IRS changes foreign gift and inheritance filing penalty assessments

The IRS has recently implemented significant changes in response to taxpayer and practitioner concerns about the automatic assessment of penalties for late-filed foreign gift and inheritance filings.

Announced by IRS Commissioner Danny Werfel at the UCLA Extension Tax Controversy Conference, these changes aim to relieve taxpayer burden and provide a fairer approach to penalty assessments on foreign gifts, inheritances, and trust filings under the Internal Revenue Code (IRC).

Highlights of the IRS policy update

• No automatic penalties: Ending automatic penalties for late-filed Forms 3520 as well as 3520-A.
• Opportunity for reasonable cause: IRS will review reasonable cause statements before assessing penalties.
• Broader impact: Reduced burden on taxpayers who received foreign gifts or inheritances and those with foreign trust reporting obligations.

Background: the challenge of international information return (IIR) penalties

The US tax system relies on voluntary compliance, encouraging taxpayers to report income and assets accurately.

The IRC imposes penalties on those who fail to comply – often using a "carrot-and-stick" approach.

However, over the past decade, automatic penalties have disproportionately affected lower-income taxpayers, immigrants, and small businesses – individuals often unaware of complex reporting requirements.

What led to changes in IIR penalties?

The IRS’s initial automatic penalty policy applied IIR penalties as a deterrent against tax evasion.

However, it has often impacted well-meaning taxpayers who discovered errors and voluntarily filed late returns. High-income individuals and large companies typically avoid such penalties, while smaller taxpayers face substantial penalties that may exceed the unreported amounts.

Automatic penalty assessments led to financial hardship for many taxpayers, particularly those unaware of foreign gift and inheritance reporting requirements.

The significant abatement rate of these penalties – 67% for certain penalties – demonstrates the high frequency of erroneous assessments and the undue burden on taxpayers.

Foreign gift and inheritance filings: what’s changed?

Understanding the reporting requirements for foreign gifts and inheritances

Under IRC § 6039F, US individuals who receive large foreign gifts or inheritances must report them on Form 3520, Part IV.

Despite being tax-free, these gifts and inheritances trigger reporting obligations, which taxpayers often overlook due to the non-taxable nature of the income. Failing to report on time has previously led to substantial penalties.

Ending automatic penalties on foreign gift filings

Effective immediately, the IRS will no longer impose penalties automatically for late-filed Form 3520 reports on foreign gifts and inheritances.

Taxpayers can now attach a reasonable cause statement explaining their situation, which the IRS will review before assessing penalties under IRC § 6039F.

How this helps taxpayers

This change will prevent automatic penalties that can reach up to 25% of the gift’s value, providing taxpayers time to comply with reporting requirements if they initially miss the deadline.

Notably, this revision aims to relieve the heavy financial penalties that lower-income taxpayers often face, reducing unnecessary hardship for those who voluntarily come forward.

Foreign trust reporting: changes in penalty assessment

Reporting foreign trust activity

IRC § 6048 requires US taxpayers to report specific events involving foreign trusts using Forms 3520 and 3520-A, Parts I–III. If these forms are filed late, the IRS typically imposes penalties under IRC § 6677.

New policy on reasonable cause review

Previously, the IRS automatically assessed penalties for foreign trust filings without considering reasonable cause statements, even if taxpayers provided explanations attached to their forms.

Taxpayers often had to contest these penalties through the Independent Office of Appeals, resulting in many penalties being abated upon further review.

From now on, the IRS will consider any reasonable cause statements provided before assessing penalties.

Impact on taxpayers and IRS workload

The IRS’s decision to consider reasonable cause before penalty assessment should lessen the burden on taxpayers and reduce the volume of appeals cases, streamlining both taxpayer and IRS processes.

This change reflects an effort to balance taxpayer rights with compliance requirements, helping lower-income taxpayers and small business owners who may lack the resources to contest penalties.

Broader implications and remaining challenges

While the recent changes to Forms 3520 and 3520-A penalty assessments are beneficial, advocates believe more needs to be done.

The automatic assessment of IIR penalties continues to affect other types of filings beyond foreign gift and trust reporting, creating a burden for taxpayers who lack the means to challenge penalties pre-assessment.

Advocates encourage the IRS to expand these protections across all IIR penalties, ensuring taxpayers can present reasonable cause defenses with an opportunity for administrative review before any penalty is assessed.

Conclusion: a step forward for fairer tax enforcement

The IRS’s decision to end automatic penalties on foreign gifts, inheritance filings, and foreign trust reporting marks a positive shift in tax policy.

By allowing taxpayers to submit reasonable cause statements, the IRS shows a commitment to promoting voluntary compliance while reducing undue financial strain on lower-income individuals and small businesses.