Federal tax law requires U.S. persons to report their receipt of foreign gifts or inheritances. IRS Form 3520, Annual Return to Report Transactions with Foreign Trusts and Receipt of Certain Foreign Gifts, is the appropriate information return. If a taxpayer misses the filing deadline, the IRS may impose significant penalties (up to 25% of the amount of the foreign gift or inheritance received).
Taxpayers often miss the IRS Form 3520 filing deadline due to misunderstandings or ignorance of the reporting requirement. For example, taxpayers (and even their tax advisors) may reasonably believe that there is not a U.S. reporting obligation associated with a foreign gift or inheritance because gifts and inheritances are not subject to U.S. income tax. Although their conclusions as to the U.S. income tax laws are correct, they are incorrect concerning the U.S. reporting laws. Another common reason for missing the IRS Form 3520 filing deadline relates to tests for U.S. residency. Under the “substantial presence” test, foreign persons are deemed U.S. residents and subject to U.S. tax reporting requirements — including IRS Form 3520 — if they are present in the U.S. a sufficient number of days.
Regardless of the reason for the missed filing, taxpayers who later discover the omission usually have questions and concerns regarding their options moving forward. Should they file a late IRS Form 3520 and risk imposition of an immediate penalty? If they elect to voluntarily come forward and file the form late, what is the likelihood that the IRS will waive all or a portion of the penalty? These concerns are discussed more fully below.
Discovery Of The Missed IRS Form 3520 Filing
Section 6039F requires U.S. citizens and residents to file an IRS Form 3520 for the tax year in which they receive a threshold amount of gifts or inheritance from a foreign person or estate. Currently, taxpayers trigger the reporting threshold if they receive more than $100,000 (singularly or in the aggregate) of foreign gifts or bequests. Reduced thresholds apply if the taxpayer receives a gift from a foreign entity, and proposed regulations, if finalized, would index this $100,000 reporting threshold.
Very generally, taxpayers have until the deadline for their individual income tax return to file an IRS Form 3520 (e.g., April 15 or, with a valid extension, October 15). If the taxpayer misses the filing deadline, penalties may apply unless the taxpayer has a legal justification against the penalty.
Outside of various IRS programs, taxpayers who miss the IRS Form 3520 filing deadline usually have two options. First, the taxpayer may come forward voluntarily and file the form late. Second, and alternatively, the taxpayer may choose not to file the form at all.
Taxpayers who elect the first option to file late face the immediate risk of a civil penalty after the IRS receives the IRS Form 3520. Nevertheless, many taxpayers prefer this option over the alternative because it can provide more certainty and less anxiety. Specifically, these taxpayers no longer need to worry about the IRS potentially discovering the omission and opening an examination because they have come forward voluntarily. From a penalty-defense perspective, this voluntarily filing late also provides a better argument for abatement of a penalty, if imposed, in that these taxpayers can contend that they elected to come forward to regain compliance regardless of the threat of penalties.
Taxpayers who do not choose the first option necessarily fall under the second option of taking no action to remedy the noncompliance. This option avoids compliance costs associated with engaging a tax professional to: (i) prepare the late IRS Form 3520, and (ii) represent the client before the IRS to avoid penalties. But this option has significant disadvantages in that the agency has an unlimited statute of limitations to assess penalties if the IRS discovers the non-filing. Unlike coming forward voluntarily to remedy the noncompliance, taxpayers who choose not to file run the risk of a harder sell to the IRS regarding penalty abatement.
Likelihood Of IRS Form 3520 Penalty
A taxpayer’s decision to file a late IRS Form 3520 or not also takes into account the likelihood of the IRS abating some or all of the penalty after the submission. Prior to recent IRS administrative changes, tax professionals usually advised their clients that it was almost certain the agency would impose penalties upon receipt of a late IRS Form 3520. Under the IRS’ existing processing procedures, the agency would assess the penalty automatically regardless of the strength of a reasonable cause statement attached to the form. If the taxpayer wanted to contest the penalty after assessment, the taxpayer would have to do so by requesting reconsideration of the determination before the IRS Independent Office of Appeals.
But the IRS changed course in late 2024. Based on an Oct. 24, 2024, announcement from the National Taxpayer Advocate, Erin Collins, the agency indicated that it would no longer make automatic penalty assessments for late-filed IRS Forms 3520 associated with foreign gift or inheritance reporting. Rather, the IRS stated that it would review reasonable cause statements submitted with a late-filed IRS Form 3520 to independently determine whether the penalty should be imposed. In light of the announcement, taxpayers who submit late IRS Forms 3520 should remember to submit a strong reasonable cause statement with the submission.
Whether the IRS ultimately accepts the taxpayer’s arguments to waive penalties depends on the facts and circumstances. I have written previously on potential penalty defenses applicable to a late-filed IRS Form 3520, which can be found here. Generally, taxpayers who can show they reasonably relied on their tax advisors concerning their U.S. reporting obligations fare the best on convincing the IRS to waive or abate the penalty. This defense becomes much weaker, though, if the taxpayer never informed the tax advisor of the foreign gift or inheritance. Another viable reasonable cause argument relates to ignorance of the reporting rules but this defense can be hit-or-miss with the IRS, depending on the agent reviewing the reasonable cause statements.
Taxpayers who are unable to convince the IRS to waive or abate the IRS Form 3520 penalty are not without options. In these circumstances, taxpayers can pay the penalty in full, file an administrative refund claim, and then seek repayment of the penalty through the federal courts. Indeed, a recent complaint filed in the United States District Court for the Central District of California demonstrates this continues to be a viable option. Taxpayers who choose this option should be careful of the so-called “variance doctrine,” however, which requires taxpayers to raise all of their arguments as part of their refund claim.
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