In a recently updated international practice unit (IPU), the IRS explained the penalty for U.S. taxpayers who fail in their obligations to file Form 5471, “Information Return of U.S. Persons With Respect to Certain Foreign Corporations.” The IPU includes, among other things, insight as to what constitutes reasonable cause for failing to file.
Note: IPUs aren’t official IRS pronouncements of law or directives and they can’t be used, cited, or relied upon as such. Nonetheless, they can let companies and shareholders identify strategic areas of importance to the IRS and give them insight into how IRS examiners may audit a particular issue or transaction.
Timely and accurate
IRS examiners are instructed to determine whether a taxpayer who is required to file the information return filed a timely and accurate form. Form 5471 must be filed along with the taxpayer’s income tax return, taking into account if the last day for filing was a weekend or legal holiday. If one isn’t timely filed, or it isn’t complete, penalties may be assessed unless the failure was due to reasonable cause.
In determining whether the form was complete, examiners should make sure that the following items aren’t omitted or incorrect:
- The filer’s category,
- The percentage of voting stock owned in the foreign corporation,
- Information about the foreign corporation, such as address and principal business, and
- Reference identification number.
Common types of noncompliance include stating that required information will be furnished upon request or audit, and providing consolidated financial statements of multiple foreign corporations. The IPU notes that the doctrine of substantial compliance may apply in considering whether a Category 2 or 3 filer (see “Category 2 and 3 filers”) timely submitted a complete Form 5471.
The substantial compliance doctrine is a narrow equitable doctrine used to avoid hardship in cases where the taxpayer establishes that he or she intended to comply with a provision and did everything reasonably possible to comply — but was unable to meet the provision’s specific requirements. The doctrine can only be applied where invocation of it wouldn’t defeat the policies of the underlying statutory provisions.
An IRS examiner who determines that the taxpayer failed to file a timely and accurate information return should establish a penalty case file and issue a notice letter. The letter should inform the taxpayer of the failure to file and explain that the initial $10,000 penalty will be imposed and that a continuation penalty will apply. Continuation penalties apply for each 30-day period (or fraction thereof) beginning 90 days after the date of the letter until a substantially complete Form 5471 is provided.
The notice letter should be mailed as soon as possible, both to obtain information early to effectively conduct the exam, and to start the initial 90-day period the taxpayer had to provide the form. There’s no provision to extend the 90-day period under the tax code. Such extensions can be allowed when reasonable, including for extreme hardship or a natural disaster.
Examiners are cautioned not to discuss the notice letter, or penalty issues generally, with a representative who isn’t designated on a Form 2848, “Power of Attorney and Declaration of Representative.” The IPU cautions that a power of attorney for the underlying income tax return doesn’t cover the penalty issue.
In determining penalties, the examiner must consider whether the taxpayer has shown that the failure was due to reasonable cause. Only the initial penalty — not the continuation penalty — can be considered for the reasonable cause exception. The taxpayer must provide a written statement that provides all of the facts alleged as reasonable cause, as well as a declaration that the statement was made under penalties of perjury.
Examiners should consider the taxpayer’s compliance with reporting and recordkeeping requirements and whether the taxpayer exercised ordinary care and prudence but still wasn’t able to provide any item of required information. Facts indicating reasonable cause include:
- Erroneous advice,
- An inability to obtain records, and
- Death or serious illness.
Ignorance of the law
Ignorance of the law isn’t by itself reasonable cause (but it might be in conjunction with other factors). The fact that a foreign jurisdiction would penalize the taxpayer for disclosing the information doesn’t generally constitute reasonable cause.
Form 8278 is the assessment document for international penalties. If both a continuation penalty and initial penalty are proposed, a separate Form 8278 is required for each.
Taxpayers should consult with their advisors if they have any doubts about compiling and filing this information return to help ensure they aren’t penalized.
Sidebar: Category 2 and 3 filers
The instructions for Form 5471 separate U.S. persons into different filing categories based on their relationship to the foreign corporation.
The category determines the type of information the U.S. person must provide. This international practice unit concerns penalties on Category 2 filers and Category 3 filers.
Category 2: A Category 2 filer is a U.S. citizen or resident who is an officer or director of a foreign corporation in which a taxpayer has acquired, in one or more transactions:
- Stock that meets the 10% stock ownership requirement in the corporation, or
- An additional 10% or more (in value or voting power) of the outstanding stock of the foreign corporation.
For purposes of both Categories 2 and 3, the stock ownership threshold is met if a taxpayer owns 10% or more of the total value of the foreign corporation’s stock, or of the total combined voting power of all classes of stock with voting rights.
Category 3: A Category 3 filer:
- Acquires stock in a foreign corporation that, when added to any stock already owned, meets the 10% stock ownership requirement,
- Acquires stock that, without regard to stock already owned, meets the 10% stock ownership requirement,
- Is treated as a U.S. shareholder of the foreign corporation,
- Becomes a U.S. person while meeting the 10% stock ownership requirement, or
- Disposes of sufficient stock in the foreign corporation to reduce his or her interest to less than the 10% requirement.
There are a number of exceptions to the filing requirement for Category 2 and 3 filers, so it’s best to consult with your advisors.