Unreported gifts from non-U.S. relatives bring big tax penalties

In 2019, Grandpa Kim died in Seoul, Korea. His estate left $200,000 to both of his grandchildren, who live in Los Angeles. Jennifer is a lawyer working at a large Century City firm and her brother James works at a Korean restaurant.

In January 2020, Jennifer met with her CPA, a partner in a 40-person West Los Angeles firm. The CPA told her to file Form 3520 to report the inheritance and assured her the form is only to report the gift; there is no tax on the inheritance. Internal Revenue Code Section ("IRC") 102. James met with his CPA, whose office is on the top floor of a two-story building above a laundromat. The CPA knew there was no income tax on bequests and concluded there was nothing to do.

At a family dinner later that year Jennifer and James both reminisce about their beloved grandfather and express appreciation for the bequest. Jennifer mentions, in passing, her filing of the IRS Form 3520. James responds: "What?"

IRS Form 3520 must be filed when a U.S. person receives more than $100,000 in a taxable year from a nonresident alien individual or a foreign estate. IRS Notice 97-34. The form is due on April 15 of the year after the gift. However, if your income tax return (IRS Form 1040) is on extension, you can file it as late as October 15. The penalty for late filing is 5% of the gift's fair market value per month, not to exceed 25% of the gift.

The IRC provides that the penalty will "not apply to any failure to report a foreign gift if the United States person shows that the failure is due to reasonable cause and not due to willful neglect." Will James be able to qualify for the "reasonable cause" exception?

Unfortunately, the answer may be "no." The U.S. Supreme Court ruled in United States v. Boyle, 469 U.S. 241 (1985) a taxpayer cannot avoid the failure to file penalty by relying on his advisor to file the return.

Jennifer refers James to her CPA. This CPA tells James, of course, to file the form. The CPA also feels James has a "reasonable cause" to excuse the late payment penalty ($200,000 X 25% = $50,000). After all, James (i) is not a sophisticated taxpayer and (ii) reasonably relied on his tax return preparer, who had full knowledge of all the relevant facts.

For the last few years, the IRS has automatically rejected reasonable cause statements and in fact, has not reviewed them. Instead: "If it is perceived late, it's penalized, even if you have a beautiful reasonable cause statement attached," according to David Price, formerly of the IRS Office of Chief Counsel.

Once James files the late IRS Form 3520 with the reasonable cause statement, the first thing he gets from the IRS is the CP 15 Penalty Notice. It informs him he is out of compliance, the Internal Revenue Code Section he has violated, the penalty amount (here $50,000), and how he can dispute the penalty. James has 30 days to respond to this notice.

One alternative: James can appeal the penalty. That will be before an IRS Appeals Officer. The advantage is he will not have to wait for a lien to be assessed against him. The disadvantage is he will have to pay the tax before a court hears his case.

The other alternative: request a Collection Due Process (CDP) hearing on Form 12153. That will be before a Settlement Officer. If James disagrees with the Settlement Officer, he can have his case heard in Tax Court possibly without paying the penalty. The downside is James must wait until he receives a notice (i) of an intent to levy or (ii) that a Notice of Federal Tax Lien (NFTL) has been filed. Those filings can have negative real-life implications, e.g., making it impossible to get a mortgage; preventing him from selling an asset. Liens are not issued in every case, so that is a risk of waiting for a CDP hearing.

A significant advantage of going to Tax Court is the judge will review the situation de novo. The Form 3520 penalty is not subject to the IRS deficiency procedures. Therefore, a taxpayer may be able to dispute the penalty in the CDP hearing and, without paying the penalty, seek review in Tax Court. Williams v. Commissioner, 131 T.C. 54 (2008); Gardner v. Commissioner, 145 T.C. 161 (2015). This route to prepayment judicial review is available only if James "did not otherwise have an opportunity to dispute such tax liability." IRC Section 6330(c)(2)(B).

James has alternatives to challenge the Form 3520 penalty other than a reasonable cause statement. For example, the "initial determination" to assess a penalty must be approved "in writing" by the "immediate supervisor" or a "higher level official as the Secretary may delegate." IRC Section 6751(b). Also, given the automatic imposition of the Form 3520 penalty, James may be able to challenge it under an "abuse of discretion" theory: was the "decision...based on a consideration of relevant factors and [was] there a clear error of judgment." Ocean Advocates v. Army Corps of Engineers, 361 F. 3d 1108 (9th Cir. 2004).

The penalties for failing to promptly file an international information return can be severe, and the ability to get an excuse for reasonable cause can be extremely limited. Hopefully, as the National Taxpayer Advocate suggested in her Jan. 12, 2022, "purple book," the IRS will change this approach before even more taxpayers are unfairly punished.