Little-known Form 3520 is required for reporting gifts or inheritances received from one or more foreign individuals totaling $100, 000 or more during the calendar year. Attorney Robert L. Sommers is based in San Francisco and is a Certified Tax Specialist, California Board of Legal Specialization, State Bar of California. He has represented hundreds of U.S. and foreign individuals and small companies on a variety of U.S. and foreign tax, business, and estate planning matters. A major portion of his practices involves foreign tax issues and obligations, including unreported foreign income, assets, gifts/inheritances and accounts. Bob explains the requirements and severe penalties if Form 3520 is not timely and accurately filed. This is the first in a series of Boomer Bob’s Tax Cafe and Coffee Bar videos, providing tax news you can use.
1. U.S. Taxpayers (generally individuals physically present in the U.S. 121 days or more during a calendar year, long-term residents and citizens) must report their world-wide income, credits and deductions on U.S. tax returns (Form 1040) and, in general, are entitled to foreign tax credits for income taxed by a foreign country. Non-residents are subject to U.S.: (i) income tax on their U.S. source income; and (ii) estate tax on their U.S. property, including real estate and securities (stocks, bonds and debt instruments) of U.S. companies and individuals. See IRS Publication 54 (also available as a .pdf) for details.
2. U.S. Taxpayers with an ownership interest or signature authority over foreign financial accounts (bank and brokerage accounts, corporate, trust and other entity accounts, certain retirement plans and life insurance with a cash value) are required to electronically file an annual Foreign Bank and Financial Account Reports (FBARS) on or before the due date of their income tax return for the following year. The maximum fine for non-willful failure to timely file an FBAR is $10,000 and there is a six-year statute of limitations for assessing the penalty. The penalty may be reduced or eliminated upon showing “reasonable cause.”
3. In addition to the FBAR requirement, starting in 2011 U.S. taxpayers with foreign financial account and certain other financial assets (generally, stock or securities, including certain employee stock benefit plans) must report those assets on Form 8938, which is filed with the Form 1040. The threshold filing requirements start at $50,000 for single taxpayers ($100,000 1 for married couples filing joint returns) living in the U.S.
4. U.S. Taxpayers who have a 10% or greater interest in a foreign corporation must file Form 5471 with the Form 1040. There are equivalent filing requirements for 10% or more ownership in a foreign partnership.
5. U.S. Taxpayers who receive a foreign gift or inheritance from an individual of more than $100,000 during the calendar year must file Form 3520 to report the gift or inheritance. The due date of Form 3520 is the same as the Form 1040, and is extended if a valid extension is filed for the Form 1040. The threshold reporting requirement for a gift from an entity or trust is much lower.
6. U.S. Taxpayers who earn wages or self-employment income while residing outside the U.S. may be entitled to a foreign earned income exclusion if they are considered residents of a foreign country or remain outside the U.S. for a period of 330 days during any 12-month period. The maximum income exclusion is $104,100 for 2018. The exclusion must be claimed on a timely filed U.S. tax return, it is not automatic. There is also a partial exclusion for housing costs, if they exceed a certain minimum.
To understand some of the issues contained in Trump’s tax returns, let’s assume the role of an IRS auditor and examine Trump’s tax returns based on the information available in news reports, principally the New York Time’s (NYT) massive investigation published on September 28, 2020.
1. Disguised Gifts:
Fred Trump (Donald’s father) apparently made numerous disguised gifts to his children, designed to avoid gift taxes and that Donald has been following in his footsteps (“like father, like son”) with suspicious payments in 2017 to Ivanka of $747,600 for “consultant” fees, when she received a salary of $2.0 million working for the Trust Organization. At first glance, if Ivanka pays income taxes on the consulting fee, what’s the big deal – the government collected the income tax, whether it was from Donald or Ivanka. We’d want proof that Ivanka actually paid taxes on the money and did not generate dubious deductions to offset the income, such as non-deductible personal expenses.
If the consulting fee was a disguised gift, Trump would owe gift taxes on the $750,000 at a rate of 40% ($300,000) in addition to the income taxes he’d owe on the non-deductible transaction, a combined federal tax approaching 80%, plus applicable state taxes. Under the tax law, if we assert a gift tax, the burden of proof is on Trump to show there was not a gift, our determination is presumed to be correct.
By doing this numerous times, Trump would be transferring wealth to his children, grandchildren or other family members without paying gift taxes, just like his father, a generational family tax dodge. Because the transaction was not reported as a gift, there is no statute of limitations, which means we could go back 20 years or more and audit each and every transfer from Trump to his children, grandchildren or other family members, searching for disguised gifts. The penalty for failure to report gifts is 20% if the actions were negligent and 75% if they were fraudulent. Depending on how consistent the pattern was, there could be sufficient evidence to assert a fraud penalty, which means if there were $1.0 million in gift taxes, the penalty would be an additional $750,000.
Conclusion: Trump has huge exposure to gift taxes, penalties and interest.
