At the end of October 2024, the IRS announced that it will no longer automatically assess penalties for late reporting of large foreign gifts. Before assessing a penalty, the IRS will now review reasonable cause statements submitted with late-filed Form 3520, which reports gifts or bequests from foreign persons, to determine whether a penalty should be imposed.

This is a sigh of relief for practitioners and their clients, and comes after concerns and comments voiced by experienced practitioners, the AICPA, and the Taxpayers Advocate.

U.S. persons are required to report on Form 3520, Annual Return To Report Transactions With Foreign Trusts and Receipt of Certain Foreign Gifts, Part IV, any gift or inheritances of over $100,000 from a nonresident alien individual or a foreign estate, pursuant to IRC Section 6039F, modified by Notice 97-34. Form 3520 is to be filed separately at the IRS service center in Ogden, Utah, by the due date of the taxpayer’s income tax return. It should not be attached to the taxpayer’s annual income tax return.

IRC Section 6039F

Under IRC Section 6039F(c)(1)(B), if Form 3520 is not filed on time to report foreign gifts described in Section 6039F, the IRS can assess a penalty equal to 5% of the amount of such foreign gifts for each month the failure to report continues, up to, but not exceeding, a total of 25% of the value of the gift.

IRC 6039F(c)(2) provides that no penalty will be imposed if the taxpayer can demonstrate that the failure to comply was due to reasonable cause and not willful neglect.

The receipt of the gift must be reported, even though these gifts are not taxable to the recipient in the U.S. This is another example of taxpayers and some practitioners being unaware of reporting and disclosure requirements relating to foreign assets, investments, etc. and highlights the example very steep penalties for international reporting non-compliance.

The penalty can be challenged in court, but only after it has been paid. Many of these international compliance disclosure requirements, as found in the applicable IRC sections, have a reasonable cause section allowing the taxpayer to request relief from harsh penalties when filing late forms. The practical approach would be for the IRS to review the reasonable cause statement as submitted and then determine if it meets the standard for reasonable cause. If the statement does not meet the requirements for reasonable cause, the penalty should then be assessed.

Until this IRS announcement, the IRS automatically assessed the late filing penalties upon Form 3520 late filing without reading the attached statement of reasonable cause. Remember, this relates to reporting that has no tax impact; this is purely disclosure of the receipt of the gift from a foreign person/estate.

As provided on the IRS website for filing delinquent international information returns (DIIR):

Penalties may be assessed in accordance with existing procedures.

• All delinquent international information returns other than Forms 3520 and 3520-A should be attached to an amended return and filed according to the applicable instructions for the amended return.
• All delinquent Forms 3520 and 3520-A should be filed according to the applicable instructions for those forms.
• Taxpayers may attach a reasonable cause statement to each delinquent information return filed for which reasonable cause is being asserted. During the processing of the delinquent information return, penalties may be assessed without considering the attached reasonable cause statement. It may be necessary for taxpayers to respond to specific correspondence and submit or resubmit reasonable cause information.

As posted on their website, the IRS provided notice this would be the procedure. This was not always the language or approach the IRS had regarding DIIR. The original language when DIIR was first established provided penalties may be imposed under the DIIR if the attached reasonable cause statement was not accepted by the IRS. Alternatively, if the reasonable cause statement was accepted, no penalties would be assessed. This, of course, was an excellent alternative to bring taxpayers into compliance, as the other available options at that time was the OVDP, the standard voluntary disclosure practice, and the streamlined programs, but each came with penalties. The reality was, despite the language posted on their website regarding the procedure for DIIR, penalties were being assessed seemingly without any regard to the submitted reasonable cause statements. In 2020, in response to the expressed frustration by taxpayers and practitioners, the language was clarified to read similarly to what we find on today’s DIIR page, which is above. Now the IRS has advised taxpayers and practitioners of the procedure relating to the late filing of Form 3520 and the attached reasonable cause statement.

Foreign Trusts

In addition to being required to report large gifts from foreign persons or estates, taxpayers must also file Forms 3520 and 3520-A to report certain transactions with, or relationships to, foreign trusts pursuant to IRC 6048. To clarify:

Form 3520 is an informational return that must be filed by any U.S. citizen or resident individual to report, among other things:

(a) gifts or bequests received by the U.S. individual from foreign individuals or foreign estates if such gifts or bequests during the year exceed $100,000;

(b) distributions received by the U.S. individual from a foreign trust;

(c) the income, gains, losses, deductions, and credits of a foreign grantor trust of which the U.S. individual is treated as a grantor (which “flow through” from the foreign grantor trust to the U.S. grantor);

(d) the creation of a foreign trust by the U.S. individual;

(e) transfers of cash or assets by the U.S. individual to a foreign trust, including a transfer by reason of death; and

(f) the death of the U.S. individual if the decedent was treated as a grantor of a foreign trust or assets of a foreign trust are includible in the gross estate of the decedent for estate tax purposes.

Form 3520-A is also an informational return that generally must be submitted by any trustee (whether U.S. or foreign) of any foreign grantor trust, where the grantor is a U.S. citizen or resident, to report the income, gains, losses, deductions, and credits of the foreign grantor trust that “flow through” to and must be reported by the U.S. grantor.

Penalties for lack of compliance as it relates to these trust reporting provisions are found in IRC 6677 and are substantial. These penalties are also being automatically assessed without regard to the attached reasonable cause statement.

By the end of the year, the IRS will begin reviewing any reasonable cause statements taxpayers attach to late-filed Forms 3520 and 3520-A for the trust portion of the form before assessing any Internal Revenue Code (IRC) Section 6677 penalty. This favorable change will reduce unwarranted assessments and relieve the burden on taxpayers by giving them the opportunity to explain their situation before the IRS assesses a penalty. TAS has recommended these changes for years, and the IRS listened. IRS Commissioner Danny Werfel announced these changes during the UCLA Extension Tax Controversy Conference.

As noted by the Taxpayers Advocate Service (TAS) from 2018 to 2021, the IRS abatement rate for automatic penalties imposed on failures to report Form 3520 for gifts and bequests was 67% (or 78% of the total dollars assessed), and the abatement rate for penalties imposed on failures to timely file Forms 3520-A was also 67% (or 54% of the total dollars assessed). The Taxpayers Advocate Service also noted that the significant abatement rate illustrates how often these penalties were erroneously assessed. The automatic assessment of the penalties causes undue hardship, burdens taxpayers, and creates unnecessary work for the IRS. Changing this procedure would help both the taxpayer and the IRS.

The approach which the IRS followed regarding reasonable cause statements and late-filed Form 3520s was unfair to taxpayers. The automatic assessment of penalties when taxpayers willingly come forward and file their late returns, without any consideration of reasonable cause, was not a good approach when trying to promote compliance; rather it discouraged voluntary compliance.

This recent announcement regarding ending the automatic assessments of penalties and the review of reasonable cause statements as it relates to foreign gifts and the further announcement of the same procedure as it relates to foreign trusts by year-end is good news and long overdue.