While speaking at the UCLA Tax Controversy Conference in Los Angeles, IRS Commissioner Danny Werfel announced a change in how the IRS will apply penalties to late reporting of foreign gifts and inheritances and the reporting of foreign trusts.
Effective immediately, the IRS will no longer automatically assess penalties on taxpayers who file Forms 3520, Part IV (reporting foreign gifts) after the filing deadline. In addition, by the end of the year, the IRS will expand that approach to the late filing of reports relating to foreign trusts (i.e., Forms 3520 and 3520-A).
Foreign Gifts
Taxpayers are required to file Form 3520 to report foreign gifts or inheritances of over $100,000, even though the receipt of these amounts are not taxable events. The IRS has been automatically assessing penalties of up to 25% of the amount of the foreign gift or inheritance under Internal Revenue Code Section 6039F. Although the taxpayer can challenge the assessments of penalties with the IRS Independent Office of Appeals and in court (but only after paying in full and bringing a refund claim), the IRS’s practice placed the burden—and cost—on the taxpayers to make the case that the late filing was due to reasonable cause.
Commissioner Werfel said he believes the change is the right thing to do.
“I think this is an important change for taxpayers and I think this room understands the type of situations this was causing for a person maybe 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, even though it’s not a taxable event, and then all of a sudden you get hit with a penalty,” he said.
Congress’ intention when creating the penalties was to prevent taxpayers from skirting filing responsibilities by disguising foreign-source income as a gift. The impact of the penalties, however, was that taxpayers who were doing the right thing by filing the Form 3520—albeit late—on nontaxable events were the ones hit with the biggest penalties.
Foreign Trusts
In addition to the requirement to report foreign gifts, taxpayers are also required to file Forms 3520 and 3520-A to report certain transactions with, or relationships to, foreign trusts. The failure to timely file these forms can lead to significant penalties, even where there is little or no tax due in connection with the reportable activity. While this area of reporting may impact slightly higher income taxpayers than many of those ensnared by the foreign gift reporting rules, many less sophisticated taxpayers can find themselves unexpectedly facing these penalties. For example, certain foreign pensions are treated as foreign trusts and may require complex reporting beyond the grasp of taxpayers who do not have access to professional advice. As with the penalties for failing to report foreign gifts, the IRS has been automatically assessing the trust-related penalties against taxpayers who late file the forms, all without taking into consideration reasonable cause statements that may be attached to the late-filed forms. The IRS will end this practice by the end of the year and will instead review such reasonable cause statements prior to assessing any penalties.
With the announcement from Commissioner Werfel, taxpayers can now expect that the IRS will not automatically assess these penalties, and instead allow taxpayers to provide a written explanation for the late filing of these forms by submitting a reasonable cause statement describing their circumstances. The IRS will now evaluate taxpayers’ reasonable cause statements before deciding whether to assess a penalty. This is an important change, especially noting that nearly two-thirds of penalties have been abated since 2018, according to the National Taxpayer Advocate.
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