2. Deducting Personal Expenses
The press is all a flutter about Trump deducting his hair cuts and personal care. Flat out: these are non-deductible personal expenses. The IRS and courts have ruled time and time again that expenses for personal appearance and clothing (except for uniforms worn by police and firefighters, for example) are not deductible. There have been specific cases involving athletes (a tennis pro cannot deduct shoes or clothing because those items can be worn outside of playing tennis), similarly, a newscaster cannot deduct suits and ties worn on camera for the same reason. That means Kim Kardashian cannot deduct payments to her “booty” tailor; however, Lady Gaga can deduct her meat dress since it is not practical to wear it off stage (especially if she works as a dog walker….) IRS has expressly ruled that expenses to enhance one’s personal appearance cannot be deducted, even if the goal is to generate income.
The NYT article describes several other instances where Trump improperly deducts personal expenses. One involves a vacation home in which he claims was a rental property, although his children have stated the property was used exclusively by his family. Since deducting personal expenses appears to be a favorite tax dodge by the Trumps, we’d want to audit other family members to make sure they are not doing the same thing. The penalty for this misconduct is usually negligence, but if it is blatant and repeated, fraud penalties could apply.
Conclusion: This is a no-brainer, Trump cannot deduct his personal expenditures.
3. Deducting Real Estate Losses Against Non-Real Estate Income.
The NYT article stated that a special provision allows real estate developers to deduct their real estate losses against non-real estate income. As a general statement, that is incorrect; a taxpayers must be considered a “real estate professional” under a set of stringent factual tests supported by sufficient evidence, before they are permitted to use real estate losses to offset other income and the test is reapplied for each tax year.
When Trump became involved with the Apprentice in 2004 through 2016 and then president thereafter, he could no longer qualify as a real estate professional. Indeed, Trump paid millions in taxes from on the earnings from the Apprentice during tax years 2005-2007, which indicates that he did could not use real estate losses to offset this income.
After 2004, the NYT article establishes that Trump was in the entertainment and licensing business and was not a real estate professional. Thus, his entertainment and licensing profits were taxable to him without reduction or offset by real estate losses. As auditors, we’d look to see whether Trump deducted real estate losses against his non-real estate income. The NYT article indicates tax year 2009 and future years are remain open for audit.
Conclusion: If real estate losses generated after 2004 were used to offset entertainment or licensing fee income, those losses should be disallowed.
4. Trump’s Current Tax Audit
According to the NYT, IRS is auditing Trump for his claim of a refund for taxes paid on his earnings from the Apprentice and other licensing ventures. Trump paid taxes totaling $72 million in 2005, 2006 and 2007, then the great recission of 2008 hit the US and the Obama administration in 2009 changed the law to allow the carryback of losses for four years. In 2009, Trump declared losses of $600 million and carried them back to tax years 2005-2007, claiming a full refund of $72 million in taxes.
From all indications, the dubious transaction (a purported “abandonment” loss) occurred after Congress was considering a change in the law and was devised solely for tax benefits. A bedrock tenant of tax law is that a transaction must have economic substance apart from its tax benefits, so even if the abandonment transaction was within the literal provisions of the tax code, it must first pass muster under the economic substance doctrine. This transaction may have been concocted after it was apparent that the loss carryback rules were being changed and devised solely with the purpose of claiming a tax benefit. At this point, there is not enough facts or evidence to analyze wither the economic substance doctrine applies.
Assuming the transaction is not stymied by the economic substance doctrine, the tax code does not allow a taxpayer to claim an abandonment loss that easily. For an abandonment loss to offset ordinary income, the taxpayer may not have received any income or economic benefit from the transaction. Relief of debt (failure to repay the debt in full) is considered income, which means that Trump had to own the investment free and clear of any debt, which goes against his established business practice of being leveraged (in debt) to the hilt.
If Trump received anything of value — note, the NYT reports Trump received a part of his abandonment transaction a 5% equity interest in new company — then the abandonment rules do not apply. In addition, there is an obvious issue of whether Trump truly had $600 million in losses. Remember, if he financed his interest in the transaction, in general he has offsetting income to the extent he was relieved of debt, meaning if he had $600 million of losses, but was relieved of debt by $550 million, losses are limited to $50 million and would be characterized capital losses ineligible to offset the ordinary income he earned in tax years 2005 through 2007. In short, it is extremely doubtful Trump can successfully run the gauntlet of the economic substance and abandonment rules, which means he could owe IRS $100 million in taxes, penalties and interest if his refund is denied, plus additional taxes, penalties and interest from tax year 2009 forward.
Although the press has been packed with articles about how the tax code is unfair and is gamed by the wealthy (which is certainly true), Trump’s tax planning seems to consist of potential fraud, phony deductions, disguised gifts, and overstatements of losses, rather than sophisticated gaming of the tax code. IRS has him in their gunsights, whether they pull the trigger is a political issue rather than an application of the tax code. In Trump’s case don’t blame the tax code, blame the taxpayer.
