Cross-Border Activities: Benefits of Filing “Protective” Returns

With the increasing focus by the Internal Revenue Service (IRS) on offshore activities, it is important to understand the tax return and information return filing obligations that may be associated with such activities. Because application of many of these obligations is not entirely clear in certain common situations, many taxpayers (including non-U.S. persons who might not otherwise consider themselves U.S. taxpayers) may be well-advised to resolve any reasonable doubt they might have in favor of filing. Although this sometimes places significant burdens on those taxpayers, the potential advantages to making these filings are likely to outweigh the burdens.

Uncertain Application of Tax and Information Return Filing Obligations

U.S. citizens, U.S. green card holders and U.S. corporations are clearly required to file a U.S. income tax return each year if their income meets the filing threshold. Less clear is whether such U.S. persons must file “information returns” for activities in which they may be involved outside of the United States, and whether non-U.S. persons who have some U.S. business-related activity are required to file U.S. income tax returns. Some examples of these situations are as follows.

U.S. persons involved in funding a foreign arrangement (such as a will or a retirement plan) may not readily be able to determine whether the arrangement constitutes a trust for U.S. tax purposes. Should they file additional information returns (Forms 3520 and/or 3520A) to report a foreign trust?
A U.S. person with an ownership interest in a foreign corporation. Should he/she file an information return to disclose that ownership?
A non-U.S. person may be involved in conducting some business-related activity in the U.S., but it is not clear whether that activity rises to the level of engaging in a U.S. trade or business. Should that person file U.S. returns?

The short answer is – when not entirely clear, the taxpayer (or potential taxpayer) is probably better off making a “protective” filing of tax returns or information returns. The primary reason is that if the IRS later concludes that such a return is required, then a protective filing of the return can preserve numerous benefits for the taxpayer which would not have been available had the taxpayer not made such a protective filing.

Reserve Benefits of Otherwise Deductible Items

Non-U.S. persons engaged in a trade or business in the U.S. are required to file a U.S. tax form even if there is no income generated from that trade or business. For individuals, the required form is called Form 1040NR (U.S. Nonresident Alien Income Tax Return). For foreign corporations, the appropriate tax return form is the Form 1120F (U.S. Income Tax Return of a Foreign Corporation). Under IRS regulations, failure to file such a return within 16 months after its due date allows the IRS to deny any deductions from adjusted gross income in determining the non-U.S. taxpayer’s tax liability. However, it can be difficult to make a definite determination as to whether a non-U.S. person’s activity in the U.S. rises to the level of “engaged in a trade or business within the United States.” When there is lack of certainty, the non-U.S. person can preserve the right to receive benefits of otherwise deductible items by timely filing a protective return. The IRS has specifically recognized that a pro forma “protective” tax return that shows no income effectively connected with the taxpayer’s U.S. trade or business, when accompanied by a statement that the return is being filed to preserve the taxpayer’s right to claim applicable deductions, is sufficient to satisfy the tax return filing requirement.

Get the Statute of Limitations Running

The statute of limitations for assessing taxes generally determines the length of time that the IRS is allowed to propose adjustments to a filed tax return. If the statute of limitations has expired with respect to a particular tax year, then the IRS is precluded from making such adjustments for that year. Generally, the statute of limitations for tax returns is three years starting from the date of filing or the date it was due (if later). The statute can be extended to six years if there is a “substantial understatement” of income. If a taxpayer never files a tax return with respect to a given taxable year, effectively there is no statute of limitations on the IRS’s right to assess additional taxes for that year. Regardless of the length of the statute of limitations, therefore, it is imperative to get the statute of limitations running.

The statute of limitations does not begin to run until a tax return is filed. Moreover, if certain information returns reporting transfers or ownership of assets outside the United States are required parts of the tax returns, then the statute of limitations does not begin to run until the required information returns are filed, because the tax return otherwise is considered incomplete. Sometimes, it is not entirely clear whether an information return is required to be filed, especially when foreign arrangements are involved. For instance, a U.S. person who has an interest in or makes a contribution to a foreign trust is required to file Form 3520 (Annual Return To Report Transactions With Foreign Trusts and Receipt of Certain Foreign Gifts) and/or Form 3520-A (Annual Information Return of Foreign Trust With a U.S. Owner). Unfortunately, it may not be easy to determine whether some of the foreign arrangements constitute a trust for U.S. tax purposes. A foreign estate planning arrangement or a foreign foundation may be deemed a trust for these purposes.

If there is a lack of clarity regarding the status of a foreign trust, then a taxpayer probably should take a conservative approach and make a protective filing of the IRS forms. Filing the forms can at least get the statute of limitations on the returns to begin running.

Likewise, if a U.S. person has certain involvement with or ownership interest in a foreign corporation, then that U.S. person may be required to disclose that involvement or ownership on a Form 5471 (Information Return of U.S. Persons With Respect to Certain Foreign Corporations). Again, if the facts are not entirely clear as to the requirement of filing such an information return, a protective filing should be considered to get the statute of limitations running.

Avoid Failure to File Penalties

Another advantage of making a protective filing is to avoid failure to file penalties. For example, if the IRS later determines that a foreign arrangement constitutes a trust, and Form 3520 and/or Form 3520-A should be filed, then failure to file the return can subject the taxpayer to severe penalties. If a required Form 3520 is not timely filed, then the initial penalty is $10,000 or 35 percent of the value of the trust assets in question, whichever is greater. If a required Form 3520-A is not timely filed, then the initial penalty is $10,000 or 5 percent of the gross value of the portion of the trust owned by the U.S. person, whichever is greater. Similarly, if a taxpayer is required to file Form 5471 and fails to do so, the failure to file penalty can be $10,000 for each year for each Form 5471 not filed.

Any Downside?

Of course, making a protective filing of the returns can be expensive. In addition, if the return is filed inaccurately, then there might be penalties. However, in most cases, the benefit of filing a protective return easily outweighs the downside of filing an inaccurate return when the IRS later concludes that a return should have been filed.