‘Draconian’ IRS Foreign Gift Penalties Serve No Practical Purpose

The IRS must change its practice of penalizing taxpayers for late filing of international information, which the Taxpayer Advocate Service described in its most recent report to Congress as “draconian and inefficient.”

This is especially true for the late filing of forms reporting foreign gifts and inheritances from foreign estates. Section 6039F of the tax code authorizes the IRS to assess a penalty of 5% for each month that the filing is late, up to 25% of the value of the gift—even if no tax is due because of the late filing.

When I talk about this problem with people who don’t work in this field, the reaction is sometimes “meh,” because they believe this only impacts wealthy taxpayers. That’s sometimes the case, but often those impacted are lower- or middle-income taxpayers.

In one real-world example, a client inherited a minority share in real estate from a foreign relative worth more than $100,000. His CPA told him he needed to report it, but he didn’t have the full information about the value at the time that his return was due. The CPA advised him to file his Form 1040 on time, and then file Form 3520 after he had the rest of the information.

The client took this advice and ended up with a penalty of 25% of the value of his share in the real estate. He didn’t have any other assets and couldn’t sell his minority share to pay the penalty. The IRS denied the client’s initial request for penalty abatement, but eventually it was reversed by the IRS’s Independent Office of Appeals. This was the right outcome, but it cost the client greatly, both in professional fees and sleepless nights.

It also cost IRS resources to process, and then later abate, a penalty that served no purpose, as the client was already voluntarily compliant. The only thing that the IRS accomplished was to create mistrust and disgruntlement in another taxpayer.

For taxpayers who don’t get full abatement on appeal, the only recourse is to pay the penalty in full and bring a refund suit. For many taxpayers, litigation is prohibitively expensive, and they can do nothing other than wait for the IRS to enforce collection against them.

Every practitioner who has worked on these cases has dozens of stories like this. We have complained to the IRS repeatedly and received no meaningful response. In the meantime, along with the Taxpayer Advocate Service and many practitioners, I recommend that the IRS take some basic steps to improve penalty administration.

Stop systemic assessment of Form 3520 penalties.

Assign trained personnel to review any reasonable cause statements prior to assessing penalties, consistent with the IRS’s own policy statement of “giving full and fair consideration to evidence in favor of not imposing the penalty.

Establish a first-time abatement policy. There already is an FTA for late filing and late payment penalties under Section 6651 for taxpayers who satisfy certain requirements. An FTA policy for Form 3520 penalties would encourage voluntary compliance, which is a primary purpose of penalties by encouraging taxpayers to self-correct when they have missed a deadline, rather than avoid their filing obligations from fear of penalties.

The IRS can implement a fairer system for evaluating whether Form 3520 penalties are appropriate where the taxpayer is already voluntarily compliant, and I hope the IRS will listen to the feedback of the Taxpayer Advocate and practitioners and finally take action.

This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

Author Information

Megan Brackney is a tax controversy attorney and partner at Kostelanetz.

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