The Internal Revenue Service (IRS) has recently made a significant change regarding the penalties associated with late filing of Form 3520, particularly Part IV, which concerns the reporting of foreign gifts and bequests. This is welcome news for taxpayers who may have inadvertently failed to report foreign gifts, often due to a lack of awareness about the complex reporting requirements. Previously, the IRS had a practice of automatically assessing penalties upon the late filing of these forms. However, this policy has been revised, offering a more taxpayer-friendly approach.
From now on, before imposing any penalties under Internal Revenue Code (IRC) § 6677, the IRS will review reasonable cause statements provided by taxpayers who file Form 3520 and Form 3520-A late. This review will specifically apply to the trust portion of Form 3520-A and relevant sections of Form 3520. This important shift in policy aims to reduce unwarranted penalty assessments and ease the burden on taxpayers by allowing them to explain the circumstances of their late filing before a penalty is levied. This change is a direct response to recommendations made by the Taxpayer Advocate Service (TAS) over several years, highlighting the IRS’s responsiveness to taxpayer concerns. IRS Commissioner Danny Werfel publicly announced this policy revision at the UCLA Extension Tax Controversy Conference.
Background: IRS Penalties on International Information Returns
The US tax system is built on the principle of voluntary compliance. To encourage this, the IRC includes penalties for noncompliance, acting as an enforcement mechanism. However, these penalties are intended for cases of negligence, recklessness, or intentional misconduct, not for honest mistakes or unintentional oversights. Taxpayers who proactively correct errors by filing late or amended returns should be supported, not penalized.
Rewarding taxpayers who willingly engage with the tax system by correcting their filings is beneficial for everyone.
The system of International Information Return (IIR) penalties was primarily established by Congress to prevent tax evasion and discourage US taxpayers from concealing income and assets in foreign countries. While the objective of preventing tax avoidance is valid, in practice, the burden of these penalties often falls disproportionately on individuals and small businesses rather than high-net-worth individuals and large corporations who typically have access to sophisticated tax advisors. These advisors often help their clients avoid such penalties or successfully appeal them. In contrast, individuals with less access to expert advice, including lower-income individuals, immigrants, and small business owners, are more likely to inadvertently trigger these penalties.
A critical aspect of many IIR penalties is that they can be applied even when there is no underlying tax liability. The regulations are broad, encompassing a range of information reporting obligations and penalties related to foreign financial assets, interests in foreign business entities, and crucially, gifts or inheritances from foreign sources.
Approximately ten years ago, the IRS adopted a policy of automatically assessing IIR penalties when taxpayers voluntarily filed late returns. This automatic assessment occurred without any prior inquiry or consideration of the circumstances, leading to significant financial penalties for many taxpayers. Following these automatic assessments, the IRS would then initiate collection efforts. Reviews conducted by the Taxpayer Advocate Service revealed that over the past decade, these IIR penalties were frequently imposed on unsuspecting lower-income taxpayers, small businesses, and immigrants, contrary to the initial intent of targeting high-wealth tax avoidance.
Focus on Gift and Inheritance Reporting (Form 3520, Part IV) and IRS Gift Tax
One particularly concerning area within IIR penalties is the reporting of gifts and inheritances under IRC § 6039F. This section mandates that U.S. persons receiving substantial foreign gifts or inheritances must file information returns, specifically Form 3520, Part IV, with the IRS. Because gifts and inheritances are generally excluded from taxable income, many taxpayers are unaware of the obligation to report them to the IRS, even when dealing with Irs Gift Tax related forms.
Numerous instances exist where taxpayers received a one-time, tax-free foreign gift or inheritance and were completely unaware of the reporting requirement. Upon discovering this requirement, these taxpayers acted responsibly by filing a late information return, only to face substantial penalties automatically assessed by the IRS due to the late filing of Form 3520. Depending on the delay in filing, penalties could reach up to 25 percent of the gift or inheritance value, despite no underlying income tax being owed. In the context of foreign gifts and IRS gift tax reporting, these penalties can be extremely large. For example, between 2018 and 2021, even taxpayers with reported incomes of $400,000 or less faced average penalties exceeding $235,000.
Alt text: Sample Form 3520, used for reporting large foreign gifts and bequests to the IRS, highlighting its importance in IRS gift tax compliance.
During this same four-year period (2018-2021), the IRS abated IRC § 6039F penalties related to Form 3520, Part IV, totaling over $179 million annually. The abatement rate was significant, with 67 percent of assessed penalties and 78 percent of the dollar amount assessed being abated. This high abatement rate underscores the frequency with which these penalties were wrongly assessed. The automatic penalty assessment process resulted in unnecessary hardship, burdened taxpayers, and created needless workload for the IRS. Ceasing this practice is a beneficial change for all parties involved in IRS gift tax and foreign gift reporting.
