not tell your preparer about your foreign assets, you can’t expect proper reporting, and if hit with penalties you can’t rely on the advice not given. As foreign penalties go, Form 5471 penalties are relatively low at $10,000 per corporation, per year. Other penalties can be much more severe.
In an interesting footnote, the Court asked the parties to address the whether there were any prohibited ex parte communications between the IRS Office of Appeals and the originating function. Petitioner failed to address the issue and therefore is deemed to have conceded it. In a CDP context, taxpayers should always make sure that the ex parte rules are followed and that any communication between the Settlement Officer and the Revenue Agent, for example, include you or your representative.
JONAHAN KALINSKI specializes in both civil and criminal tax controversies as well as sensitive tax matters including disclosures of previously undeclared interests in foreign financial accounts and assets and provides tax advice to taxpayers and their advisors throughout the world. He handles both Federal and state tax matters involving individuals, corporations, partnerships, limited liability companies, and trusts and estates.
Mr. Kalinski has considerable experience handling complex civil tax examinations, administrative appeals, and tax collection matters. Prior to joining the firm, he served as a trial attorney with the IRS Office of Chief Counsel litigating Tax Court cases and advising Revenue Agents and Revenue Officers on a variety of complex tax matters. Jonathan Kalinski also previously served as an Attorney-Adviser to the Honorable Juan F. Vasquez of the United States Tax Court.