The IRS is assessing penalties regarding U.S. filing obligations related to foreign activity more frequently and abating them less. When taxpayers face large penalties, large claims follow.
By Deborah K. Rood, CPA, MST
Traditionally, claims related to tax services are the most frequent type of malpractice claim asserted against CPA firms. While that is unwelcome news for tax preparers, most tax claims are not as severe, or as expensive, to resolve compared to other services.
Unfortunately, based on the claim experience of CNA, the endorsed underwriter of the AICPA Professional Liability Insurance Program, this may be changing, primarily due to errors and omissions related to U.S. filing obligations for foreign activity (hereinafter referred to as “international tax filings”).
Why are international tax filing claims severe?
When providing tax services, damages are typically limited to interest and penalties, not additional tax owed, because the taxpayer would have owed the tax regardless of the CPA’s alleged mistake. Most tax penalties are not considered large, but exceptions exist, particularly those related to international tax filings, such as Form 3520, Annual Return to Report Transactions With Foreign Trusts and Receipt of Certain Foreign Gifts; Form 3520-A, Annual Information Return of Foreign Trust With a U.S. Owner; Form 5471, Information Return of U.S. Persons With Respect to Certain Foreign Corporations; Form 5472, Information Return of a 25% Foreign-Owned U.S. Corporation or a Foreign Corporation Engaged in a U.S. Trade or Business; and FinCEN Form 114, Report of Foreign Bank and Financial Accounts (FBAR). When taxpayers do not comply with these filing obligations, penalties generally start at $10,000 and can quickly rise to over $1,000,000.
The international tax filing requirements have not changed, nor has the calculation of IRS penalties for noncompliance, so why is claim severity increasing?
Janet Everson, J.D., LL.M., a partner with Murphy, Pearson, Bradley & Feeney, who has experience defending CPAs against malpractice claims, offers an explanation. Everson notes that “in my experience, the IRS is assessing penalties on some tax forms, such as Forms 3520 and 3520-A, more frequently and abating all international tax penalties less often.” When taxpayers face large penalties, large claims against the tax preparer often follow. Consider this:
A CPA ran into a longtime tax client at a baseball game. The client mentioned that she was cotrustee of her mother’s trust and recently settled the estate in Canada. The next day, the CPA reviewed the client’s file and noticed that the prior years’ organizer FBAR questions were unanswered and the workpapers included bank statements for the trust. This prompted the CPA to ask additional questions and research filing requirements related to the foreign activity. In doing so, the CPA learned that the client should have filed:
- Form 3520 for the three years she was co-trustee of the trust;
- FBARs for the trust’s bank account on which she was a signatory for three years; and
- Form 3520 for seven years, as her mother had gifted her $300,000 each year.
The CPA informed the client of the filing requirements, prepared the additional forms, and provided them to the client to file. The client was assessed penalties of several hundred thousand dollars. When their penalty abatement request was denied, a claim was made against the CPA.
Why do claims related to international tax filings occur?
While each claim is unique, there are commonalities in claims stemming from international tax filings.
Not identifying filing requirements
Are you familiar with IRS Form 926, Return by a U.S. Transferor of Property to a Foreign Corporation? This form is required if property is transferred to a foreign corporation. What about Form 8865, Return of U.S. Persons With Respect to Certain Foreign Partnerships, which reports interests in foreign partnerships? Form 8858, Information Return of U.S. Persons With Respect to Foreign Disregarded Entities (FDEs) and Foreign Branches (FBs), which reports foreign disregarded entities and foreign branches? There are a multitude of forms and filing requirements that relate to foreign activity. Unless you frequently practice in this area, you may not be able to identify when an international tax filing requirement exists.
Not asking enough questions
Appropriate questions should be asked to help identify a filing requirement. Despite knowing how aggressive the IRS enforces FBAR penalties, some CPAs still do not ask clients about foreign accounts. Or, if the client is asked about foreign accounts, the question is not sufficiently detailed to help clients respond appropriately. In the above example, the client did not realize being a signatory on her mother’s trust’s foreign bank account created a filing obligation.
Similarly, CPAs might not ask if the client received any gifts because there is no income tax impact and, thus, may overlook a Form 3520 filing requirement.
Forgetting to file
Large claims have also arisen because the CPA did not timely file or extend forms. Form 3520-A, which is generally due March 15, was frequently filed late. Failing to include international tax filing requirements in the firm’s docket system increases the likelihood of a missed due date or extension.
Risk management recommendations
If you are unfamiliar with all of the international filing requirements, take training to help identify and understand the required forms, including indicators of when these forms are necessary.
A well-written engagement letter clearly defines the scope of services and helps defend claims related to the CPA’s scope of services. For most tax-compliance services, the scope typically excludes Form 3520, Form 3520-A, and FBARs. Engagement letters may also include a provision that informs the client it is their responsibility, not the CPA’s, to discuss additional filing obligations.
However, using engagement letters does not eliminate potential liability. For instance, because Forms 5471 and 5472 are part of a tax return, regardless of entity type, the CPA may have an obligation to prepare them. If there is information in the client’s file indicating they may have additional filing obligations, an engagement letter may have limited effectiveness.
Organizers and checklists
For individuals, organizers generally address FBARs, but the questions asked may not be comprehensive enough to identify foreign accounts other than with traditional financial institutions. If insufficient, consider a supplement to your organizer with more specific questions, such as questions to determine ownership of foreign trusts.
Follow-up and documentation
Not all clients “talk tax” and may not understand organizer questions. For instance, the question “Did you or your spouse own any foreign financial assets?” may not identify a taxpayer’s vacation home. As a result, consider discussing foreign activity with every client. A lack of understanding on the client’s part and finger-pointing at the CPA as the “expert” can contribute to a claim. A discussion with the client, rather than solely relying upon the organizer, may better identify additional filing obligations. Remember to document those discussions.
Good news on the horizon?
Recent court decisions may provide some good news in the form of penalty relief. In the Bittner decision (Bittner, No. 21-1195 (U.S. 2/28/23)), the U.S. Supreme Court found that the penalty for nonwillful failure to file an FBAR is assessed on a per-report basis instead of a per-account basis. While this is certainly welcome news, the IRS defines “nonwillful” very narrowly. The penalty for a willful failure to file continues to be calculated on a per-account basis.
In the Farhy decision (Farhy, 160 T.C. No. 6 (2023)), the Tax Court determined that the IRS lacks statutory authority to collect failure-to-file penalties for Forms 5471 and 5472.
Despite these decisions, the IRS-taxpayer game of whack-a-mole continues. CPAs should be prepared for the IRS’s response to these decisions and the persistence of large penalties related to noncompliance with international tax filing requirements.
Exposing foreign assets
1970: The year the Bank Secrecy Act was enacted, requiring foreign asset reporting.
Source: Sheppard, “Evolution of the FBAR,” 7 Houston Bus. & Tax L.J. 1 (2006).