The IRS’s decision to re-evaluate its penalty approach and discontinue automatic assessments for late-filed information returns concerning foreign gifts and inheritances is commendable. It is a step in the right direction. This policy change will provide individuals with the necessary time to manage often unexpected gifts or bequests and to comply with reporting obligations without the immediate threat of a potentially crippling penalty if Form 3520, Part IV, is filed after the deadline.
Foreign Trust Reporting and Form 3520-A
Another significant challenge for taxpayers involves the automatic assessment of IIR penalties when they fail to timely file Parts I-III of Forms 3520 and 3520-A. IRC § 6048 requires taxpayers to report information about certain reportable events related to foreign trusts. This information is reported on Forms 3520 and 3520-A. Section 6677 imposes penalties for the failure to timely file Form 3520 for Parts I-III and for the failure to timely file Form 3520-A. These penalties, similar to those for foreign gifts, can also be substantial.
Historically, when Forms 3520 and 3520-A were filed late, the IRS automatically assessed the IRC § 6677 penalty, often at the maximum possible amount. Compounding the issue, while the IRS has the authority to waive these penalties if taxpayers can demonstrate reasonable cause for the late filing, the IRS previously did not consider any reasonable cause statements or supporting documentation provided by taxpayers before automatically assessing the penalties, even if these statements were attached to the returns. Many affected taxpayers were then forced to file protests with the Independent Office of Appeals. Although a significant number of these automatically assessed penalties were eventually abated upon confirmation of reasonable cause, the initial assessment was unduly burdensome. Over the four-year period from 2018 to 2021, the IRS abated IRC § 6677 penalties associated with Forms 3520 and 3520-A, totaling over $224 million per year. The abatement rate was 67 percent of penalties assessed and 54 percent of the dollar value assessed.
Alt text: Example of IRS Form 3520-A, Annual Return of Foreign Trust With a U.S. Owner, emphasizing its role in reporting foreign trust activities and avoiding penalties.
The majority of these penalties were automatically assessed, broadly applied, unnecessarily harsh, and frequently unexpected by taxpayers. The IRS’s prior practice of automatically assessing penalties when taxpayers voluntarily came forward to file late returns, without considering reasonable cause, was unfair, violated taxpayers’ right to pay no more than the correct amount of tax, and discouraged voluntary compliance, especially in areas related to IRS gift tax reporting for foreign beneficiaries.
The IRS’s previous stance of not considering reasonable cause before assessing these penalties, even when taxpayers provided evidence of reasonable cause with their returns, created significant difficulties for taxpayers. Because IIR penalties are not subject to standard deficiency procedures, taxpayers lacked a pre-assessment legal avenue to challenge them. While taxpayers could administratively contest the penalty with Appeals post-assessment or pay the penalty and then litigate in U.S. District Court or the U.S. Court of Federal Claims, these options are time-consuming, costly, and often impractical due to the large penalty amounts.
The IRS’s decision to discontinue this problematic practice and to consider taxpayers’ reasonable cause statements before assessing penalties for late Forms 3520, Parts I-III, and 3520-A is a positive development for taxpayers. This change will benefit both taxpayers and the IRS by streamlining the process and ensuring fairer outcomes in IRS gift tax and foreign trust reporting compliance.
Conclusion: A Positive Step for IRS Gift Tax and Foreign Reporting Compliance
The IRS’s policy revisions represent excellent news for taxpayers, and it is encouraging to see the IRS moving in a more taxpayer-centric direction. Eliminating automatic penalty assessments for individuals who are late in reporting foreign gifts or inheritances is a significant step forward. Similarly, reviewing reasonable cause statements before assessing penalties for other taxpayers filing Form 3520 or 3520-A is another positive change. These IRS changes will reduce taxpayer burden in these specific areas and help ensure that penalties are only applied when truly warranted, improving the fairness and efficiency of IRS gift tax and international reporting enforcement.
Concerns about the IRS’s approach to IIR penalties have been voiced on numerous occasions. These penalties were systematically assessed without prior review or opportunity for taxpayers to present reasonable cause or other defenses. They were often incorrectly classified as immediately assessable, requiring payment before judicial review, which denied taxpayers access to the U.S. Tax Court and caused financial strain. Furthermore, these penalties were disproportionately high compared to any potential underlying tax liability and disproportionately affected lower-income taxpayers and small businesses.
While the recent changes by the IRS regarding Forms 3520 and 3520-A are highly beneficial, the IRS should consider expanding the elimination of automatic assessments to all late-filed IIRs. Providing all taxpayers with the opportunity to raise a reasonable cause defense and have it administratively reviewed by Appeals before assessment would further enhance taxpayer rights and promote fairer tax administration. Advocacy for these broader rights will continue.
