IRS Hears Concerns from TAS and Practitioners, Makes Favorable Changes to Foreign Gifts and Inheritance Filing Penalties

Spoiler Alert

The IRS has ended its practice of automatically assessing penalties at the time of filing for late-filed Forms 3520, Part IV, which deal with reporting foreign gifts and bequests. And…

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) § 6677 penalty. This favorable change will reduce unwarranted assessments and relieve 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.

Background: International Information Return (IIR) Penalties

We are all aware that our tax system is based upon voluntary compliance. The IRC incentivizes taxpayers to comply by applying penalties for noncompliance (the proverbial carrot and the stick approach). However, the stick should only apply to negligent, reckless, or intentional conduct. Taxpayers should not be penalized when they discover errors or mistakes and voluntarily come forward and file late or corrected tax or information returns.

Our tax system should reward taxpayers’ efforts to do the right thing. We all benefit when taxpayers willingly come into the system by filing or correcting their returns.

Congress established the IIR penalty regime primarily to combat tax avoidance and discourage U.S. taxpayers from hiding income and assets abroad. I appreciate Congress’s efforts to prevent tax avoidance; however, based upon my experience, high net worth individuals and large companies are often not the ones penalized. They have sophisticated advisors and generally avoid these penalties or successfully obtain abatements. By contrast, lower-income individuals, immigrants, and small businesses generally do not have advisors with the same expertise, and these taxpayers tend to inadvertently trigger the penalty.

By statute, many of these IIR penalties apply even when there is no underlying tax liability. The statutory structure is wide-ranging, and taxpayers are confronted with a complex series of information reporting requirements and associated penalties covering, among other things, specified foreign financial assets, certain interests in foreign business entities, and gifts or inheritances from foreign sources.

Unfortunately, about a decade ago the IRS shifted its policy on IIR penalties and began automatically assessing penalties when taxpayers voluntarily filed late returns. No questions asked – just the imposition of potentially life-altering penalties. After the IRS automatically assessed large penalties against these taxpayers, the IRS started collection efforts against them. My office reviewed many of the IIR penalties assessed for the past decade, and contrary to what most people assumed these penalties were assessed against unsuspecting lower-income taxpayers, small businesses, and immigrants.

Gift and Inheritance Information Filings

One area of particular concern regarding IIR penalties is with gifts and inheritance subject to IRC § 6039F reporting. Section 6039F generally requires U.S. persons who receive large foreign gifts or inheritances to submit information returns (Form 3520, Part IV) to the IRS. Because gifts and inheritances are excludable from income, taxpayers may not realize they have to report them.

There are numerous examples of taxpayers who received a once-in-a-lifetime tax-free gift or inheritance and were unaware of their reporting requirement. Upon learning of the filing requirement, these taxpayers did the right thing and filed a late information return only to be greeted with substantial penalties, which were automatically assessed by the IRS upon the late filing of the Form 3520. Depending on how late it was filed, these taxpayers were penalized up to 25 percent of their gift or inheritance despite owing no actual tax. In the foreign gift context, the penalties can be huge; over the years 2018-2021, even taxpayers who reported $400,000 or less in income received an average penalty of over $235,000.

Over this same four-year period from 2018-2021, the IRS abated IRC § 6039F penalties assessed with respect to Form 3520, Part IV, totaling more than $179 million. The abatement rate was 67 percent of the penalties assessed and 78 percent of the dollars assessed. 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. Stopping this practice will benefit everyone.

I appreciate the IRS revisiting its penalty approach and making a change to stop the systemic assessments for late filed information returns for the receipt of gifts or inheritance. It was the right thing to do. This change should provide people the time they need to manage these gifts or bequests, which are often unexpected, and to comply with the reporting requirement without being assessed a potentially huge penalty if their Form 3520, Part IV is filed late.

Foreign Trust Reporting

Another area of considerable problem for taxpayers is the automatic assessment of IIR penalties when taxpayers fail to timely file Parts I-III of Forms 3520 and 3520-A. IRC § 6048 requires taxpayers to report information concerning certain reportable events of foreign trusts. Taxpayers report this information on Forms 3520 and 3520-A. Section 6677 imposes a penalty for failure to timely file Form 3520 reporting information required in Parts I-III and for failure to timely file Form 3520-A. Again, these penalties can be substantial.

When Forms 3520 and 3520-A are filed late, the IRS automatically assesses the IRC § 6677 penalty, generally assessing the maximum penalty amount. To add insult to injury, while the IRS can waive the IRC § 6677 penalty if taxpayers show that they had reasonable cause for filing the returns late, the IRS does not consider any reasonable cause statements or other information provided by taxpayers prior to assessing the penalties, even when attached to the returns. Many of these taxpayers file a protest with the Independent Office of Appeals (Appeals). Once reasonable cause is confirmed, the IRS abates a significant number of the penalties that were automatically assessed but were not justified. Over the four-year period from 2018-2021, the IRS abated IRC § 6677 penalties assessed with respect to Forms 3520 and 3520-A totaling more than $224 million. The abatement rate was 67 percent of the penalties assessed and 54 percent of the dollars assessed.

Most of these penalties were automatically assessed, broadly applied, needlessly harsh, and often unexpected. The IRS’s automatic assessment of penalties when taxpayers willingly come forward and file their late returns, without any consideration of reasonable cause, was unfair to taxpayers, violated their right to pay no more than the correct amount of tax, and discouraged voluntary compliance.

The IRS’s prior position not to consider reasonable cause prior to assessing these penalties, even when taxpayers provided evidence in the form of a reasonable cause statement attached to the return, created huge burdens on taxpayers. Since IIR penalties are not assessed through the deficiency procedures, taxpayers had no preassessment legal avenue to challenge the penalties. Although these taxpayers can administratively contest the penalty with Appeals after assessment or can pay the tax and litigate the appropriateness of the penalty in the U.S. district court or U.S. Court of Claims, these actions are time consuming and expensive and full payment is often impossible as many of these penalties are huge.

I am pleased with the IRS’s decision to stop this onerous practice and consider taxpayers’ reasonable cause statements prior to assessing penalties for delinquent Forms 3520, Parts I-III and 3520-A. This is a positive change for taxpayers, which will benefit all parties.

Conclusion

The IRS changes are great news for taxpayers, and I am pleased to see the IRS moving in the right direction. Stopping the automatic penalty assessment for individuals who are late reporting the gift or inheritance they received from a foreign individual is a great step forward. Reading the reasonable cause statements before assessing the penalty for other taxpayers filing the Form 3520 or 3520-A is another step in the right direction. The IRS changes will alleviate taxpayer burden in these areas and help ensure that penalties are only assessed when warranted.

I have expressed my concerns with the IRS’s approach to IIR penalties on many prior occasions. These penalties are systemically assessed, without any prior review or opportunity to establish reasonable cause or other defenses. They are often erroneously classified as assessable and therefore must be paid before judicial review, which deprives taxpayers of review in the U.S. Tax Court and causes financial hardship. They are disproportionate in comparison with any potential underlying tax and fall particularly hard on lower-income taxpayers and small businesses.

While the changes the IRS has made with respect to Forms 3520 and 3520-A are beneficial for taxpayers, the IRS should expand its elimination of automatic assessments to all late filed IIRs and provide taxpayers the ability to raise a reasonable cause defense with the opportunity for an administrative review with Appeals prior to assessment. I will continue to advocate for these rights.