Note: For more information on cryptocurrency taxation and tax planning strategies, purchase my Tax Brief for just $9.95: Cryptocurrency Income Tax Planning: A Tax Brief
It’s been all over the news that IRS mailed 10,000 letters to potential cryptocurrency participants, warning them that IRS suspects they have engaged in cryptocurrency transactions (IRS uses the term “virtual” currency) and reminding them to report gains and losses. IRS has received substantial information from Coinbase, which was obligated under court order to turn over transaction records. Coinbase subsequently supplied detailed information on more than 14,000 customers. Using its success against Coinbase, IRS is targeting other on-line exchanges with similar lawsuits and the court have thus far sided with the government.
If you receive an IRS warning letter, treat it very seriously. One letter asks you to sign under penalty of perjury that the response information is correct.1 It unwise to reply without first obtaining professional advice because signing under penalty of perjury could lead to criminal perjury charges if IRS already has or obtains information contradicting your written declaration.
It is now IRS standard audit practice to inquire about cryptocurrency investments. Remember that IRS may already have this information and submitting a false response could lead to criminal charges or severe civil (non-criminal) penalties.
New Tax Return Question:
Starting tax year 2019, Form 1040 (Individual Income Tax Return), Schedule 1 poses the following question: At any time during 2019. did you receive sell send, exchange or otherwise acquire any financial interest in any virtual currency?
You must answer that question “yes” or “no” under penalties of perjury. If you did not have transactions in 2019, there’s nothing to report and you can safely answer the question “no.”
If you answer the question “yes” and report your taxable cryptocurrency transactions, there is no reason to believe IRS will automatically audit you. If you answer the question “no” and IRS has information to the contrary, you could land in big trouble; if you intentionally failed to report your cryptocurrency transactions, in addition to taxes, penalties  and interest, you could be staring at federal criminal perjury or tax evasion charges. Note: failing to respond when you have significant cryptocurrency transactions is considered the same as marking the box “no.”
IRS is aggressively pursuing on-line exchanges for information and forcing taxpayers to disclose cryptocurrency transactions with written responses made under penalties of perjury. If you have not reported your cryptocurrency transactions, it behooves you to get into compliance as soon as possible. Deceiving IRS by falsely claiming you do not have any transactions can lead to civil fraud penalties, perjury charges or possibly criminal tax evasion charges, depending on the severity of the situation.
 The typical negligence penalty is 20% of the tax due,; however, if there was fraud, the penalty can be 75% of the taxes due. Misleading IRS by falsely checking the box no is an indicator of fraud.
I’ve written a Tax Brief discussing long-term U.S. tax planning for cryptocurrency investors. Every such investor must be fully aware of the potential tax traps and planning opportunities involving cryptocurrencies. My Tax Brief runs the gambit from absolute disaster and financial ruin to extremely favorable taxation, including in some cases, cryptocurrency gains without federal or state taxation. Here are excerpts from my Tax Brief – you decide whether spending $9.95 for this information is worth it:
Beware – Major Tax Trap!: Trading in cryptocurrencies carries a huge tax risk! Losses from one calendar year cannot be carried back to offset gains from prior years. This drawback often occurs with day traders of securities and others who do not understand how the capital gain and loss rules work. Consequently, taxpayers can generate a huge tax without retaining sufficient assets to pay it.
Cryptocurrency As Payment For Goods or Services: Receiving cryptocurrency as payment creates ordinary business income, but the asset is subject to capital gains and losses, so the cryptocurrency recipient has ordinary income as to the fair market value of the product being sold or service performed, whether or not the cryptocurrency thereafter increases or decreases in value.
The Lesson: Be cognizant of your gain or loss position and make sure you sell loss positions by the end of the calendar year to offset gains during the year. Selling the loss positions in the subsequent year can lead to disaster because you cannot carry them back. For merchants and service providers, make sure your cryptocurrency transactions comprise a fraction of your business transactions or sell them immediately to protect yourself against a devaluation; remember, your income is based on the price of the product or service sold and not the subsequent value of the cryptocurrency.
Tax-Planning Concept: A C corporation is a separate taxpaying entity. Prior to 2017, C corporations were taxed at a maximum federal rate of 35%; the 2017 tax act lowered the corporate tax to 21%. This compares favorably to the highest federal individual tax rate of 38.8%. However, if a C corporation makes dividend distributions to individual taxpayers, the dividends are taxed at capital gains rates, so there is a potential double tax on corporate income, once at the C corporation level and again at the shareholder level. If the goal is to invest and reinvest in cryptocurrencies (or any other investment asset, such as stock or securities) for the long term, the initial savings in taxes by using a C corporation should outstrip the potential for a shareholder-level tax down the road. The earnings of the corporation may be used to fund family real estate ventures or other investments, without triggering a tax on dividends. Note: with careful planning, state income taxes can be avoided as well. A C corporation can protect you against individual liability if disaster strikes in the form of gains in one year and losses in a subsequent year.
Conclusion: Savvy taxpayers should consider investing through a C corporation to reduce taxation and for personal asset protection. At a minimum, investors need to thoroughly understand how capital gains and losses work, since IRS considers cryptocurrency property, an asset, and not the equivalent to actual currency. Thus, every transaction with cryptocurrency is taxable.