In recent months, the IRS has fired two separate shots across the proverbial bow, highlighting the dangers of “incomplete” or “inadequate” reporting as it relates to imposition of penalties and the elongation of the statute of limitations. This blog post explores an International Practice Unit issued by IRS Exam detailing when compliance is not “substantial” and therefore international information return penalties apply. A separate blog post, linked here, explores a Legal Advice memorandum wherein the IRS ruled that a gift tax return did not adequately disclose a gift and therefore the return did not start the limitations period.
As part of its efforts to manage knowledge and internal “know how”, the IRS develops through a collaboration process Practice Units which serve as both job aids and training materials on tax issues. On June 19, 2017, IRS released an International Practice Unit (IPU) on the meaning of “substantial compliance” for purposes of determining whether certain international information returns are sufficiently complete to avoid penalties. The IPU is linked here.
In exploring IRS rulings and court decisions defining the substantial compliance doctrine, the IPU emphasizes the distinction between income tax returns and informational returns. Information reported on income tax returns is necessary to determine tax liability. As such, if a taxpayer omits information that is not necessary to determine tax liability, the return may be considered complete notwithstanding the omission. By contrast, information returns are required so that the IRS can properly administer the revenue laws. If material information is left off an information return, such omission can impede the Service’s ability to perform the duties placed on it by Congress. Because income tax and information returns serve different functions, the IPU notes that different rules should apply. Also, the IPU questions whether the judicial substantial compliance doctrine may apply in situations where the regulations under IRC sections 6038 and 6038A, providing rules on whether Forms 5471 and 5472 are substantially complete to avoid penalties, apply. Further, the IPU provides several examples where an international return was not “substantially complete” and penalties applicable. Among the noteworthy examples are:
- A taxpayer filed a Form 5471 that “accurately reported the majority of the information, but it failed to accurately report major transactions with related parties.” The IRS rejected an “aggregate approach,” under which a taxpayer would be considered to be in substantial compliance if it accurately reported a certain percentage of the information required to be reported on the Form 5471.
- A taxpayer filed separate Forms 5471 for a large number of Controlled Foreign Corporations (CFCs). Each Form 5471 reported much of the required information and included numerous pages of detailed financial information regarding financial condition, corporate stock structure, shareholders and results of operations. However, the IRS identified significant understatements of purchases from and/or sales to some CFCs and related third parties (reported on Schedule M, Transactions Between Controlled Foreign Corporation and Shareholders or Other Related Persons) and significant inconsistencies in the reported earnings and profits of some CFCs.
- A taxpayer filed Form 5471 that reported amounts on Schedules C, Income Statement, and F, Balance Sheet that were not in accordance with GAAP and failed to attach Schedule O, Organization or Reorganization of Foreign Corporations and Acquisitions and Dispositions of Its Stock. In concluding the Form 5471 was incomplete, the IRS declared that “failure to include Schedule O, by itself, is likely to cause the taxpayer to fail the substantial compliance test.”
The takeaway: filing is simply not enough. A return that is incomplete is no return at all, potentially exposing the taxpayer to penalties and/or an unlimited statute of limitations. As tax practitioners, we are well advised to heed these IRS warnings and make sure that the returns filed by our clients meet the minimum thresholds for completeness.
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