On October 24, 2024, Commissioner Daniel Werfel announced that the Internal Revenue Service (IRS) would end its practice of automatically assessing penalties for late-filed forms relating to foreign gifts or bequests, effective immediately. Contrary to popular belief, such penalties were frequently assessed against lower-income taxpayers, immigrants, and small businesses. The change in procedure, which relates to the late submission of Form 3520, Annual Return To Report Transactions With Foreign Trusts and Receipt of Certain Foreign Gifts, means that the IRS will now consider reasonable cause statements that are attached to the late-filed forms.
Failure to timely file returns reporting gifts from foreign persons can carry a steep penalty, depending on the size of the gift. The penalty is 5% of the unreported transfer, for each month the form is late, up to 25% of the foreign gift or inheritance. Additional penalties may also be applied if the taxpayer’s non-compliance continues for more than 90 days after the IRS mails a notice of failure to comply with required reporting.
Approximately 10 years ago, the IRS shifted its policy to automatically assess penalties related to international information returns like Form 3520. Since gifts and inheritances are excludable from income, many taxpayers may not realize that they are required to report them, possibly incurring penalties. The Taxpayer Advocate Service studied the issue and determined that between 2018 and 2021, the IRS abated 67% of the penalties assessed (78% of the dollars assessed) for failure to report large foreign gifts or inheritances. They also found that the IRS abated 67% of penalties (54% of dollars assessed) related to the timely filing of Form 3520 as it relates to foreign trusts. The total amounts abated for these penalties totaled in hundreds of millions of dollars.
Clearly, the automatic assessment of penalties was not working as intended, and too many taxpayers with reasonable cause were hurt as a result. As Commissioner Werfel said in his announcement, “[a] person may be with parents living overseas; a parent dies, now you’re dealing with the estate, you’re dealing with grief, you’re dealing with all the moving pieces, and maybe in the middle of all this, you late file your form that you’re required to file.” The change in IRS practice should be a relief for taxpayers who had reasonable cause in late filing their Forms 3520.
The IRS’s updated policy concerns Section IV of Form 3520, which reports U.S. recipients of gifts or bequests received from foreign persons. As a general rule, a U.S. person must report any gifts or inheritances from foreign persons if the gift exceeds $100,000. The threshold is lower, at $19,570, if the gift is from a foreign corporation or partnership. The IRS will now consider reasonable cause statements that are attached to late-filed Forms 3520 before it issues any penalties. The IRS has also proposed indexing such thresholds to inflation. If the proposal is enacted, that would be an additional benefit for taxpayers.
If a taxpayer has “reasonable cause” and includes a reasonable cause statement with their late-filed Form 3520, any potential penalties may be avoided. With Commissioner Werfel’s announcement that the IRS will consider reasonable cause statements prior to assessing penalties for late filing of Forms 3520, many taxpayers may now avoid the costly process of having to get improperly assessed penalties removed. That said, proving reasonable cause can be difficult and there is no fixed set of criteria a taxpayer can satisfy to prove their reasonable cause. Instead, a taxpayer must demonstrate that they exercised ordinary business care and prudence in attempting to meet their tax obligations but that circumstances outside of their control contributed to the noncompliance.
In preparing their reasonable cause statement, a taxpayer can include facts such as their education, knowledge, and experience with regards to the Form 3520 and its requirements. The Internal Revenue Manual and Treasury Regulations offer some guidance and factors that may be considered for reasonable cause. Possible factors include things like serious illness, natural disasters, inability to obtain necessary records, and reliance on a tax professional. No one factor is determinative. In that regard, a taxpayer’s reasonable cause statement should include as much detail and information as possible to demonstrate their reasons for tax non-compliance.
The IRS’s change in policy addresses some of the criticism leveled at the IRS and its administering penalties for foreign information reporting. The penalties involved in international information returns are often disproportionate to the underlying tax and typically fall on lower-income taxpayers and small businesses. The Taxpayer Advocate Service continues to argue for the elimination of automatically assessed penalties for all IIRs, but the IRS’s change in policy to review reasonable cause statements for late filed Forms 3520 and 3520-A is a step in the right direction.