Is the IRS Being Reasonable when it comes to “Reasonable Cause”?

My recent blog post discussed how I approach “streamlined procedure” filings for taxpayers with unreported income, for example, from offshore assets or accounts. Often, the tax noncompliance for such cases involves unfiled international information returns as well.  As discussed in the blog post, I draft the required statement of non-willfulness in such a manner that the explanation can, to the greatest degree possible, also cover the client’s case based on a “reasonable cause” defense.

Many provisions in the tax law refer to “reasonable cause” as a means of permitting a taxpayer to escape tax penalties. For example, the accuracy-related penalty will not be imposed on any portion of a tax underpayment if it is shown that there was “reasonable cause” for the taxpayer’s position and that the taxpayer acted in good faith with respect to that position.  IRC § 6664(c)(1); Treas. Reg. § 1.6664-4(a).  Making the determination whether a taxpayer acted with reasonable cause and in good faith is based on all of the particular facts and circumstances involved.  The determination is made on a case-by-case basis and there is no one-size-fits-all approach.  One of the most important factors is the extent to which the taxpayer made an effort to assess his proper tax liability. The taxpayer has the burden of proof to demonstrate he has “reasonable cause” and must show that he exercised ordinary business care and prudence in meeting his tax obligations but nevertheless failed to meet them.

US International Tax and Reasonable Cause

In the international/foreign context “reasonable cause” takes on particular significance. There are a vast array of international foreign information returns required of US persons who engage in non-US transactions or have ownership interests in a non-US entity. These forms include Internal Revenue Service (IRS) Forms 5471, 5472, 3520, 3520-A, 8938, 926, 8865, 8621, 8858 as well as others.  Hefty civil penalties are assessed for failures to file them, but “reasonable cause” is a defense to most international information return penalties. For example, the failure of a US taxpayer to report receipt of a foreign gift or bequest pursuant to IRC Section 6039F, can result in a penalty of 25% of the value of the gift/inheritance. However, if the taxpayer can establish the failure is due to reasonable cause and not due to willful neglect, the statute provides that the penalty will not be applied.   IRC Section 6038(b) provides a monetary penalty for failure to furnish information returns regarding ownership interests in certain foreign entities, but it can be abated if the failure is due to reasonable cause.

The IRS has a special procedure for filing delinquent international information returns without penalties and it requires the taxpayer to demonstrate in writing that he has “reasonable cause”.  Demonstrating one has reasonable cause in the international context is not always easy.  Given the IRS’ push over recent year to educate taxpayers about their filing duties for offshore assets and transactions, the IRS now expects that taxpayers will have a certain degree of awareness. The IRS takes a strict approach — taxpayers conducting foreign business or offshore transactions have a responsibility to exercise ordinary business care and prudence in determining their US tax filing obligations. For example, this may mean the IRS will reject a taxpayer’s claim that he had no knowledge of tax filing duties with respect to the foreign transactions. The reasonably prudent taxpayer would have done some investigating and it would be expected that he contact a US international tax professional.  The result may be different with a fact pattern involving a so-called “Accidental American” who has lived his entire life outside of America.  Might such a taxpayer have reasonable cause for unfiled international information returns?

My blog post here gives more detail on the IRS delinquent international information return procedure.  Unfortunately, as explained in my post, the IRS procedure warns that “during processing of the delinquent information return, penalties may be assessed without considering the attached reasonable cause statement.” How comforting is that?  Taxpayers should carefully consider the various options to regain compliance since using the special procedure may be fraught with risks and difficulties.  An experienced tax professional would be able to explain the options and assist in the decision-making process by providing the taxpayer with full information – the good, the bad, and the ugly.

Can You Establish “Reasonable Cause”?

Reasonable cause relief may be granted by the IRS when it can be demonstrated that the taxpayer exercised ordinary business care and prudence in meeting his tax obligations but nevertheless failed to meet them. In making this determination, the IRS will consider all available information, including:

• The reasons given for not meeting tax obligations
• The taxpayer’s compliance history
• The length of time between the failure to meet one’s tax obligations and subsequent compliance
• Circumstances beyond the taxpayer’s control

Reasonable cause may still be established even if the taxpayer claims he was not aware of specific tax obligations, depending on the facts and circumstances. Among the facts and circumstances that will be considered are:

• The individual’s education and background
• Whether the taxpayer had previously been subject to the tax
• Whether the taxpayer has been penalized before
• Whether there were recent changes in the tax forms or law that the taxpayer could not reasonably be expected to know
• The level of complexity of a tax or compliance issue

Not everyone will easily be able to establish “reasonable cause”. This is especially true in light of the IRS’ concerted efforts to educate taxpayers with offshore assets, accounts and international business interests. The courts look carefully at the taxpayer’s efforts to comply with the requirements of the tax rules and consider those efforts a very important factor.

The taxpayer who tries to establish reasonable cause will not only need good facts, but will also require a competent tax professional well versed in the world of US international tax.  The professional must be able to present those facts in the most favorable light and to make sure that any special procedural requirements imposed by the law or IRS Treasury Regulations are met.  These can be technical, so care is required.  For example, if the taxpayer has failed to file Form 5471, the written statement must contain a declaration that it is made under the penalties of perjury and certain other requirements must be satisfied as set out in Treasury Regulation Section 1.6038-2(k)(3).

If you need assistance, I can help you navigate the maze with my solution-focused approach.

Posted July 21, 2022

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